Peace of Mind In Handling a Target’s Taxes: Tax insurance can cut the risk of a post-deal financial blow

Inheriting a target’s tax attributes historically is one of the trickiest challenges that a buyer faces in the deal process. Even with the most diligent and expert effort to gauge the complete picture, there rarely is complete assurance that the combined company won’t be dunned for unpaid state, federal, or foreign taxes — allegedly or actually due — well after the deal closes. The sums can be sizable, and contesting the delayed bills can be complex, expensive, and time consuming. To cushion the jolt, acquirers can purchase tax insurance — a risk management tool for defraying the costs. In this article, Gary Blitz, attorney and executive of Aon Financial Solutions, explains what tax insurance is all about and how it fits into dealmaking at a time when the tensions between businesses and tax regulators such as the IRS are increasing and controversial new formats to avoid or reduce tax loads are coming under attack. To highlight the most important points, the article has been structured in a question-and-answer format. For starters, what is tax insurance? Tax insurance is one of a suite of risk-transfer insurance products –along with reps and warranties insurance, litigation buyout insurance, and environmental insurance — that are aimed at addressing deal risks. Tax insurance provides protection to a taxpayer in the event that a tax position it has taken is challenged by the IRS or a state, local, or foreign taxing authority. The policy can cover tax liability, interest, penalties, contest costs, and a gross-up. In concept, it’s quite simple. The policy works in a manner similar to a private letter ruling from the IRS. The insured taxpayer represents to the insurer the facts underlying a transaction and the policy covers what the tax law will apply to those facts in the manner intended. The insured taxpayer sets the limit of liability it buys. Typically, this number is based on potential tax liability, interest, penalties, contest costs, and gross-ups. Some insured parties will seek to cover the total of all of these potential costs. Others are more practical about this decision and seek to insure only a portion. In that case, the premium costs are smaller because less insurance is bought. Is tax insurance different from “tax opinion insurance”? Not really. The names often are used interchangeably. The typical scenario involves a policy that covers a risk that a tax expert has opined or advised on. I like to think of the tax insurance product as being broader than tax opinion insurance because it will address situations in which opinions may not be issued and ancillary risks, which might not be subject to opinions such as recapture of historic tax credits due to physical damage or foreclosure. Why do acquirers buy tax insurance? The reasons vary. Private equity firms use the product, as well as companion products addressing reps and warranties, litigation, and environmental risks, to avoid a large unanticipated tax payment that was not modeled in the acquired company’s cash flows. Coverage often is used to provide comfort to a third party. For example, a buyer and a seller might disagree over the treatment of a tax attribute of a target company. The insurance provides a means to address concerns of the buyer if the seller’s view of its tax position does not pan out. Another example might be the inability of a seller to provide an indemnity, perhaps because it is a PE fund winding up and seeking to return funds to investors. Tax insurance is a mechanism for providing the comfort of an indemnity to a buyer — without the seller’s having to stay in existence to address the contingent liability associated with the tax issue at hand. Do sellers buy coverage? Absolutely, sellers are frequent buyers. Deal dynamics often dictate who makes the call to buy the insurance. It may be the seller who is seeking to address an issue raised by a potential buyer so it doesn’t have to provide an indemnity or minimize the need for an indemnity. Another scenario we see is a seller seeking to prepare a company or asset for sale and using tax insurance to simplify the due diligence process. In either scenario, the cost of the insurance will fall on the seller in practical terms, either as a direct premium payment or an actual or implicit price adjustment by the buyer to defray the cost. An exception to the rule is the case in which the buyer proposes a structure that is beneficial in the context of the buyer’s tax attributes but is irrelevant to the seller. In that case, the insurance is for the buyer’s benefit and the buyer might pay the cost of the insurance. Why not simply get a private letter ruling (PLR) from the IRS? There are various reasons why a taxpayer might forego the ruling process and opt for insurance. These begin with unavailability of a ruling under IRS ruling policies. The list of issues the IRS will not rule on in advance in the corporate area is extensive. Confidentiality and timing concerns relating to getting a pending deal closed also come into play. What about timing? Describe the insurance process. If a deal requires speed, the insurance process can move fairly quickly. Typically, a non-binding indication of insurer(s) interest can be obtained in about a week to 10 days. Often, this can be based on non-confidential information or draft documents. If acceptable to the client, a more detailed due diligence stage would begin. This can take about two to three weeks but often can be accelerated, as a transaction schedule requires. What sort of situations can be insured? Policies have been used to cover a broad range of tax risks. It is most common to see the policies