This GT Advisory shares practical guidance on insuring tax risks in the context of M&A transactions, with a particular focus on warranty and indemnity (W&I/R&W) and specific tax risk insurance. Drawing on experience from the UK and European markets, it sets up five top considerations for understanding the insurer’s perspective, presenting tax risks clearly, considering coverage holistically, avoiding common pitfalls, and preparing for potential claims scenarios.
1. Understand the insurer’s perspective
Understanding the insurer’s position is key to getting and improving good tax coverage. This is especially true for W&I insurance. The insurer is often described as “stepping into the shoes” of the seller but, in reality, the insurer has far less visibility and a different risk/reward calculation. Quantum of the risk can be as important as the risk rating when an insurer is determining whether it can take on a particular risk.
The insurer does not have the seller’s knowledge of the target’s historic tax risks. In fact, the insurer often has even less visibility than the buyer: the insurer is typically relying on a tax due diligence report and responses to underwriting questions, whereas the buyer usually has direct involvement in the due diligence process and access to management.
The risk/reward is also different. A seller in an uninsured deal might well be willing to stand behind an indemnity for a particular tax risk rather than accept a price reduction, especially if they are confident in the technical position the target has taken during their period of ownership. On a £100m deal with a £1m potential tax risk, it is entirely understandable that the seller might offer an indemnity in the hope that the tax liability never arises and they get to keep the full £100m. By contrast, a W&I insurer in the same scenario will be getting a policy premium that is a small fraction of the deal value (for example, for a policy limit of £20m the premium could be comfortably less than £200k) but is exposed to the full £1m tax risk if they cover it. The seller has (broadly) symmetrical risk/reward; the insurer has asymmetric risk/reward.
In that context, arguing that the W&I insurer should cover something solely on the basis that a seller would stand behind it in an uninsured deal may not be successful.
Instead, if the insurer does raise concerns around a particular tax risk, consider focusing on how to bridge the gap to get the insurer comfortable. The quality of the tax due diligence – or, in the case of a specific tax risk policy, the tax opinion – is (obviously) paramount, but the importance of meaningful engagement with underwriting questions can often be overlooked, especially under the pressure of a tight deal timetable. Resist the temptation to simply refer an insurer back to a section of a tax due diligence report they have already reviewed; good underwriters rarely raise specific questions that are already fully answered in the due diligence report. Sometimes all that is needed is some additional clarification; other times more detail on the technical analysis might be required. Where a direct response on the technical position is not possible, bear in mind that good underwriters are pragmatic and practical comfort can also go a long way.
For example, an insurer may be willing to cover out of scope jurisdictions to some extent based on practical comfort on, say, profits (corporate income taxes), revenue (VAT, sales taxes, etc.), gross salary cost and number of employees (payroll taxes). Some insurers can be very pragmatic on identified tax issues, such as imported mismatches under anti-hybrids rules, based on a discussion of the likely range of scenarios in practice even where the factual position is unclear (provided the issue is viewed as “low risk” on the available facts). Where the due diligence is more limited in a particular area or has identified more ‘systemic’ (but comparatively minor) compliance concerns, exploring sub-limits or higher retentions for specific tax risks might be another potential path through to obtaining (some) coverage.
Specific tax risk insurance is, by its nature, very different to general coverage of tax risks under a W&I policy. That said, the same principles apply to presentation of the risk to the market, handling underwriting questions and negotiating the terms of the policy (including representations and limitations).
2. Present tax risks clearly
The more clearly tax risks are presented, typically the easier and faster it is to get good cover for them. This is true for both W&I and specific tax risk insurance, but for the latter it can make all the difference to whether insurers are willing to provide terms for a specific tax risk at all.
Thorough analysis (or due diligence) provides comfort in and of itself, even if it is far from ‘clean’. Insurers often take comfort from the quality of review and, generally speaking, are more willing to take on risks when they have a better sense of the range of possibilities. This can be particularly pertinent for specific tax risks. Considering a range of competing analyses, for example, can bolster the credibility of the adviser’s conclusion on the ‘correct’ analysis.
This can also reduce the risk that an insurer quotes a risk based on a light-touch analysis, only to discover issues or concerns in underwriting that require the scope of cover to be narrowed or, in a worst-case scenario, to decline to provide cover at all. This can result in lost costs for the prospective insured, as underwriting fees are not conditional on signing the policy.
