Beyond M&A Risk Management: The Expanding Role of Transactional Liability Insurances in Lending and Taxation – Q2/24
Originally driven by the complex domain of International mergers and acquisitions (M&A), there has been a significant and steady incline in the adoption of buy-side warranty and indemnity (W&I) insurance policies. This trend is largely attributable to the dominance of acquisition frameworks that feature limited recourse for buyers and the attractive, increasingly flexible terms that insurers now offer.
This article provides an overview of W&I insurance as collateral security and looks at the treatment of certain tax risks from an operational (non-transactional) perspective.
W&I Insurance in the M&A context: Strategic Exit and Financial Distribution
Sellers, particularly those in the realm of private equity, favour W&I insurance as it facilitates a smoother transaction exit. This enables the quick distribution of sale proceeds without the entanglements of potential claims. For private equity sellers bound by the stringent conditions of their fund agreements, which often prohibit the assumption of SPA liabilities or necessitate immediate capital distributions to investors, W&I policies that exclude seller recourse—despite carrying a higher premium—become an attractive option. Such policies not only expedite the closure process but also align with the investors’ expectations for swift financial returns, enhancing the appeal of the investors’ operational strategies.
The treatment of operational and financing perspectives often provides grounds for different uses of W&I or the application of other transactional insurances in a non-transactional context.
For financial institutions financing M&A deals, a robust W&I policy adds a layer of security to their investment. The existence of a well-constructed W&I policy should be an attractive prospect from the perspective of lenders financing an acquisition and a key element of their security package. Notably, if a target business becomes distressed after acquisition, a claim under the W&I policy may be the only remaining asset that provides a route to a recovery. Consequently, it is essential for lenders to ensure that the security over these claims is properly structured and enforceable. The intricate nature of these policies demands that lenders engage in detailed scrutiny of the policy’s terms and conditions to ensure alignment with their security needs. The first step in leveraging a W&I policy effectively is for lenders to conduct a comprehensive review of the policy alongside the SPA. This is crucial as the lender’s rights under the policy can never exceed those granted to the buyer. Coverage and Exclusions: At its foundation, a W&I policy should cover claims related to the seller’s representations and warranties under the SPA, albeit with certain exclusions and the possibility of enhancements. The policy will usually detail the extent of coverage for each warranty or indemnity, identifying which are insured outright and which are subject to amendments or exclusions. Common exclusions might include known risks, forward-looking statements, buyer fraud, secondary tax liabilities, pension scheme funding shortfalls, or other deal-specific risks inadequately vetted during due diligence. Additional Coverage Options: It is possible for buyers to obtain supplemental coverage for risks that exceed the standard policy limits, such as fundamental warranties about the legal and beneficial ownership of shares. These risks might be covered under a separate title insurance policy, and buyers may also opt for enhanced terms for an additional premium, which can provide broader coverage than the warranties specified in the SPA. Policy Assignment Considerations: While most W&I policies permit the assignment of claims proceeds to third parties providing financing, lenders must confirm this ability and ensure compliance with the policy’s specific requirements for such transfers. It’s vital to check that the security agreement aligns with any stipulated policy conditions to effectuate an assignment, like using a designated notice form to the insurer. It is imperative to restrict such an assignment to the rights to the proceeds from claims, rather than transferring the entire policy. A full transfer could inadvertently transform the assignment into a novation of the insurance contract, potentially leading the insurer to deny claims based on a lack of insurable interest by the new policyholder. Thus, the term “assignment” should be clearly limited to the rights to the proceeds to avoid any ambiguity. Provided the policy terms do not prohibit it, an equitable assignment of rights to the proceeds can be converted into a statutory assignment by complying with the conditions outlined in section 136(1) of the Law of Property Act 1925. This involves providing written notice of the assignment to the insurer. Transforming an assignment into a statutory form is advantageous as it allows the assignee (the secured party) to initiate proceedings against the insurer directly for