used in a deal setting, but ongoing tax situations also can be covered. Insurers, however, are most comfortable with sound business transactions with tax implications that have greater financial consequences than the parties can afford to or choose to bear. Some examples of insurable situations are tax-free reorganizations, tax-free spin-offs, treatment of redemptions, loss of Section 338 (h)(10) election due to defective S corporation status, golden parachute excise tax, structured real estate transactions, and net operating losses. Basically, if a situation is capable of a tax expert’s analysis, it probably is insurable. How about tax shelters or aggressive transactions? No and no. Neither tax shelters nor aggressive deals are the sort of transactions insurers want to insure. They are looking to provide comfort where there is a sound tax structure and business purpose. Generally speaking, insurers look for a “should” level of comfort with a deals. By the way, buying tax insurance does not trigger reporting requirements. On more technical points, will tax insurance protect the insured for the statute of limitations? Yes. At the option of the client, the policy can be designed to cover the three-year or six-year statute of limitations applying to various tax liabilities. What is the cost? There is a prepaid premium, which is a percentage of the amount of coverage purchased. Depending on the insurer’s underwriting judgment on the likelihood of loss, limits, retention, and term, the premium tends to be in the range of 5% to 8% of the limit purchased. For example, premiums on a $10 million policy might range from $500,000 to $800,000. How do insurers underwrite the policy? Is a legal opinion required to obtain insurance? An insurer forms an independent view of the structure of a transaction and bases its underwriting decision on that view. Some insurers use outside counsel, others use in-house expertise. While information on a deal obviously has to be provided to insurers, it does not have to be in the form of an opinion. We find, however, that from the policyholder’s viewpoint, there are benefits to providing an insurer with a well thought-out and credible roadmap to understanding the risk. This may be in opinion form, a memorandum, or even a ruling request. An opinion offers an excellent way to do this and has added credibility if it comes from the insured’s tax or legal adviser. It also can be more cost effective than paying the insurer’s cost of creating its own analysis. Does a tax insurance policy require a client to act differently in working with the IRS? Insurers try to have their policyholders act the same as if they were uninsured. If there is a contest with the IRS, which insurers expect if there is a basis for the contest, the insurer, as with other liability insurance policies, will want to be kept informed and consulted with regarding important strategic decisions. Of course, settlements cannot be entered into without the consent of the insurer. Do these policies work when it comes to claims? Clearly, an insured party does not want to substitute a dispute with the IRS for a dispute with an insurer. We understand that insurers have paid some claims under these policies but because the policies tend to protect against catastrophe in areas where loss is not expected, the loss history is not extensive. However, there are two key reasons why a policyholder should be less likely to find itself in a dispute under a tax policy than a traditional insurance policy. First, the policy is very clear. It specifically refers to the deal or situation that is covered. It also specifically refers by tax code section to the intended tax treatment. Contrast this with a traditional liability insurance policy, which covers something a company may do in the future. Such traditional policies, therefore, must devote pages of text to specify what is intended to be covered and what is not so intended. A tax insurance policy can be very straightforward and have very limited exclusions. The second reason is that the policy itself is customized — what the insurance industry calls “manuscripted.” This permits the insured party and its advisers to negotiate the language of the policy to address any concerns they might have. If the policy is not satisfactory to the client, that should be considered in its purchase decision. What is the role of a broker in the tax insurance process? An insurance broker should be selected because of its specialized expertise in transactional insurance products. The market for tax insurance is fairly specialized and a broker with deep experience can add value in structuring and placing the coverage. It will work on behalf of the client and its counsel to structure the tax insurance aspect of the deal, identify the appropriate insurers to consider providing coverage, and, in the case of large risks, assemble a syndicate of insurers and put together the submission for insurers. As a deal moves forward, the broker should advise the client on quotes received from insurers and work with clients and their legal advisers to negotiate terms and conditions for the coverage. At what stage of a transaction should the broker be called? It’s always good to begin this process early, even if just to brainstorm and understand the process before a buyer or seller is too deep into a deal. As noted earlier, it’s not unusual for an astute seller to try to address a perceived risk in anticipation of going to market. Gary Blitz is a Managing Director of Aon Financial Solutions, provider of insurance brokerage services with expertise in transactional insurance. (c) 2005 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved. http://www.majournal.com http://www.sourcemedia.com