Managing M&A tax risks in 2021
April 2021 | TALKINGPOINT | MERGERS & ACQUISITIONS
Financier Worldwide Magazine
April 2021 Issue
FW discusses M&A tax risks with Jordan Tamchin and Matt Movafaghi at CAC Speciality.
FW: Could you provide a general overview of tax insurance?
Tamchin: Tax insurance protects the insured against a tax loss arising from a taxing authority’s challenge to a tax position. It covers additional taxes, interest and penalties on those taxes, contest costs which relate to the costs to defend the taxing authority’s challenge, and a gross up, which are taxes incurred upon the receipt of insurance proceeds. This allows the insured to execute the underlying transaction or investment with complete tax certainty, providing a level of comfort similar to a private letter ruling. Effectively, it is a risk management tool allowing the insured to transfer the economic risk of a tax loss to the insurance market.
FW: In what ways can insurance solutions help to manage tax risk between parties, or allow for specific issues to be ringfenced from wider transaction negotiations?
Tamchin: In the M&A context, tax insurance complements representation and warranty (R&W) insurance. R&W insurance covers unknown breaches of all the representations and warranties, including tax representations, made by the seller in the purchase agreement. Typically, any known issues identified during diligence and included on the disclosure schedules – for example a known tax issue – are excluded from coverage under an R&W policy. This exclusion leaves the buyer uncovered for the identified tax issue, and the buyer is generally left with the choice to self-insure the tax risk, request a purchase price reduction to account for the tax risk or seek a separate tax indemnity and possible escrow for the identified tax risk. None of these options is particularly appetising to either the buyer or the seller.
Movafaghi: Tax insurance is all about risk allocation. Given that the seller believes its tax position is correct and does not want the buyer to hold back any of the purchase price proceeds in escrow, and the buyer does not want to take on any risk related to the seller’s tax position, tax insurance is a perfect solution to bridge the gap between the buyer and the seller by transferring the risk of loss to the insurance market. Tax insurance can be used as a competitive tool by either the buyer or the seller as part of the M&A process. It can be purchased by the buyer to make its bid more competitive or may be purchased by the seller as part of its preparation for sale to address a known tax risk, thereby taking the issue off the negotiation table.
“Tax insurance offers liquidity while avoiding the negative cash flow arising from a tax liability.”
FW: What benefits can tax insurance provide to the parties in an M&A situation?
Movafaghi: First and foremost, tax insurance helps the transaction parties close deals. It takes an otherwise ‘dealbreaker’ tax issue off the table by facilitating deal negotiations and eliminating the need for a tax indemnity or escrow. Some of our favourite success stories involve tax insurance saving deals that otherwise would have died. Second, it enables a clean exit by eliminating a long-tail contingent tax exposure, allowing the seller to retain all of the sale proceeds. This is particularly relevant in the case of a transaction where there is management rollover. The last thing a buyer wants to do is to sue its new business partner for a tax indemnity claim. Finally, tax insurance offers liquidity while avoiding the negative cash flow arising from a tax liability. Tax insurance is intended to make the insured completely whole in the event of a challenge by the taxing authority.
FW: Could you highlight common insurable tax risks in M&A transactions?
Tamchin: There are three buckets of insurable risks in M&A transactions where tax insurance can be utilised. First, tax insurance can reduce or eliminate the tax risk related to historic tax positions taken by the target on seller’s watch – for example debt versus equity treatment, deduction versus capitalisation of expenses or employee versus independent contractor treatment. Second, tax insurance can address tax issues arising from the transaction itself – for example any pre-closing restructuring, treatment of the transaction as a tax-free reorganisation or availability of a tax basis step-up. Third, tax insurance can insure the historic tax treatment of the target entity itself – for example subchapter corporation, real estate investment trust or master limited partnership status.
FW: What advice would you offer to buyers and sellers seeking tax insurance to manage risk on their M&A deals?
Movafaghi: Investment bankers and deal parties continue to compress the timeline between executing a letter of intent and signing a purchase agreement. Many times, tax due diligence is completed within a few days of signing the purchase agreement. The good news is that the tax insurance market runs on deal time and can provide quick-turn-around solutions. That said, parties to an M&A transaction are strongly encouraged to consider tax insurance as soon as they become aware of a potential tax issue. This way, there is time to prepare a submission for the insurance market and receive proposals setting forth the proposed terms to cover the underlying risk. This is the best way to obtain optimal terms and gives parties to an M&A transaction another tool in their toolkit when negotiating how to allocate the risk of loss related to the tax issue. There is no cost for a potential client to obtain proposals.
