January 2020 Issue
FW discusses tax risks in M&A with Justin Pierce Berutich at Euclid Transactional, LLC.
FW: To what extent are transaction parties showing greater awareness and understanding of potential tax risks in the M&A process, and the importance of managing them?
Berutich: Managing tax risks has always been of great importance to M&A transaction parties, whether as a result of the potential deal structure or a historic tax position taken by the target company. An adverse tax ruling has the ability to be catastrophic by either eliminating a buyer’s perceived value proposition for an investment or by creating a large liability for an exiting seller. As a result, transaction parties spend a great deal of resources planning, structuring and diligencing potential tax pitfalls associated with their potential M&A transactions and their potential targets. In the past, there were three main options for managing an identified tax risk. First, buyers would be forced to self-insure. Second, sellers would be subject to a large indemnity or would be required to tie up sales proceeds in an escrow. Third, the deal would fall apart. More recently, however, taxpayers have found that levering tax insurance is a better and more efficient means of insulating themselves from the impact of an adverse tax ruling.
FW: Could you outline some of the common types of M&A-related tax risks that typically surface?
Berutich: The most common types of M&A risks are typically related to deal structure, or the prior restructuring of a target company, and include tax-free reorganisations, restructurings and spin-offs. However, tax implications are global, complex and ever-changing. For example, taxpayers and their advisers are still working to determine the implications associated with the Tax Cuts and Jobs Act (TCJA), which instituted the transition tax, global intangible low-taxed income (GILTI), foreign-derived intangible income (FDII), and the base erosion and anti-abuse tax (BEAT). The uncertainty associated with the TCJA has led to many related M&A tax risks. The acquisition of an S-Corp., and any related 338(h)(10) election, often leads to tax risks as a result of the historic operations of the S-Corp. and whether those operations created an S-Corp. foot-fault – ineligible shareholders, second class of stock, disproportionate distributions and late elections – inadvertently terminating the S-Corp. status and creating entity-level tax. M&A transaction parties also frequently come across tax risks associated with whether a distribution is considered debt or equity, the classification of income as ordinary or capital, whether there are indirect transfer tax implications, and the impact, if any, of Section 382 limiting NOLs and Section 409A.
FW: As one way to help manage these risks, could you provide an overview of tax liability
insurance and the benefits it can provide?
Berutich: Tax insurance has proven to be a very efficient tool for transaction parties to manage the risk associated with an identified, supportable tax position not qualifying for its intended tax treatment. Even the strongest tax opinions acknowledge that the tax position is not free from doubt. Private letter rulings are not always available or can take a significant amount of time and energy to procure. Tax risks, by their very nature, can linger for prolonged periods of time. As a result, identified risks often lead to tense negotiations that have the potential to force the parties to walk away from the deal. Tax insurance is a cost and time efficient product that enables the parties to transfer the risk associated with an identified tax position to an insurer. It saves buyers from having to self-insure the entire risk or engage in tense negotiations to procure an indemnity, and when indemnities do arise, sellers can insulate themselves from an indemnity claim via tax insurance. Generally, tax insurance provides the insured with coverage for the taxes owed if the position does not receive the intended treatment, any associated interest and penalties, and the costs associated with defending the position, as well as a ‘gross-up’ to cover any income taxes assessed on the receipt of the insurance proceeds.
“The tax insurance market will continue to grow as more taxpayers come to understand its benefits.”
FW: What trends are you seeing in terms of policy coverage, terms and pricing, as well as claims processing?
Berutich: The tax insurance market has certainly become more competitive in recent years. One positive result of this shift is that tax insurance policies have become much more cost-effective. Additionally, in most cases the individuals underwriting tax risks are former tax and M&A attorneys or advisers, who thoughtfully consider the tax risk and, when necessitated by the risk, can offer longer policy periods and creative coverage terms. This experience, along with growing familiarity with the product, also helps drive better terms. At the end of the day, we view ourselves as a partner with the insured working together to craft the best – and often a very innovative – approach to the identified issues. Given this partnership mentality and the nature of the identified, supportable tax risk, the claims process is not contentious as the insurer and the insured are both advocating for the same tax treatment.
FW: In your experience, what considerations should acquirers make when assessing the options available for tax liability insurance? How should they go about choosing the right policy for their particular situation?
Berutich: An acquirer needs to look both internally and externally when determining the best option to address a tax risk. Internally, the acquirer needs to consider several things. First, it should determine how much of the risk it is willing to bear – even if its adviser has provided a tax opinion on the issue, as opinions are not a guarantee of success. Second, the acquirer needs to think about its ability to transfer the risk to the seller, but also about how attempting to transfer the risk will impact negotiations, especially in a competitive process. Third, no matter how remote, it must weigh how an adverse resolution of the tax issue would impact its acquisition – adverse resolutions often result in significant financial implications. Finally, the acquirer will want to consider if it has the ability and the time required to obtain a private letter ruling. Externally, the acquirer will want to determine whether the seller is creditworthy enough post-sale to stand behind any indemnity, the ability to lock-up sale proceeds in an escrow for an extended period of time, and how either a request for an indemnity or an escrow may impact the deal. If an acquirer does not want to bear the entire risk and does not have the leverage to push the risk entirely onto a creditworthy seller, then insuring the tax risk may be an excellent option. Representations and warranties insurance (RWI) is designed to cover unknown risks resulting in a breach of a specific representation in the transaction agreement. By their nature, identified, material tax risks are excluded from RWI policies. On the other hand, tax insurance is an efficient means to transfer the risk associated with the identified, material tax risk and is often used in connection with RWI insurance to provide broader overall coverage.
FW: Could you provide an insight into insurers’ underwriting process for tax liability insurance, and related timescales? What information do underwriters typically require, both initially and during the formal underwriting?
Berutich: After receiving a submission requesting tax insurance coverage from one of the specialised, experienced tax insurance brokers, the underwriter researches the issue and cross-references it against the position presented by the taxpayer and its advisers. While an opinion from an adviser is not always necessary, so analysis of the tax issue is generally required and will certainly expedite the submission review process. When timing is not imperative, the underwriter generally has a week to share its non-binding terms with the broker. The broker aggregates all terms submitted by potential markets and works with the client to select the market most attractive to it. Once formally selected by the client, the underwriter will perform additional analysis of the tax issue, request additional supporting documents and, more often than not, engage outside counsel to assist in the underwriting process. During the formal underwriting process, the underwriter also works with, and through, the broker to negotiate a bespoke policy specifically tailored to address the tax risk at hand. The formal underwriting process normally takes a week or two, but when time is a determinative factor, the entire process can be expedited. In some circumstances – for example when a transaction is at risk – the entire process can be completed in 48 hours.
FW: Going forward, do you expect to see increasing appetite and rising demand for tax liability insurance?
Berutich: Tax insurance is a practical, efficient tool to address identified, supportable tax positions. When tax insurance is utilised, transaction parties are no longer required to expend their valuable time and resources to acquire private letter rulings nor engage in tense, protracted negotiations for seller indemnities or escrows. The tax insurance market will continue to grow as more taxpayers come to understand its benefits. As the market grows, its ability to insure these complicated risks will increase and, assuming responsible underwriting, the cost to do so will remain attractive.
Justin Pierce Berutich is senior vice president and head of tax at Euclid Transactional, LLC. A former M&A and transactional tax attorney, he enhances client value through the promotion and underwriting of representations & warranties, tax indemnity and contingent liability insurance solutions. Mr Berutich’s corporate, tax and insurance experience allows him to bring a unique perspective to each matter. He can be contacted on +1 (646) 817 2919 or by email: jberutich@euclidtransactional.com.
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