M&A: the role of the tax deed and tax warranties and usual indemnities and exclusions

Tax deeds vs tax warranties

Although there are technical differences between the terms ‘tax deeds’, ‘tax indemnities’ and ‘tax covenants’ they are all commonly used to describe the same thing – the document or provisions that are used to allocate tax risk on the sale and purchase of a company. We will use ‘tax deeds’ when describing the document used to set out the relevant provisions and 'tax indemnities’ when describing specific tax covenants to pay within the tax deed.

Tax liabilities relating to periods prior to the sale of a company stay with the company after the sale. Therefore, to give a buyer comfort that the company does not have large outstanding tax liabilities relating to pre-completion periods, a seller usually provides a buyer a tax deed, drafted as a 'covenant to pay' the buyer the amount of any pre-completion tax liabilities on a pound for poud basis, though they are subject to some limitations and exclusions.

Tax warranties are statements provided by a seller and typically found in the share purchase agreement. For example "Each group company is, and in the three years ending on completion always has been, resident only in the United Kingdom for tax purposes.’

The role of tax warranties together with the diligence process goes to the heart of the English legal principle of 'caveat emptor' or ' buyer beware', which puts the duty of inspection on a prospective buyer. The warranties are also another form of contractual protection given by a seller. To the extent disclosure is not made or is inaccurate, a buyer will have a claim for breach of contract against a seller.

There are a number of differences between the protections a buyer derives from a tax deed and from tax warranties.

Some of the key differences are:

• Disclosure: A seller may disclose against a tax warranty to the extent it is not true or accurate and so prevent itself from being in breach of that tax warranty. However, any disclosure a seller makes in respect of a tax warranty will not remove the seller from liability under a tax deed. So when a tax deed is provided the tax warranties are seen primarily as a mechanism for eliciting information from a seller.
• Breach of contract vs debt claim: Where there is a breach of a tax warranty, damages are awarded to the buyer based on the proven loss suffered by the buyer and there is a duty on the buyer to mitigate loss. The buyer is put back into the position he would have been in had there been no breach of warranty. However, a claim brought under the tax deed results in a £ for £ debt claim and there is no obligation on the buyer to prove loss or to mitigate. Therefore, a claim under the tax deed provides a clearer, quicker and more efficient way for a buyer to obtain redress.
• Look back periods: Tax warranties are usually limited to look back periods of between three to six years ending on the date of completion. Therefore tax warranties only provide the buyer with information relating to relevantly recent activities of the company. However, the tax indemnities in the tax deed usually cover all pre-completion periods.

The tax indemnities

Pre completion

Tax deeds usually contain a number of market standard tax indemnities. Most important is the general tax indemnity covering any ‘liability for tax of the company arising in respect of, by reference to or in consequence of any income, profits or gains earned, accrued or received on or before completion or any event which occurred on or before completion’. This indemnity is deliberately broad and unless specifically excluded, all pre-completion tax liabilities should be caught by it. To ensure this is the case, defined terms such as liability for tax, event and tax should be checked carefully.

Post completion

There are also some key tax indemnities that should be included in the tax deed on behalf of a buyer as they relate to liabilities arising post completion and therefore would not be covered by the general indemnity. This includes tax indemnities relating to secondary liabilities – where the tax liability is the primarily liability of another person but under secondary liability legislation, can fall on the company after completion. Specific indemnities may also catch PAYE and NICs on options granted prior to Completion which are exercised, released, disposed or varied after Completion or where under Part 7A ITEPA 2003 a ‘relevant step’ is taken after completion as part of a ‘relevant arrangement’ which was put in place before completion.

A buyer may also try to extend the definition of ‘event’ which is used in the general tax indemnity to include a series or combination of events only the first or some of which occurred on or before Completion. This broadens the general tax indemnity to cover the post completion liabilities mentioned above. However, sellers would likely reject this as it is too broad. Although there are compromise positions that may be accepted.

Limitations

Tax indemnities are generally limited by specific exclusions, financial limits and time limits.

It is common for the seller to request a number of exclusions to liability.

An important exclusion is that the seller will not be liable to the extent that the liability is provided for in the Accounts of the Company. The rationale behind this exclusion is that the seller should not be liable to the extent the tax liability has been priced into the transaction. Therefore it is important that the buyer checks how the transaction has been priced. If the deal as been priced, for example on a multiple of EBITDA, then arguably the seller should not benefit from this exclusion.

Another important exclusion is that the seller will not be liable to the extent that the liability arises as a result of a voluntary act of the company or the buyer after completion outside the ordinary course of business of the company. The buyer may limit this exclusion in a number of ways for example by stating that it only applies to acts which the buyer knew (or ought reasonably to have known) would give rise to the liability in question or by carving out acts required by law.

A seller’s liability under the tax deed is usually limited to the amount of consideration. However, it is not usually market practice for the seller to have the benefit of minimum financial thresholds that need to be exceeded before a claim under a tax deed can be brought.

The tax deed is usually subject to a time limit for bringing claims. The length of the time limit is usually between three and seven years to track the time limits that HMRC has to raise an enquiry. Most tax deeds will specifically state that no limitations will apply in the case of fraud or deliberate default by the seller.

The different routes to redress a buyer has under the tax deed and tax warranties demonstrates the different roles each of these play in a transaction and the importance to the buyer of having a tax deed in place. The general tax indemnity should cover all pre-completion tax liabilities but the buyer should be mindful of certain liabilities which may arise post completion and which they would want protection for. The tax indemnities are always subject to the limitations and exclusions and therefore these should always be checked carefully.

This update is based on an article by Satvi Vepa of Pinsent Masons, the law firm behind Out-law.com, which was first published in Tax Adviser in September 2018.