The tax drawbacks of W&I insurance-backed transactions

On the face of it, W&I-backed transactions are helpful for both a buyer and a seller. The seller’s liability is capped, often at just £1, and the buyer is covered for many risks by the insurance policy. Such transactions are, however, not always appropriate from a tax perspective.

W&I policies contain many exclusions, meaning that a buyer is often left with a choice of seeking cover from the seller outside of the £1 cap, taking out a specific tax insurance policy or, even worse, accepting they have no protection at all for certain tax risks. As a result, a buyer should not automatically assume that a W&I-backed tax deed is appropriate for their transaction.

What are W&I transactions?

Typically, when an M&A transaction is covered by W&I insurance, the seller’s liability under the transaction documents, including the tax deed, is capped at a limited sum. This liability cap is usually just £1 - although it can also be set at minimum threshold under the W&I policy.

W&I insurance is most often taken out by the buyer, with the insurance provider essentially stepping into the shoes of the seller. This means that, in general, the buyer’s only means of recovery if there is a claim under the transaction documents is to claim under the insurance policy. It is rare – although still possible – for a seller to take out W&I insurance and to claim under the insurance policy should the buyer make a claim against the seller under the transaction documents.

The tax deed and tax warranties in the share purchase agreement are negotiated between the buyer and seller as normal. The transaction documents, together with the disclosure letter and due diligence reports, are then sent to the insurance provider. The provider produces a policy document detailing which provisions in the documents it is, and is not, willing to provide cover for – as well as any other risks it wishes to exclude.

Tax deed provisions

Generally, parties must negotiate before arriving at the agreed form of tax deed, and the fact that the seller’s liability is capped at £1 may impact on the drafting of many of its clauses.

Indemnities

Unless the buyer is seeking a specific insurance policy or coverage from the seller outside of the £1 cap it is rare to include specific tax indemnities.

Exclusions

The number of exclusions from liability under the tax deed and tax warranties will typically be shorter than in a standard, non-W&I tax deed. For example, an exclusion stating that the seller is not liable under the tax deed or tax warranties if a relief is available to eliminate the liability, or because the buyer has not complied with the conduct of claims provisions, is not appropriate, or necessary, when the seller’s liability is capped at £1.

Conduct of claims and tax returns

It is not usually considered appropriate for a seller to have any input into the conduct of a tax claim or the drafting of the tax returns of the target company, since this could potentially cut across the insurer’s rights and will not be accepted. If the seller is giving coverage for a specific issue outside of the £1 cap, then the position will be different, and the seller would seek greater conduct rights. In an increasingly common compromise, a seller can be given rights to comment on the conduct of a tax claim or drafting of a tax return where it is reasonably likely to impact on the seller’s own tax position.

Third party recovery, overprovisions and savings

Third party recovery, overprovisions or savings clauses are rarely included in a tax deed in a standard, £1 cap W&I deal. The insurance provider may want the buyer to recover from a third party where possible, and require overprovisions and savings to be offset against claims under the policy, but these should not be provisions a seller is requiring from a buyer when the seller’s liability is capped at £1.

Buyer’s covenant

The buyer’s covenant is one of the more contested clauses in a W&I-backed tax deed. Some practitioners and sellers do not offer the covenant as a rule because the buyer does not have cover for secondary liabilities under the tax deed, due to it being a standard exclusion from a W&I policy. Others consider the buyer’s covenant to still be equitable given that it will only apply where the target company or target group fails to pay its tax on time.

The covenant only takes effect in very limited circumstances, and it is within a buyer’s control to ensure that tax is paid on time after completion of the transaction. Those in favour of including a covenant will argue it is not unreasonable for a seller to ask for comfort that the target’s tax will be paid on time after completion. Therefore, provided that an appropriate cap on the covenant is agreed, a buyer may be comfortable with including this clause in a W&I tax deed.

