Tax opinion insurance (TOI) is a specialist insurance product designed to cover the liabilities incurred if a specific piece of tax planning ultimately falls foul of governments’ revenue services. With TOI, the insured is protected against the revenue successfully challenging a tax position resulting in a tax liability crystallising. Given the traditional reluctance of private equity houses to provide warranties and indemnities, TOI is particularly pertinent to the private equity arena. Basically, TOI provides cover for tax risks the parties to an acquisition or disposal are unable to allocate between themselves.
“TOI can transfer a tax risk which has been identified and scoped but which the deal principals are either unable, or unwilling, to maintain over the long term,” explains Anka Taylor, a director of the insurance company Aon’s transaction liability unit.
The product’s key selling point is its ability to facilitate the completion of transactions that might otherwise have foundered. “Potential tax liabilities can block a deal if the seller is not prepared to indemnify the buyer against an unfavourable tax outcome. A TOI policy can remove a specific concern from a transaction that might otherwise have been a deal breaker,” says Taylor. “It enables contingent tax positions to be managed and secured and can protect inward investment by ensuring that certain legal issues are ring-fenced,” she says.
Taylor points out that exiting private equity investors, in particular, are unlikely to want an ongoing contract with their divestment. Investors buying into a business, meanwhile, will not welcome the possibility of a tax liability leaving a large hole in their business model. “Tax risks tend to be ‘all or nothing’; if a liability is triggered then a company could be looking at a £100m charge. Although the risk is low, the quantum can be high in relation to a deal,” she warns.
Without TOI, deals that reach deadlock have often had to be radically restructured or abandoned altogether. “If a tax problem is uncovered in a private equity context then it generally has to be dealt with in a way that achieves finality. However, the mainstream solutions, such as price adjustments or retentions, can often be unpalatable and far less satisfactory in terms of managing tax risk than incorporating TOI into a transaction,” adds Daniel Max, a vice-president at insurance brokers Marsh.
Anka Taylor explains that while it is not always possible to determine whether a particular tax position or situation will result in a tax loss, it is now possible to manage the situation, should it arise, by having TOI in place prior to the knowledge of any loss.
TOI hinges on the fact that while a seller might have put together a seemingly secure tax structure nothing is cast in stone, a tax ‘opinion’ is exactly that, and the tax office reserves the right to reconsider a treatment and to apply a taxation charge retrospectively. “One can never be certain how a particular piece of law will be interpreted,” notes Max. “Advisers will provide advice to the best of their endeavours but their opinion is not certainty. TOI is a mechanism that can deliver certainty and enable sellers to draw a line underneath any liability,” he says.
A company might seriously consider buying TOI if, despite having been careful and professional in their implementation of a tax plan and happy to carry the residual risk, an incoming lender or investor is not prepared to take it on. It is also useful where a company heading for flotation does not want to have to publicise a tax risk in its IPO prospectus.
According to Taylor, tax risks most commonly become an issue or a problem when a client is implementing tax planning to achieve a specific strategic business purpose or during due diligence when preparing to make an acquisition or disposal.
The party with the primary tax liability generally buys the policy to cover a potential liability due to an indemnity given contractually (possibly in the sale documentation.) Alternatively, a target company could take out a policy immediately before a sale so the benefit of the policy passes with it on the sale to the buyer.
“It can be prudent, as part of cleaning up a business prior to exit, for divestors to tackle a potentially negative tax situation head-on by putting a TOI policy in place. It is likely that any potential liability will be discovered by a prospective purchaser during their due diligence anyway. It is far better to be in control of the situation rather than confronted with a tax problem further down the line and risk it becoming a negotiating point,” observes Max.
TOI is particularly geared to cross-border deals since these have the potential for tax liabilities in multiple jurisdictions. Despite its attributes, advisers do not universally applaud TOI. Sean Finn, a tax partner in law firm Lovells, is among the dissenters. He says that while he has seen a few deals where TOI has been considered, clients are generally averse to it and ‘hugely sceptical’ of the benefits. “Clients tend to regard TOI as expensive and difficult to claim under. It also injects another team of lawyers into a transaction, which inevitably slows everything down. There are other ways of getting comfort on a possible tax risk and, frankly, if tax is a big issue then it can usually be priced into a deal,” he says.
