During the diligence phase of a transaction, it is not uncommon for a buyer to identify potential tax liabilities that may be caused by a number of situations: uncertainty over a tax structure, an estimated fair market value utilized in tax structuring, concern over a potential dispute with tax authorities, or any other reason that may generate an uncertain tax position. Rather than considering an adjustment to the purchase consideration, negotiating an indemnity/escrow, self-insuring the risk of a potential future tax liability, or worse, watching the deal fall through, tax liability insurance is a popular tool utilized to manage the risks and uncertainties associated with tax positions in a merger and acquisition (M&A) transaction.
However, the uses of tax liability insurance extend beyond M&A transactions, often incorporated for other purposes to support tax positions. Two common areas where companies secure a tax liability insurance policy are to bolster support for a new tax structure or position and in support of a key tax-related aspect of a restructuring, turnaround, etc.
Coverage
Tax insurance policies typically provide coverage for the tax owed, any associated interest, fines or penalties, and costs related to defending the position, and they may also cover gross-up costs (the amount by which the insured's taxes are increased because of the payment of proceeds under a tax insurance policy). There are myriad tax exposures that can be covered by a tax liability policy; some of the more common are:
- Tax-free spinoffs, mergers, and other tax-free intended transactions
- Energy tax credits (PTC/ITC)
- Worthless stock deduction
- Issuance of debt or equity
- 338(h)(10) and 338(g) elections
- Foreign Investment in Real Property Tax Act (FIRPTA)
- Capital gain versus ordinary income treatment
- Net operating losses
- Cancellation of indebtedness
- State and local tax (SALT) issues
- Real Estate Investment Trust (REIT) qualifications
- Partnership issues
Valuations and Tax Insurance
One area that often is a central point of uncertain tax positions revolves around valuations. Whether the valuation in question is of the overall company or individual legal entities, their respective tranches of debt and/or equity, or tangible and intangible assets, there are a variety of reasons a valuation can create an uncertain tax position. Some of the common examples are as follows:
- A recent valuation of the subject company that is inconsistent with the proposed acquisition price. This is a common occurrence when a fair market value is ascribed to the company as part of a recent recapitalization, and the company subsequently enters into an agreement to sell the business at a significantly higher value. The arm's length price can provide an indication that not all of the facts and circumstances surrounding the subject company as of the valuation date were appropriately considered within the prior valuation analysis.
- The valuation was not conducted in accordance with the specific approaches, methodologies, assumptions, etc., relative to the tax guidance and/or the specific jurisdiction. Certain approaches utilized to value intangible assets for financial reporting purposes may be inconsistent with the approaches required for a valuation for tax reporting purposes, or with how the local tax jurisdiction conducts its valuations (which can vary across jurisdictions).
- Understanding tax-free spinoffs is paramount. Regulation §1.368-2 defines the conditions necessary to qualify for tax-free reorganizations, encompassing mergers, acquisitions, and spinoffs. A comprehensive understanding of the criteria outlined in this regulation is essential for structuring transactions to optimize tax efficiency and mitigate adverse tax outcomes.
- Preferred partnership structures can be complex – selecting a preferred coupon rate that does not reconcile to the relevant arm's length metrics, such as third-party or intercompany debt interest rates, or ascribing a fair market value to the entities in a partnership structure that does not reasonably reconcile to the fair market value of the overall company, are just two examples of how valuations for a partnership structure can create an uncertain tax position.
- A valuation of legal entities as part of a legal entity rationalization/reorganization that does not fully incorporate the company's intercompany transfer pricing agreements in the relative profit margins of each entity. Similarly - in the absence of transfer pricing agreements or not following the terms of the agreements - not considering the relative roles played by each legal entity, such as a limited risk distributor, intangible asset holding company, entrepreneur, manufacturer, etc. This typically causes a potential tax liability in both the U.S. and the local tax jurisdictions.
- FIRPTA valuation – the complexities and subjectivity associated with estimating the fair market values of the U.S Real Property Interests (USRPIs) and total assets over a five-year period, combined with the fact that tripping the 50.0% threshold at any given point over the five years will result in a U.S. Real Property Holding Corporations (USRPHC) designation, can create a significant uncertain tax position caused by the valuation.
- Lack of documentation to support the deduction of intercompany interest expense. Without a detailed company valuation utilized to estimate its arms-length debt capacity, and an analysis to ascribe an intercompany interest rate that reflects terms consistent with a third-party loan, there could be an uncertain tax position.
- Failing to correctly identify all relevant changes in control for the purposes of valuing the Net Operating Losses (NOLs) benefits pursuant to IRC Section 382. This section provides guidelines for valuing NOLs in the context of changes in control. It is important for companies to accurately determine the value attributable to NOLs when undergoing ownership changes to ensure compliance with IRC Section 382 limitations.
- In certain transactions, part of the consideration may be ascribed to personal goodwill. In these cases, a well-documented, thoroughly conducted valuation that adopts the widely accepted approaches, methodologies, assumptions, etc., must be prepared to support the tax position taken as part of the transaction. In cases where there is no supporting analysis, the underlying assumptions are overly aggressive, and/or inconsistent with best methodologies/assumptions, an uncertain tax position may arise.
In conclusion, tax liability insurance offers a valuable risk management tool for companies facing uncertainties in tax positions, whether in the context of M&A transactions or other business activities. By providing coverage for potential tax liabilities, associated costs, and legal defense expenses, tax liability insurance can mitigate financial risks and enhance transactional certainty. It is essential for companies to carefully evaluate their tax exposures and consider the potential benefits of securing tax liability insurance to protect against unexpected tax liabilities. By doing so, companies can proactively manage their tax risks and safeguard their financial interests.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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