‘Hybrid’ tax deeds

‘Hybrid’ tax deeds are becoming increasingly common if a seller wants to offer any coverage outside of the £1 cap. These are a mixture of a fully negotiated tax deed and one that is subject to a £1 cap. In this context, increased exclusions and seller protection clauses are expected, covering only the specific indemnities that the seller is standing behind.

W&I coverage

A W&I policy aims to provide coverage for any unknown tax liabilities which may be assessed on a target group. Typically, the policy will cover a period of seven years from completion, which mirrors the market standard time period for bringing claims under a tax deed. The scope of the policy will be different for each transaction and will depend on the requirements of the specific provider and the risk profile of the target. However, there are some matters which appear to be standard practice amongst providers. Broadly, there are three categories of risks which are excluded from a W&I policy.

Standard exclusions

Standard exclusions cover loss of a tax asset, secondary liabilities and transfer pricing. These three issues are viewed by insurers as difficult to assess through due diligence and also – particularly in the case of tax assets and secondary liabilities – potentially affected by actions of third parties.

General exclusions

While a buyer might expect that there will be certain matters which the W&I policy will not cover, it is often a misconception that only a few, specifically listed carve-outs will apply in respect of tax. Buyers are often surprised that any ‘known’ tax issues are also generally excluded from the W&I policy. This general exclusion includes any risks which have been flagged in a buyer’s due diligence of the target company – including any reports prepared by an external due diligence provider which a buyer is presumed to be aware of.

Due diligence reports typically highlight many potential risks and this inadvertently will impact on the scope of cover. Each policy may address the exclusion of known items in a different manner, some referring to the knowledge of particular deal team members, and others referring specifically to any due diligence materials and matters deemed to be known.

Specific exclusions

Any specific tax exclusions will depend on the transaction and the tax affairs of a target company. However, W&I insurance providers are increasingly seeking to exclude, almost as standard, specific risks in relation to areas of the tax code being scrutinised by HM Revenue & Customs (HMRC). 

Officials are, for example, scrutinising the sums claimed under the Coronavirus Job Retention Scheme (CJRS) and have been notifying up to 3,000 employers a week that they may need to return money to the scheme. Where an employer is found to be not entitled to CJRS payments, the money can be clawed back by way of a 100% income tax charge. Given the extensive use of the CJRS and other coronavirus protection measures, and the pressure on HMRC to recover monies lost through furlough fraud, this remains high on the radar of insurance providers. 

Another hot topic for HMRC is compliance with the new IR35 rules which came into force in April 2021. The new rules make large businesses liable for determining the employment tax status of contractors who are engaged through intermediaries, such as personal services companies. In recent months HMRC has been requesting information from businesses about how their contractors and off-payroll workers are engaged, indicating this is also high on their agenda.

Approaching W&I head on

When acting for a buyer at an early stage, it is important to explain what is excluded from the W&I policy. This allows them to decide whether they are comfortable absorbing the tax risks or whether they require further protection. Ideally, a buyer would make this assessment based on their understanding the full scope of the W&I cover, but all too often the policy is not available until just before completion.

From the outset, therefore, a buyer should be aware that coverage tends to be limited. This will also ensure that the buyer can approach commercial discussions regarding the allocation of any specific tax risks as early as possible and prevent a delay to completion of the transaction. Any additional protection a buyer requires may take the form of a specific indemnity from the seller which sits outside of the £1 liability cap, a specific insurance policy which covers the relevant tax issue or a price chip. 

W&I coverage for tax matters in a standard policy is becoming increasingly limited as new areas appear on HMRC’s ‘hit list’. The limited scope of the W&I cover might only be fully appreciated when a claim comes to light. Buyers should think carefully about whether W&I insurance is the most appropriate way to safeguard against tax risks. If tax-related coverage continues to narrow, the occurrence of W&I-backed transactions could reduce, or at the very least shift back towards fully negotiated tax deeds to cover excluded rights – even where W&I insurance is sought.

Co-written by Zita Dempsey and Lois Dale of Pinsent Masons. A version of this analysis piece was originally published in the Tax Journal.