“Over the past five years, tax insurance has really matured.”
FW: How would you describe trends in the tax insurance market, in terms of competition, policy terms and premiums, for example?
Tamchin: Over the past five years, tax insurance has really matured. The insurance market can now provide coverage for US and non-US taxes and tax insurance can cover all types of taxes, both income and non-income. There are more than 10 primary US markets that each have at least $50m of capacity, providing insureds a choice in insurers and competition between insurers that results in better terms and pricing. There are an additional 10 primary and excess markets that can participate on any given programme with smaller limits. In the aggregate, there is now over $1.5bn of total capacity for any US tax insurance placement, making tax insurance more relevant for the biggest transactions.
Movafaghi: As far as pricing, the all-in cost for tax insurance for a US risk is typically between 2.5 and 4 percent of the limits purchased. Again, this is the all-in cost – not just the premium. There is a one-time premium payment, which is typically paid at the binding of the insurance policy. The retention is generally limited to contest costs only – which is the cost to defend a taxing authority’s challenge, typically ranging between $100,000 to $250,000. After this retention, the policy covers first dollar of loss for additional taxes, interest and penalties, contest costs and gross-up. The policy period is generally seven years. Tax insurance is a claims-made policy – a claim must be made to the insurer within the policy period, but the underlying tax issue does not need to be resolved with the taxing authority within the policy period. Compared with most insurance policies, there are very few exclusions in a tax insurance policy, which are generally limited to inconsistent filing positions, materially inaccurate misrepresentations made by the insured, and a change of law.
FW: In your opinion, what does the future hold for tax insurance?
Tamchin: We are seeing the biggest growth in the use of tax insurance outside the M&A context. Tax insurance can be used to protect taxpayers against contingent tax exposures even when there is no M&A transaction. The tax code is complex and, despite receiving tax advice from an attorney or accountant, the proper tax treatment of a transaction or event may be uncertain – perhaps because there is no clear guidance on the tax issue, the fact pattern is unique, the tax position requires a degree of judgment or an evaluation of intent is required. If the Internal Revenue Service (IRS) disagrees with the taxpayer’s tax position, the taxpayer may owe unanticipated and potentially significant additional taxes, interest and penalties. Tax insurance removes the tax uncertainty from any tax planning contemplated by companies – for example internal reorganisations or restructurings or transactions with shareholders – as well as any internal transactions or events that are part of a company’s ongoing business operations, such as transfer pricing, accounting methodology, R&D credits and carryback of net operating losses. In each of these instances, tax insurance allows the company to execute these transactions with complete tax certainty.
Movafaghi: Tax insurance will be used in the corporate setting to allow companies to take tax positions that are at least at a more likely than not level of comfort. I have seen corporations forgo certain transactions because of the potential large tax liability associated with the position. Tax insurance can allow a company to take the transaction without having to worry about an outsized loss. What corporation, when under audit for a certain tax position, would not gladly pay three to four cents on the dollar to settle the issue? For these reasons, I see tax insurance being used more in the future as a private letter ruling substitute. It is worth noting that tax insurance may be purchased either before or after the tax position is reported on the tax return. So, for example, if the taxpayer executed a transaction in 2018 and is concerned with the underlying tax position reported on its 2018 tax return, tax insurance is still available to mitigate that tax risk. Moreover, in certain circumstances tax insurance may even be purchased to ensure the outcome of a pending tax audit of a tax position – meaning the tax position has already been reported on the taxpayer’s tax return and is now being reviewed or challenged by the taxing authority. As expected, the cost for this coverage is generally more expensive than other types of tax insurance.
Jordan B. Tamchin is a senior vice president and leader of the tax insurance practice at CAC Speciality. Mr Tamchin specialises in delivering innovative and unique insurance solutions for the most complex tax risks, bringing technical tax expertise, underwriting experience and business acumen. He is a leader in the tax insurance industry and continues to play an instrumental role in its dynamic growth and acceptance among insurance carriers, corporations and private equity funds. He can be contacted on +1 (561) 715 5043 or by email: jordan.tamchin@cacspecialty.com.
Matt Movafaghi is a senior vice president in the tax insurance practice at CAC Specialty where he specialises in providing multinational corporations unparalleled insurance solutions for complicated tax risks. His legal and in-house corporate tax experience contribute to the expansion and recognition of the use of tax insurance in the insurance market. He can be contacted on +1 (415) 565 9777 or by email: matt.movafaghi@cacspecialty.com.
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