This will be a balancing act that is specific to the facts and the nature of the tax risk. It is legitimate to present a tax risk in the best light possible and to seek to avoid creating undue concerns by including more niche potential analyses, but if ‘bad’ or unhelpful facts have not been presented and then come out in underwriting, the underwriters may lose confidence in the risk . Likewise, the depth of analysis will need to consider the cost relative to the quantum of tax risk, but a standard due diligence report will typically not have sufficient detail or analysis for an underwriter to evaluate more complex or higher quantum risks.
It should also be remembered that in the UK the insured has a duty to make a fair presentation of the risk to the insurer and that failure to do so could undermine or vitiate the insurance cover.
3. Consider cover holistically
It is important to look at tax coverage in the round, with particular focus on the impact of exclusions and any policy enhancements.
In W&I policies, historically the ‘actual knowledge’ and ‘disclosed’ exclusions in particular have caused issues and uncertainty for tax coverage.
In the past, the broad drafting of both exclusions (and related defined terms) meant has been a concern that issues flagged in tax due diligence as risks could be excluded, even though there would be no suggestion of an insured making a claim under the policy unless a tax authority later challenged the legitimate filing position. This is a particular issue for tax because there are often a range of interpretations and a spectrum of risk, so it is common for various ‘risks’ of tax liabilities to be identified in tax due diligence, even though the position taken is not ‘wrong’ per se. In those circumstances, a key concern is language that could exclude a claim where the “facts, matters or circumstances” (often referred to as “FMC”) that ultimately gave rise to the liability were known or ‘disclosed’ at the time the policy was put in place.
Those concerns have reduced in recent years thanks to the narrowing of the ‘actual knowledge’ and ‘disclosed’ exclusions to be closer to what one would expect, generally by removing the FMC references in both the exclusions themselves and from the definition of what constitutes a “Breach” that can give rise to a claim under the policy. As a result, there may be more specific exclusions in W&I policies than was the case historically, as a greater range of identified issues may not be caught by the new, narrower drafting. Drafting varies between insurers, though, so it is important to consider the wording in each case – for example, some policies still use FMC language in relation to tax covenant claims.
It is also important to consider any policy enhancements in the round, together with any knock-on changes to the policy.
For example, ‘affirmative cover’ may be available for tax risks flagged in tax due diligence, typically for an additional premium. The purpose of affirmative cover is usually to clarify that if a tax liability arises in the future, that liability is not excluded from cover simply because the due diligence report highlighted a risk of a tax authority challenge that could give rise to that tax liability. The drafting of ‘affirmative cover’ wording itself can vary significantly, with potential for meaningful impact on how much it improves cover. Given the general narrowing of the ‘actual knowledge’ and ‘disclosed’ definitions across the market, there might also be less need for affirmative cover as a technical matter depending on the exact drafting of the exclusions. That said, the clarity can provide comfort to the insured and, as discussed in #5 below, might be valuable in a claims scenario.
Other popular enhancements in a W&I context include ‘no general disclosure of the data room’ and ‘no disclosure of due diligence reports’. These are base positions in R&W insurance in the United States but they are not standard in Europe. It is not always possible to get both enhancements together, but it is worth considering them as a package. For example, the findings expressed in due diligence reports are typically based on documentation that is included in the data room, so non-disclosure of due diligence reports as an enhancement may be less valuable on its own than when paired with non-disclosure of the data room.
If under a W&I policy the due diligence reports are disregarded for the purpose of disclosure, there may be more specific exclusions in the policy to deal with items that are disclosed in the due diligence. This may make coverage appear worse than without that enhancement. However, it may be helpful for a buyer in creating certainty. Insurers are often pushed by brokers for “clean” policies (i.e. with as few specific exclusions as possible) and to rely instead on risk items being excluded under the ‘disclosed’ exclusion (despite the narrowing of that exclusion in recent years, as discussed above). This can result in disagreements after the event where insurers do not believe that they are providing cover for certain risk items but the buyer assumed (absent a specific exclusion) that they were ‘covered’ and so did not realise that those risks should be included in pricing discussions with the seller. An insured may prefer an insurance product where there is less scope for surprises down the line on what is and isn’t covered – it is essential, therefore, to consider whether a risk might fall within the ‘disclosed’ exclusion, even if it is not the subject of a specific exclusion.