Finn believes most clients would prefer to go to a QC for another opinion on a tax treatment or even to approach the Revenue to get a clearer indication of the risk. “With these avenues of second and third opinion available, clients would only consider TOI as a last resort, and most would perceive it an unsatisfactory position to be in,” he says.
However John Burton, a partner in law firm CMS Cameron McKenna, contends that TOI is an increasingly important transactional tool. “There is now a far greater awareness and acceptability of TOI than five years ago. Users can be deterred by its cost but when it is a bespoke package covering a specific, identifiable risk then it is generally quite well regarded. And if advisers have told their client that there is a genuine, material tax risk then this has to be seen as an appropriate response to the situation,” he says.
John Challoner, a tax partner at law firm Norton Rose, admits to having initially been an ‘unbeliever’ as far as TOI is concerned. Lately, however, he has been converted having seen the product used successfully in several client situations. These have included property developments and other transactions involving high capital expenditure where the banks were reluctant to lend without it since, if a particular tax liability emerged, the borrower could struggle to repay the loan.
Challoner has also seen TOI underpin tax deeds as part of the warranties and indemnities given by the seller of a company where the purchaser was not prepared to take a credit risk on the seller. “This is more tricky since the real knowledge of whether there is likely to be a tax charge lies with the seller, although the insurers do their own due diligence,” he says.
“But before you look at any technical aspects you have to question why the client wants to take out TOI. If there are valid reasons then you go ahead. If the reasons are bad; a client with a cavalier attitude to tax planning when running a company who is then not prepared to stand behind that risk when it comes to disposal, for example, then you do not,” Challoner says.
Since TOI cover is not intended to serve as a substitute for poor advice or poor due diligence, particular scrutiny is placed on deals that require cover for changes in law or accuracy of underlying facts or circumstances. Adverse legal developments in case law will usually be taken on by the underwriters as will retrospective changes in law and revenue practice. However, prospective changes will not be covered.
Marsh’s Daniel Max draws a clear distinction between tax ‘avoidance’ and tax ‘evasion’. “While the market would insure the former we will not touch the latter. We only support corporates that have a genuine business reasons for a tax liability rather than tax dodging,” he says.
Although TOI is making headway in the European corporate finance market, Max believes it is still often misunderstood. “Many dealmakers simply don’t understand how it is applied and the value it can bring. Clients have used it in situations where otherwise the result would have been deadlock. It can be absolutely critical to a deal,” he says.
Confidentially clauses have not helped dispel the scepticism. “It is written into the terms of most policies that the insurance is invalidated if its presence in a deal is publicised. The very existence of a TOI policy acknowledges a tax risk. This could attract Revenue attention and subsequently cause the mechanism to be triggered,” says Max.
Because it is highly specialised and tailored to each situation, TOI is difficult to price, hence the range of premiums is enormous; from 3% to 25% of the limit of insurance bought. However, most policies are likely to sit in the 5% to 15% range with only a few coming in at over 10%. This reflects the full amount of the tax liability plus an allowance for interest and defence costs. “Past 15% and the risk is usually uninsurable and ultimately the policy needs to work from an economic standpoint,” says Max.
Max maintains that the cost of TOI is not normally the client’s primary focus. “The major consideration is usually whether the risk is insurable. The product then either adds value or it doesn’t,” he says.
“PE players are highly professional and will never pay a penny more for something than they have to, but they are often pleased to have a solution to what might otherwise have been an intractable problem,” Taylor maintains. “After all, having to make a large provision, put funds in escrow or offer a major indemnity can kill a deal,” she says.
