Lifecycle of a transaction: Tax protections and W&I
This article was originally published in the Tax Journal, May 2025 and is reproduced with permission from the publisher.
In the mid-life of the transaction cycle – with structuring (hopefully) finalised, and negotiation of the SPA in full flow – it will be necessary to turn to the tax protections provided by the seller to the buyer.
Typically, these take the form (of course) of tax warranties and a tax covenant. These protections provide comfort to the buyer that the target should not have any unknown tax skeletons in its closet and that, if any such nasties should, following completion, prove to exist, then the seller will make the buyer whole for those liabilities.
In this article, we will discuss the nature of each of these core tax protections and their typical limitations, along with both the key differences between the protection afforded by each of them, and the extent to which W&I insurance impacts those protections and erodes the distinctions between them – matters which can be easily glossed over in the rush of negotiation.
Case study
Continuing with our case study set out in our previous articles in our series: Fundco has now established its acquisition structure and put in place its financing arrangements and so is ready to proceed with its purchase of Jersey Propco (a Jersey incorporated but UK tax resident company). All that remains is for it to ensure that it has adequate protection against historic liabilities. Fundco turns to its legal advisers for assistance and confirmation that the tax provisions set out in the transaction documents are sufficient for these purposes.
Tax warranties
Core tax warranties give essential representations about the state of the target business. They are statements of fact about the target’s tax position at the date the SPA is signed (and, potentially, about its state at completion, too).
Typically, key warranties will provide that the target has paid all tax that has fallen due, that the relevant accounts provide for all tax in accordance with relevant accounting standards, that the target has duly submitted all required tax returns, has retained all such records relating to tax as it should have retained, and is not involved in any dispute, investigation or similar with the tax authorities.
However, often, buyers will request tax warranties which go beyond these matters, sometimes seeking warranty suites running to several pages.
Many warranties will significantly overlap with one another in terms of the protection they grant. For example, there may be warranties that the target has paid specific taxes such as stamp duties or does not have overseas tax liabilities, which are largely duplicative of the general warranty that the target has paid all tax it ought to have paid.
The rationale for drafting such multi-layered protection is generally that the warranties are, in fact, not primarily intended to provide contractual protection, but rather to elicit information from the seller through the disclosure mechanism, whereby the seller should detail all instances in which the target’s true position derogates from that set out in the tax warranties (with such disclosures then being matters in respect of which the buyer can no longer make a claim under the warranties).
Tax covenant
The tax covenant, however, is a very different beast, and is generally seen as the core tax protection (rather than the tax warranties) for a number of reasons.
First, it offers broader and simpler protection than the warranties, being drafted as a covenant to pay an amount equal to (broadly) any tax liability arising in respect of income, profits or gains arising, or any events occurring, on or prior to the transaction’s completion (though it may have additional, more specific limbs too).
Second, it does not require the buyer to prove that it has suffered loss. This is in contrast to warranties, which require a buyer to demonstrate that the shares it acquired are worth less than they would have been absent the breach: instead, under the tax covenant a buyer simply submits a claim to the seller for payment on a pound for pound basis equal to any liability within its scope.
Third, unlike warranties, there is no common law obligation on a buyer to mitigate any loss.
Fourth, disclosure, or buyer knowledge, of a tax issue does not preclude the buyer from making a claim under the covenant, as it does in respect of warranties.
And fifth, while the tax warranties will typically be subject to a financial de minimis and threshold under the SPA – such that a claim can be made only if the claim value is over the agreed de minimis sum, and if all such claims exceed an agreed threshold or ‘basket’ sum – the tax covenant, as noted above, offers straightforward pound-for-pound protection and should not be subject to these financial limitations.
Accordingly, it would be an unusual buyer who, given the option of making the same claim under a tax warranty or the tax covenant, opted to claim under the tax warranty alone.
Both the tax warranties and the tax covenant will, typically, survive for seven years from the date of completion. As a result, the seller will be potentially liable to claims throughout that period. This may be unpalatable or even, in the case of certain sellers (such as fund or private equity sellers), impossible, on the basis that they must distribute the gains made on sale to investors and cannot hold on to funds in case of potential future claims. In these circumstances, or instances where the seller otherwise wants a clean break, W&I insurance – a product which has continued to grow steadily in popularity over the past several years – will often be the answer. Under W&I, the seller’s liability under the tax protections will typically be limited to a nominal £1, with the insurer effectively standing in the seller’s shoes should a claim arise.
How does W&I insurance impact the tax protections?
Despite W&I insurance being increasingly common, the significant impact that insurance has on the eventual buyer coverage position is not always considered in detail. Key distinctions between tax protections as given by the seller, and as given by an insurer, are discussed below.
First, the insurer will typically exclude three elements of risk which would be covered by the seller in an uninsured deal. Insurers will not, generally, provide protection against transfer pricing risks, secondary tax liability risks (although withholding tax obligations generally won’t count as secondary tax liabilities for these purposes), or against any loss of tax assets which are unutilised as at completion. The rationale for these exclusions is, broadly, that such matters are not adequately diligenced (and/or, in the case of the loss of tax assets, the buyer is not paying for the relevant tax assets).
