Coverages can revive transactions, protect tax credits and more

Your company is weeks into negotiations to acquire another organization and you get a call from one of your attorneys with some bad news. Looks like the deal is off, she says. It seems the target has taken a historic tax position that could result in substantial taxes, interest and penalties, depending on how tax authorities rule in a potential future audit. If you proceed with the acquisition, the loss would be yours. The risk is too great to move forward. Or is it?

Proceeding with a transaction under these circumstances may still be possible, thanks to tax insurance designed to protect companies against future adverse tax rulings. Rather than horse-trade the tax risks in the deal, tax insurance allows deal parties to shift the risk to an insurer and sometimes save deals that otherwise would not move forward.

But tax insurance is not limited to reviving M&A deals that may have otherwise died. It also can be used to secure the benefits of tax credits and protect corporate tax positions outside the M&A context.

Transactional tax insurance

Three main types of transactional insurance have emerged in recent years to help merger participants allocate post-closing risks. Representations and warranties insurance (RWI) is the most popular. Another is contingent liability insurance. But the fastest-growing of these transactional coverages is tax indemnity insurance. Indeed, increased competition and capacity have driven expansions in tax-insurance appetite and availability among carriers in the United States and abroad.

Organizations can work with insurance professionals to build one-off tax-insurance policies to address one or more specific risks identified in an M&A deal. For example, if a buyer’s tax diligence report identifies an issue with the seller’s tax practices or historic tax positions that might be excluded from RWI coverage, the buyer should consider whether the issue can be transferred to a tax policy. Here’s a case that illustrates:

A public company sought to purchase a closely held S corporation. In the purchase agreement, the seller made standard representations and warranties but was only willing to put up 0.5% of the purchase price as an indemnification escrow amount. The seller also insisted on limiting the survival period for the indemnification obligation to 12 months after closing. The buyer purchased RWI coverage to increase protection against breaches of the seller’s representations and warranties, and extend the survival period for both general representations and tax and fundamental representations.

But during due diligence, the buyer’s tax advisor identified several issues with the seller’s qualification as an S corp, and prior to closing the parties completed an F reorganization aimed at preserving the seller’s S corp status. A potential tax risk remained, however, and the RWI policy excluded it as a “known” issue.

The parties used a dovetailing tax-insurance policy to achieve a solution: The buyer agreed to indemnify the seller, subject to a cap, against any post-closing taxes owed if the IRS later determined the seller didn’t qualify as an S corp—subject to the availability to transfer that indemnity obligation to tax insurance. The buyer was indeed able to fully transfer the S-corp qualification risk to a tax-insurance policy, thereby skirting an issue that initially appeared to be impassable.

In other words, the parties used the RWI and tax policies to bridge negotiation gaps regarding indemnification both for breaches of representations and warranties and an identified tax risk.

Who’s the named insured?

A transactional tax insurance policy can be structured with either the buyer or the seller as the named insured, depending on the structure of the underlying transaction and which party bears the tax risk after closing.

A tax insurance policy can address:

  • Certainty needed regarding tax risks 
  • Time and cost of receiving an IRS ruling
  • Inability to receive an IRS ruling
  • Limited recourse in the event a tax opinion is wrong or no opinion is prepared

Tax credit coverage

Other forms of tax insurance protect against risks unrelated to M&A deals. One is tax credit insurance, which protects organizations against losing out on expected income tax credits.

For example, the owner of a wind farm might buy tax credit insurance to protect against losses related to wind-farm production tax credits being phased out by the Protecting Americans from Tax Hikes (PATH) Act of 2015.

To obtain 100% of the production tax credits, the corporate taxpayer must—among other things—show it had begun construction on its wind farm prior to 2017. IRS regulations defining what constitutes “begun construction” are complex, and the agency can challenge whether a taxpayer began construction in time to qualify for 100% of the credits rather than some reduced percentage.

Tax credit insurance can protect a company against losses related to an adverse IRS ruling in this regard, or with respect to a number of similar issues involving a wide range of tax credits.

Tax position policies

Another form of tax insurance unrelated to merger transactions is coverage that protects against unfavorable tax opinions. One company recently used such “tax position” insurance to support an internal reorganization.

Several years ago the company was advised to create a foreign parent entity for its U.S. businesses in order to achieve tax benefits and support its eventual expansion into foreign jurisdictions. The U.S. businesses grew, but the plans to expand internationally never materialized. Eventually, a new tax advisor suggested the company’s approach resulted in a less-than-optimal tax outcome. In fact, the advisor said the company could owe several years of back taxes if the IRS determined its foreign parent was in fact an inverted U.S. corporation. Or, even worse, the company could have been operating as a Passive Foreign Investment Company (PFIC), which would result in approximately double the tax liability.

In response, the company reorganized to revert to being a U.S. company, dissolving the foreign parent. It also amended its tax returns to pay back taxes for several years as an inverted U.S. corporation (to avoid the higher taxes PFIC status would entail).

To protect against the IRS successfully contending the corporation was operating as a PFIC prior to its reorganization—which would result in an additional $40 million tax liability—the company purchased a tax position insurance policy. In the event of an adverse tax ruling, the policy would cover the additional tax liability as well as related interest, fines, penalties and defense costs in excess of a small retention.

Beyond this example, some uncertain tax positions can be insured at the time they are taken, allowing a company to avoid posting a reserve in connection with them.

A multifaceted tool

Tax insurance doesn’t make sense for every deal or for every company. But it’s a very important tool to have in your M&A toolkit, as well as to protect against non-deal related tax risks.

At BB&T we offer tax insurance through our McGriff, Seibels & Williams insurance brokerage firm affiliate. To find out if your corporation can resurrect an M&A deal or mitigate an unfavorable tax ruling through tax insurance, and explore coverage alternatives, contact your BB&T Relationship Manager.

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