non-payment of the claim proceeds without needing to involve the original policyholder. Challenging Policy Terms: Any entitlement to claim amounts under the policy is always contingent on compliance with the policy’s terms. Lenders evaluating the security value of an assignment should be wary of onerous conditions, such as stringent claims reporting requirements or restrictions on third-party settlements that allow insurers to avoid liability. Premium Payment and Policy Activation: The effective activation of most policies hinges on the timely payment of a premium, usually a lump sum due at the completion of the transaction or shortly thereafter. It is crucial for lenders to have certainty that the premium has been paid, as the policy will not cover risks if this condition is not met. This may be a stipulated requirement of the SPA, or, if the policy necessitates post-completion payment, this should be addressed as a condition subsequent to the facilities agreement. Liability Limitations and Retentions: W&I policies often include liability limitations such as a “de minimis,” which is the threshold loss amount necessary to trigger coverage. This threshold is frequently aligned with the materiality thresholds used during due diligence. Once this threshold is reached, the policy may fully cover the loss, although some policies only cover losses exceeding this amount. Additionally, policies typically require the buyer to absorb a certain aggregate proportion of claims under an aggregate retention. Furthermore, the overall liability limit under W&I policies is commonly set between 10% and 30% of the transaction value, except in certain asset-heavy transactions where additional top-up cover might be obtained. Excess Policies: For higher limits of liability, it is common for buyers to secure additional coverage from other insurers via excess policies. If such policies are in place, it is critical to ensure that any security interests extend to these excess policies as well, and that direct notifications are made to those insurers to maintain alignment with the terms of the primary policy. Security Structuring: Ensuring Effective Assignment: Lenders generally prefer to secure an assignment of the buyer’s rights under the W&I policy, typically as a mortgage over those intangible rights. The documentation for such an assignment, when dealing with an English company as the buyer, usually forms part of the broader English law ‘all asset’ debenture granted by the buyer. This occurs concurrently with the signing of the SPA and facilities agreement. In the intricate negotiations and structuring of M&A transactions, securing a robust interest over a W&I policy is increasingly critical. This security interest often represents a significant safety net in adverse scenarios where the policyholder and/or the target business have become financially distressed, and the warranties and indemnities in the SPA have been breached, giving rise to recourse under the policy. Tax liability insurance is designed to address a very specific circumstance rather than provide general coverage. It protects a taxpayer against the failure of a tax position in connection with a transaction, reorganization, accounting treatment, investment, or other type of taxable event. Specifically, it covers the taxpayer’s loss if the applicable taxing authority deems you have a greater tax liability than what you’ve claimed. Tax liability insurance can cover a particular transaction, such as an investment in renewable energy, or the tax treatment of a non-transactional situation, such as restructuring or simply the preparation of annual tax statements. Oftentimes, requests for insurance have been driven by new legislation which lacks clarity, precedent or guidance, new case law creating uncertainty, or even growing tax authority aggression. Furthermore, exchanges of tax rulings/information has motivated taxpayers to seek protection against the increased risk of challenge. Tax insurance is a highly bespoke product. Premiums reflect the likelihood of a challenge being made by a tax authority in practice, with rates generally fluctuating between 1.5% and 8% of the limit of liability. For matters already before a tax authority, 8%+ is normal. Practical examples of tax liability insurances can provide an overview of different types of transactional and non-transactional use of such products. Value Added Tax (“VAT”) Application of incorrect VAT rate towards a given transaction: this risk is especially high in case of so-called comprehensive services whereby there is a main service and secondary service(s) or in case of reinvoicing of services, such as VAT risk management for Real Estate transactions. In some countries, accurate recognition of tax implications of transfer of real estate which is not considered as transfer of enterprise or its organized part – such transaction may be recognized as (i) subject to VAT, (ii) subject to VAT exemption with possibility to opt VAT taxation, (iii) subject to VAT exemption without possibility to opt VAT taxation. Capital Gains