Tax liability insurance in Europe: an effective solution for tax uncertainties
November 2020 | SPECIAL REPORT: CORPORATE TAX
Financier Worldwide Magazine
November 2020 Issue
Uncertainty and complexity are unavoidable realities in the international tax arena and can even lead to the frustration of a number of different transactions, such as M&A or corporate restructuring processes, where potential tax risks normally arise and where uncertainties, risks and delays need to be avoided.
Tax affairs have always been an area of controversy. Tax law can often be unclear and subject to multiple interpretations, especially as a result of the diverse local implementation of several new tax rules issued by international bodies. These include the 15 Actions of the base erosion and profit shifting (BEPS) plan set forth by the Organisation for Economic Co-operation and Development (OECD) or the Anti-Tax Avoidance Directives within the European Union (EU), among others. In addition, different interpretations are made by tax authorities at the national level. Other factors have also contributed to making the tax environment increasingly complex and uncertain, such as the aggressive tax collection of many national tax authorities.
This environment has led to the development of tax liability insurance, which has proved to be a very effective tool to protect parties against uncertainty. Its proliferation throughout the EU in the last five years is remarkable (especially in the UK, Ireland and continental European countries such as Germany and Spain), and it is making inroads in other jurisdictions, such as Australia.
What is tax liability insurance and what does it cover?
Tax liability insurance is an insurance contract with a typical policy period of seven years, that gives coverage against an identified but uncertain tax risk indemnifying the policyholder (be it the buyer or the seller), in exchange for a one-off premium (which is paid at the inception of the policy), for financial loss arising from a successful challenge from a tax authority, covering not only the amount of taxes potentially claimed, but also interest, penalties, defence costs and the gross-up of the proceeds of the policy if they are taxed in the hands of the insured.
It is important to clarify that tax liability insurance is different from warranty and indemnity (W&I) insurance (also known as representations and warranty insurance) which can be purchased by the buyer or the seller in an M&A transaction to protect against loss or liability arising from an unknown or undisclosed matter (be it tax-wise or not) that is covered by the warranties or indemnities agreed between the parties. Thus, the main difference between both insurances is that W&I insurance covers unknown issues as opposed to tax liability insurance which covers bespoke specific and identified tax risks.
However, not all tax risks can be covered by tax liability insurance. In order to determine whether a specific tax risk is eligible or not, a number of factors have to be considered.
The main factors on which insurability depends are: (i) the likelihood of a challenge by a tax authority (legal advice is necessary to determine whether the tax risk qualifies as a low to medium risk); (ii) the defensibility of the position taken; (iii) evidence of a wide, non-tax commercial purpose in the transaction; (iv) the location of the risk (the relevant jurisdiction should have a stable court system with legal certainty); and (v) the quantum of the liability and the motivation for insurance. Also, the matter must not already be subject to an enquiry, investigation or dispute with respect to the tax authority.
Under no circumstances is tax liability insurance available for intentional tax evasion or tax avoidance.
Tax liability insurance covers mainly tax risks arising from corporate income tax, but also from any other tax, such as individual income tax, VAT, transfer tax or withholding taxes originating from the application of double tax treaties.
Typical tax risks usually covered, which may differ depending on the jurisdiction, include risks arising from corporate restructuring processes, which usually relate to the existence of valid commercial reasons among other requirements to apply the tax neutrality regime or the indirect taxation treatment of a restructuring, and risks derived from debt restructuring processes normally related to stamp duty risks on mortgage debt refinancing, or to potential taxable income on debt restructuring.
Other tax risks typically covered by tax liability insurance include historic tax risks detected in the due diligence process of an acquired entity or asset, as well as those in relation to the tax treatment of hybrid instruments, to the potential applicability of transfer tax or non-resident capital gains tax on the transfer of land-rich entities, or to the substance of a company receiving dividends in the context of anti-abuse provision provided by the EU Parent-Subsidiary Directive.
Advantages and usefulness of this type of insurance
Tax liability insurance offers a new way to manage risk, as well as the certainty required to allow a transaction to progress or save time.
In particular, tax liability insurance can give peace of mind in relation to a historic tax position, remove the need for an escrow or reserve, stand behind or replace an indemnity, prevent price negotiations or delays by mitigating identified risks, allow investment funds to be liquidated and proceeds returned to investors, provide a liquidator with the comfort required to release proceeds, remove uncertainty from a restructuring or reorganisation, mitigate a risk to allow for favourable financing terms, or provide a quicker and confidential alternative to a tax authority clearance (or provide the comfort of a clearance if this is not available).
The role of the different players
The main players involved in tax liability insurance are, aside from the insured and the insurance company, the broker, the underwriter and the insured tax adviser, with each playing a different and essential role in the assurance process.
The broker has market access, advises on insurability, approaches insurers, mediates on policy terms and on claims, and manages the process.
The underwriter, in conjunction with a tax adviser in the jurisdiction where the risk lies, determines the insurability and scope of the work to be carried out, assesses the tax risk, produces and negotiates the policy, determines the price, and works with the broker to manage the insurance process and find solutions.
And the insured tax adviser identifies the risk, pre-assesses and recommends the tax insurance route, prepares a legal memorandum explaining the grounds for insuring the risk, coordinates the preparation of a defensive file, and reviews and negotiates the policy.
Conclusion
Tax liability insurance is a new product in Europe with the ability to unlock operations that otherwise would not be possible. There is no doubt that in the current climate, tax liability insurance has become an innovative, simple, flexible and efficient tool, providing certainty to investors and companies by transforming a potential tax risk into a quantified insurance cost. It is playing an important role, especially for investment funds and private equity.
Eduardo Gracia is a partner at Ashurst LLP. He can be contacted on +34 91 364 9854 or by email: eduardo.gracia@ashurst.com.
© Financier Worldwide
BY
Eduardo Gracia
Ashurst LLP
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