When Is Reps & Warranties Insufficient For Tax Exposures?

A Discussion with Concord Specialty Risk Regarding the Coverage Afforded Under R&W Policies v. Tax Indemnity Policies

Tax indemnity coverage is no longer sitting in the shadows. Although tax insurance pre-dated the existence of R&W insurance, it nevertheless sat dormant for decades while R&W insurance grew slowly and then exponentially. Over the past two years, however, with the use of tax coverage to facilitate equity investor tax credit transactions, the coverage made its way into the spotlight and has been enjoying consistent growth ever since. 

Within the M&A context, however, tax insurance is still not as prevalent as it should be or could be. One reason is that R&W insurance covers a significant portion of the tax exposures of the target by covering the tax rep. Another reason is that most buyers historically obtained a comprehensive tax indemnity from the seller which goes beyond the coverage typically afforded under a R&W policy.

R&W insurance covers a breach of the tax rep but may not track the full scope of the tax indemnity. Tax reps are modified by items disclosed in disclosure schedules as exceptions to the reps.  Therefore, these items cannot give rise to a breach of the tax rep and are therefore not covered under the R&W policy. Typically, the parties allocate the risk of disclosed items by either adjusting the purchase price (to allow the buyer to take the risk) or obtaining a separate indemnity from the seller for all pre-closing taxes regardless of whether the tax rep was breached. Tax insurance can be used to cover the tax indemnity (or one or more specific items disclosed as exceptions to the tax reps). On occasion, such as when the exposure is viewed as a fraction of the retention, the matters may be covered under the R&W insurance via a specific coverage expansion. 

We thought it would be helpful to have the benefit of an underwriters’ perspective on how both types of policies should be viewed as respects tax matters and, specifically when separate tax policies should be considered. We approached David S. De Berry, CEO of Concord Specialty Risk, one of the top insurers of R&W Insurance and the industry leader in tax indemnity insurance, to get his perspective on tax risks and how best to address them.

---

Q1. (NR): What tax risks are covered under an R&W policy? 

A1. (DD):  Generally, R&W Insurance covers the representations and warranties made regarding a target company’s historical taxes and tax liabilities. The representations may include statements regarding the target’s historical tax return practices: that state and federal returns were timely filed in all required jurisdictions; that the returns were complete and accurate; that required taxes were paid; and, that the target is not aware of any audits or pending audits.  Representations may also cover more specific issues regarding the target’s historical withholding practices (as respects employees and independent contractors, for example), as well as representations that the target has not engaged in any “reportable transactions” and is not liable for the taxes of others.

Depending upon the definition of “Loss” under the R&W Insurance (and perhaps how loss or damages are defined in the underlying merger or stock purchase agreement), R&W Insurance may also cover pre-closing attributes and characterizations inherited or adopted by the buyer in its post-closing tax filings. The target’s asset basis being amortized, or its employee/independent contractor classification for payroll withholding are all examples of pre-closing attributes. However, other attributes – – such as net operating loss carry forwards are typically excluded, which may give rise to the need for a tax indemnity and/or a tax insurance policy. 

While most stock purchase agreements define “losses” as damages, liabilities, obligations, and expenses…,” occasionally (perhaps at the prodding of tax counsel), “losses” may include any reduction in tax attributes (such as net operating losses), which further broadens the scope of the representation and loss for its breach. 

Q. How does a tax indemnity in a PSA differ from the indemnity related to the breach of the tax rep?

A. The tax indemnity will contain indemnification provisions addressing both breaches of the tax rep as well as all pre-closing tax liabilities (known or unknown) owed by the seller. As noted earlier, the separate tax indemnity covers the broad tax representations as if not qualified by what has been disclosed in the Disclosure Schedules. Either the tax rep or the tax indemnity will typically include that no taxes not reserved as of closing will be owed for the pre-closing period on the tax returns filed post-closing.  The tax covenants also typically address cooperation, refunds, future audits, withholding taxes, and certain post-closing conduct. 

The tax indemnity may also expand “taxes” to include transfer taxes and may expand “loss” so that, for example, a post-closing tax year that relied upon a pre-closing tax year attribute (such as NOLs or the tax basis in assets that may be depreciated or amortized) can give rise to loss if the attribute is challenged. 

Q. With respect to NOLs and transfer pricing risks- -which are the only tax matters that are routinely, specifically excluded under many R&W policies- -why are these matters not covered under the R&W policies, despite a “clean” diligence review? 

A.  Many R&W Insurance underwriters share the view that certain tax positions require a very in-depth analysis before they can be substantiated. For example, net operating losses may entail a consideration of the tax returns that gave rise to the operating losses, which may require an analysis of revenue recognition, debt vs. equity, capitalization vs. deductible expenses, consolidated return rules, etc.  In addition, net operating losses are subject to limitations in the event of an “ownership shift.” This requires a detailed review of stock ownership for all appropriate testing periods. Similarly, transfer pricing often entails a review of “contemporaneous documentation” setting forth the best method for determining arm’s length pricing to determine the legitimacy of the pricing charged between the target’s subsidiaries and/or divisions.  Incidentally, other tax matters may be viewed as too inherently complex for R&W Insurance.  Tax liability stemming from the target’s prior acquisition of a member of a consolidated group or from a “permanent establishment” in a foreign jurisdiction, previous restructurings (including a worthless stock deduction, a prior tax-free spin-off, or a refinancing, etc.), or whether a foreign subsidiary is a passive foreign investment company or incurs Subpart F income, may also fit within the grouping of tax positions that are inherently complex and require in-depth review in order to confirm the accuracy.  

For these inherently complex tax positions, the view is that the parties may not have invested the full effort required to substantiate the tax position and/or that the position is beyond the intended scope of R&W Insurance (which, in candor, may mean beyond the kin of the R&W Insurance underwriter, who is not a tax specialist and does not wish to retain a tax specialist within the pricing structure of R&W Insurance, or beyond the type of risk that an insurer or its reinsurer contemplated it would take on when it entered into R&W Insurance).  Tax insurance stands ready to fill the void.

Q. Some R&W policies will not expressly exclude and/or will remain silent regarding NOLs and transfer pricing risks, implying coverage. Are there reasons why the policy would not respond to losses arising from such matters?

A. When R&W Insurance is silent as to tax indemnity and contains no specific exclusions, the R&W Insurance is generally covering the tax representations, subject to other standard exclusions such as matters disclosed in the Disclosure Schedule, the “actual knowledge” (no breach) exclusion, and perhaps the purchase price adjustment. All or none of these standard exclusions could be applicable, depending on the circumstances. If the parties are at the NBIL stage, they should be concerned with what, if any, tax matters will be raised in the buyer’s tax due diligence and/or by the seller in its draft disclosure schedules.

Q. What are some of the more common insurable tax issues arising in M&A transactions that Concord has insured? 

A.  Without question, issues concerning Subchapter S status predominate. Other issues that are common to tax indemnity insurance include: executive compensation, deferred compensation, prior restructurings or recapitalizations, withholding taxes, preservation of tax attributes (particularly net operating losses), debt vs equity, and expected deductions and losses to be reported during the stub or straddle period.

Q. Do you require opinions to insure these specific risks? What type of diligence do you require to underwrite a risk?

A. We do not require an opinion, but if an opinion was issued, we generally desire to review it pursuant to a common interest agreement.  The tax due diligence will be tailored to the tax uncertainties sought to be insured.