The focus in a specific tax risk policy will be in defining the risk that is to be insured, but there are still other terms that should be considered for assessing the quality of coverage. In particular, it is important to ensure that, as far as possible, representations are limited to factual statements which have been verified. If representations are untrue, that may vitiate cover under the policy. Conduct rights in the event of challenge are also important: the insurer is rightly only concerned with the risk they have taken on, but the insured should take into account reputational aspects and any wider group concerns (for fund managers, this might also extend to similar positions taken on entirely separate structures where a consistent approach has been adopted).
4. Be mindful of potential bear traps
The diverse range of fact patterns and policy wordings means that there can be various bear traps for the unwary, especially on W&I insurance. As some examples:
- Affirmative cover – as discussed in #3 above, the precise drafting can make a real difference to the quality of cover.
- Voluntary acts – remember that tax triggered by voluntary acts will typically be excluded, so the insured should keep that in mind throughout the life of the policy. If any post-completion restructure is envisaged at the time of the transaction, it is worth exploring whether the insurer will agree to a specific carve-out in the policy to prevent that being a voluntary act for those purposes.
- Conduct and hybrid cover – it is always worth factoring in that the W&I insurer will need to be kept informed and given conduct rights in relation to any tax enquiries and disputes. That can be particularly complicated if the seller provides an indemnity outside the £1 cap for certain tax risks. In those scenarios, it is worth considering how the seller’s indemnity will apply if there is any conflict between the seller’s conduct rights for a specific indemnity and the W&I insurer’s conduct rights (e.g. if there is a general enquiry that potentially spans issues covered by both the W&I policy and the seller’s indemnity).
- Carve-out transactions – where the target group is being carved out of a wider group that will remain owned by the seller, the impact of leaving tax groups (e.g. VAT groups, loss relief groups, corporate interest restriction (CIR) groups, Pillar 2 groups, etc.) will need to be considered carefully. For some types of tax grouping, there are fairly standard SPA provisions for dealing with the transitional arrangements and associated tax returns. Typically, though, such standard SPA provisions do not take account of potential interactions with a W&I insurance policy (or, indeed, pricing adjustments). It is worth checking that any transitional mechanics, even where in a standard form, dovetail with the W&I cover and pricing mechanics.
- Non-disclosure of due diligence reports and/or data room – as discussed in #3 above, it is worth considering the overall effect if these are not available as a package, as well as the impact of the no claims declaration including a representation that the deal team has read and understood the due diligence reports.
5. Imagine advising in a claim scenario
Insurers have an increasingly strong track record of paying claims. Clearly, though, there will still be scenarios where claims take a significant time to be paid or are denied entirely. Insurers will not be minded to settle a dispute with a tax authority where they have put confidence in the tax analysis, whereas, understandably, insureds will be keen to settle for a good price and move on.
A specific tax insurance policy should typically be clear-cut, and if the risk does crystallise into a tax liability it should be clear that it is covered. In theory, that is true; in practice, it can depend on how clearly defined the risk is in the policy. It also assumes that the accuracy of representations given by the insured are not called into question.
For example, if it is a complex risk where there are multiple potential points of challenge, the insured will want the specific tax insurance to respond in all of those scenarios. Close attention should be paid to the drafting of the definition of the insured risk. The more clearly the insured risk is defined, the greater the likelihood of an insurer confirming cover and making payment promptly.
The same logic also applies to W&I policies. Again, clarity is key. As already discussed, the range of legitimate interpretations and analyses can mean that there is less clarity over tax cover than other areas. Clarity in the policy drafting maximises the chance of an efficient claims process. If, for example, a tax risk is to be affirmatively covered, all aspects of the policy (including enhancements) should be consistent with that, or the affirmative cover should be drafted so that it takes priority.
It is also worth bearing in mind that the individuals underwriting the policy will not necessarily have any involvement in handling any future claim. Timing and cost permitting, there can be real value to the insured in obtaining additional clarity on any agreed interpretations or understanding in writing as part of the policy wording.