Factors which influence pricing are the assessed level of risk of a revenue challenge which would incur defence costs; the applicable limitation period; the level of risk borne by the insured; the degree to which the tax loss is ‘all or nothing’; and the level of precedent relating to the tax code/law and the jurisdiction(s) concerned.
Underwriters will undertake extensive due diligence before providing a binding quotation. All costs are borne by the clients, even if a policy is not executed. Cover can usually be bought for up to seven years. Policy limits are usually up to €200m with further capacity potentially available. As with other forms of insurance, insurers usually insist on policy excesses to ‘align the interests’ of the parties. This is determined primarily by the size of the transaction. Exclusionary language is also used where insurers are unable to find comfort on certain aspects of the risk.
“Because TOI is a bespoke, case-by-case product, it tends to be more complicated than plain warranty and indemnity insurance and policies usually take longer to structure,” says Max. “Our approach to transaction risk therefore has to be as much one of consulting as it is of actually placing an insurance contract. Fairly early on in the process we will be able to see if the product is likely to be of benefit to the buyer,” he says.
“The negotiation of policies is a significant part of the process,” agrees Taylor. “You have to be prepared to really roll up your sleeves and collaborate with tax professionals, so it can be intense,” she says.
The insurers also spend a long time ensuring the TOI documentation is presented in the best way. “There is always a detailed amount of policy wording concerning the terms and trigger mechanism to ensure that it is documented to fit the potential liability situation. We put a great deal of effort into ensuring the policy is sufficiently robust and mirrors the potential liability. We have to be highly confident in the way that any policy will respond to an actual liability,” says Max.
Max concludes that TOI is only loosely an insurance product. He would prefer it to be perceived as encompassing the use of ‘insurance capital’. “Depending on the terms of coverage and assuming that the process of putting the insurance in place does not impede the deal, it facilitates the more efficient use of capital, as well as generally oiling the wheels on many deals, and enables companies to better fund transactions,” he says.
Covering the tax breaks
Tax opinion insurance (TOI) is essentially a subset of warranty and indemnity insurance, alongside products such as environmental liability cover, and has really only begun to catch on in the UK in the last five or six years. It is sold by a handful of brokers, including Aon, Marsh, Willis and AIG.
In short, TOI is designed to:
provide a definitive quantification of a particular tax risk?
remove a deal-breaking barrier?
enhance a company’s enterprise value by eliminating a contingent liability?
facilitate a clean exit through the removal of identified risk areas ?
transfer historic liabilities from previous transactions?
reduce, or remove the requirement for an escrow account in an M&A transaction. ?
TOI is particularly useful when the financial seller/buyer is:
unable to take on long-term, if theoretical, liabilities?
if there are doubts regarding the financial strength of the covenantor?
in cross-border transactions where inward investors are unfamiliar with the tax regime of the target and consequently nervous about the tax risk.?
Case study: insurance unlocks the deal
The purchaser in a secondary buyout approached the insurance market where the parties were deadlocked over the provision of an indemnity by the exiting financial sellers. The structure of the target company at the time of the initial buyout was complex with a number of holding and operating companies. This meant administration of the business was time-consuming and inefficient. The debt providers at the time also insisted that the various EBITDAs were consolidated.
The subsequent restructuring simplified the business, but also resulted in significant tax benefits. The law in the jurisdiction concerned allowed the tax benefit so long as the main purpose of the restructuring had an overriding commercial purpose (and was not simply tax avoidance.)
The seller had obtained opinions from an international law firm that supported the planning, but there was a remote chance that the tax authorities could challenge the planning and claw back the tax relief.
The seller refused to provide an indemnity and the buyout would not proceed without one. An insurance policy in the name of the target company was structured with the acquisition vehicle as loss payee. The buyer represented to the insurer via a letter attached to the policy that the information provided to the insurers was true and accurate and that the steps taken in restructuring had in fact occurred and that the reliefs were therefore available. The insurers issued the policy in reliance upon these facts.
The policy was a first part insurance, meaning that the seller was not required to provide an indemnity. The premium was paid as an adjustment to the purchase price and the transaction completed successfully.