Tax Capital gains tax on sales by foreign shareholders of certain Polish RE rich companies, to be withheld by such RE rich company – exemption from tax under relevant DTT. Intellectual Property Taxation of Intellectual Property (“IP”) and non-pecuniary assets In some cases it is possible insuring a reclassification risk that special, more favourable than standard method of accounting for certain earned income related to intellectual property. Furthermore, the circumstances that specific provisions on taxation of transfer of non-pecuniary assets as a result of economic operations (e.g. redemption of shares, liquidation of a company, etc.) were not applied can be insured. Withholding Tax (“WHT”) Withholding tax on interest/dividends/royalties paid to foreign companies on cross border deals can result in exemption or preferential tax treatment which, in some jurisdictions, is often challenged by the tax authority. Thin capitalization Insurance against risk that tax deductibility of financial costs was not excluded based on thin-cap regulations. Tax neutrality of share for share exchange In case there is no or limited business rationale for the restructuring, some European tax authorities may try to (i) challenge tax neutrality of the share for share exchange and (ii) challenge tax step up which may be achieved as a result of share for share exchange. Reclassification of B2B contracts into employment contracts Insuring a potential challenge of engagement structures for board members, whereby their remuneration is split into 2 separate streams: (i) remuneration for management or supervision paid under resolution or management contract and (ii) remuneration for advisory duties paid under B2B contract. Risk at the side of the employer, due to the fact that it is the employer who performs the function of tax and social security & health insurance contributions remitter in case of employment contract and management contract. Such income is subject to progressive taxation and full social security & health insurance contribution instead of flat rate or lump sum taxation which may be opted in case of income from business activity. For specific groups of employees (e.g. IT programmers, employees from R&D departments) preferential taxable costs may be applied amounting to 50% of revenue for transfer of copyrights from an employee to its employer. General Anti-Avoidance Rule (“GAAR”) risk GAAR applicability may be avoided in case there are strong business reasons for conducting the transactions or business operations. The expanding role of transactional liability insurances, including Warranty and Indemnity (W&I) and tax liability insurance, underscores their growing importance in today’s complex financial landscape. W&I insurance provides crucial protection in M&A transactions, facilitating smoother exits for sellers and offering essential security for buyers and lenders. For lenders, a well-structured W&I policy serves as a valuable asset, enhancing the stability and attractiveness of their investments. Concurrently, tax liability insurance addresses specific tax-related risks arising from ambiguous legislation, aggressive tax authority actions, and evolving case law, offering tailored coverage for various scenarios from VAT and Capital Gains Tax to Intellectual Property and Withholding Tax. As businesses and individuals navigate these intricate financial and tax challenges, transactional liability insurances offer indispensable risk management tools, ensuring financial predictability and compliance while supporting strategic financial operations. Matrix are authorised and regulated by the Financial Conduct Authority. ” This security interest often represents a significant safety net in adverse scenarios where the policyholder and/or the target business have become financially distressed, and the warranties and indemnities in the SPA have been breached, giving rise to recourse under the policy. “ Dr Gergely Juhász is a Mergers and Acquisitions and Transactional Liability Insurance expert with broad experience in structuring insurance and legal solutions for the international financial services markets. Before joining Matrix, Gergely was both a transactional lawyer and an underwriter of W&I insurance, as well as an independent broker of transactional liability insurance products. As a transactional and finance lawyer, Gergely started his career at a Magic Circle law firm. A member of a market leading underwriting team in London, Gergely was one of the early contributors to the W&I insurance market. Gergely built a pan-European transactional liability insurance platform, offering more experience and more flexibility to clients than other market stakeholders. Gergely’s work experience spans across continents, with main transactional activity focused on Europe, Africa and the UK.W&I Insurance from the lenders perspective: W&I Insurance as collateral security
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Taypayers Perspective: Tax Liability Insurance on the Rise
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