Second, the insurer will typically impose a de minimis and threshold on the tax covenant, as well as the tax warranties, such that the buyer does not in fact get true pound-for-pound cover.
Third, an insurer will also oblige the buyer to act as a ‘prudent insured’, effectively requiring it to sensibly mitigate any loss which is covered under the tax warranties or covenant, as though it were not, in fact, insured – in distinction to the position in an uninsured deal, under which the buyer typically has no mitigation obligation as regards the tax covenant.
Fourth, any matter which is disclosed (under the disclosure mechanism or in diligence reports, for example), or which is otherwise known to the buyer, will not be covered. While as noted above this limitation effectively already applies in respect of the tax warranties, in an insured deal, the same is true of the tax covenant as well. The buyer will therefore have no protection against any risk which is known. Ironically, this can have the effect that the better the tax diligence which the buyer undertakes, the less good that buyer’s coverage under a W&I policy – save where the target business has been well-run from a tax perspective.
These points of distinction leave the buyer with a number of options. It may of course choose, as a commercial matter, to accept the more limited cover which W&I provides. But, if the buyer becomes aware of issues within the target which are matters of concern and where standard W&I does not assist, these are several other routes to explore.
One such route is affirmative cover. If a buyer has particular concerns which are not covered (or at any rate not clearly covered) by W&I, then, for an additional premium and in respect of items which are reasonably low risk, an insurer may be willing to make explicit that the policy will provide cover for the relevant issues.
For risks which are more likely to crystallise, and for which affirmative cover is therefore inappropriate, a standalone specific tax risk policy may be available. This option is often overlooked in an M&A context. In some instances, this is due to the common misapprehension that known risks cannot be insured against (which, while true so far as W&I policies go, and of course true of where there is a certain tax liability, is not true of tax insurance more broadly). In others, it is because the diligence process will almost inevitably be running in parallel with deal negotiations, and material risks may become clear only when signing is near – such that time to negotiate a standalone insurance policy for last-minute issues may be limited. While this is a purely practical problem arising due to the tight timelines which transactions by their nature require, it’s worth bearing two points in mind. Firstly, the buyer’s tax diligence team would do well to alert the buyer’s advisors of any issues or potential issues as soon as possible, rather than waiting for diligence to be finalised, as this will give the best chance of a sufficient time window to obtain an additional insurance policy for a known tax risk. Secondly, insurers can be fast in considering such risks – so that even when deadlines are tight, it’s worth considering whether a standalone policy may be available.
Insurance aside, other routes for a buyer to consider broadly require the seller to take contractual responsibility. A price reduction for higher-risk and quantifiable issues may well be a good option. An escrow, similarly, may be appropriate, although this relies to an extent on the seller’s ability to hold back funds for this purpose, i.e. it does not need to promptly distribute all consideration to investors.
A third option, which is sometimes seen (but which, again, requires a seller with the ability to do so) is to ‘split’ the tax protection between insured and uninsured risk. This may take the form of the seller agreeing to pick up any liability under the tax protections which the insurer will not. This leaves the buyer in a strong position, with all risk covered by either the insurer or the seller. But it can prove complex in terms of drafting, since many practical questions are often overlooked (not least because this option is often employed at the last minute, when it becomes clear that certain risks cannot be covered by the insurer). For example, how is it to be demonstrated that the insurer will not provide cover? Must the buyer actually make a claim and have it turned down, before the seller’s coverage obligations kick in? Must the policy specifically exclude the claim in question, or will exclusion by disclosure be sufficient, in order for the seller to become liable? Will the seller pay for sums which W&I does not on the basis that they are below the W&I de minimis, or only for excluded matters? These practicalities will take careful consideration if the parties are to be clear on process and responsibilities in the case of a future claim.
Alternatively, this option could take the form of a specific tax indemnity or indemnities, which protect against specific risks which the insurer will not cover. While this plugs fewer gaps in cover from a buyer’s perspective, it also provides more clarity to all parties.
For the seller, of course, the impact of W&I is straightforward: seller liability will almost invariably be capped at a nominal amount (fraud aside). However, as buyers seek to ensure maximum protection, they become more prone to asking sellers to stand behind risks which W&I will not cover – leading both parties to consider the options discussed above.
Looking forward
All in all, buyers will have a number of ways to skin the tax protection cat and maximise cover, using a potential hybrid of commercial decisions as to price, protections which the seller stands behind, and protections which an insurer will stand behind.
Once the tax protections are agreed (and once it is agreed whether the seller, insurer, or both, will be providing them), it remains only to hope that no skeletons in the target’s closet emerge to materialise into actual tax liabilities: although if they do, the buyer should know where to turn to be made whole.
The remaining guides in this series look at how the buyer can maximise VAT recovery on its costs, and how – should any such tax skeletons ultimately pop-up – any dispute relating to them may play out.
