Tax warranties and indemnities in M&A transactions are intended to allocate the risk of unforeseen pre-completion tax liabilities between the buyer and seller. Typically, the buyer will have rights, subject to certain exceptions, to recover amounts in respect of pre-completion tax liabilities that were not provided for in the accounts relevant to the sale price.
Tax claims are usually subject to detailed notification and conduct of claim requirements (as well as requirements under English contract law). When a potential tax liability arises, whether a tax indemnity works as intended may depend largely on the extent those requirements are complied with.
In this briefing, we explore the key issues relevant to (from a buyer perspective) getting a claim right from the outset and (from a seller perspective) potential defences. We look at the tax indemnity in this briefing. Similar issues also arise in relation to tax warranties. If the transaction is insured, it is important to check the terms of any warranty and indemnity policy to see what is required.
Identifying the issue
1. Managing information flow
To make a timely notification, it is critical that the right people are made aware that a potential tax claim has arisen.
When the tax authority first makes contact, it may not be apparent that there is a notifiable claim under the tax provisions in the sale and purchase agreement. The first step taken by the tax authority may be an information request, or raising the matter informally (e.g. during a relationship meeting). In addition, the personnel dealing with the tax authority may not have been closely involved in the M&A transaction, particularly where the tax issue relates to a local subsidiary or business.
Accordingly, buyers should ensure that relevant stakeholders are made aware of the potential for claims and that arrangements are in place to facilitate information flow to the legal team.
Preparing the notification
2. Time limits
Like other warranties and indemnities in M&A transactions, tax warranties and indemnities are usually subject to a time limited notification period, which commences upon the relevant party (which could include a group company as well as the buyer) becoming aware of the claim.
The nature of the time limit will always depend on the particular wording used. Some provisions will require compliance with the time limits as a condition precedent for an indemnity claim to be valid. In other words, if a notification is made late, an indemnity claim may not be valid.
Even if notification within a certain time period is not a condition precedent to liability, a delay in informing the seller may still allow the seller room to argue that it has been prejudiced by that delay.
As a result, it is critical to get time limits right. Where there is uncertainty, be conservative in calculating the last date to notify. Aim to prepare the notification well before the deadline. Inevitably, the drafting process may identify further information which should be included in the notification and needs to be requested, which can generate delay.
3. Potential claim or actual claim?
Notification of a ‘potential claim’ may not be a valid notification (this will depend on the wording of the indemnity). In order to trigger a claim, usually the buyer/indemnitee will need to notify an actual claim. Something which amounts to little more than a reservation of rights may not be valid.
This does not mean that a claim cannot be made on the basis of a contingent liability, but it does mean that the way such is a claim is couched is important. Usually, such claims should be presented as an actual indemnity claim in respect of which there is an element of contingency to the ultimate liability, rather than as a contingent or potential indemnity claim.
4. Claim detail requirements
Claim notification provisions can require the buyer/indemnitee to provide some details of the claim, often expressed as “reasonable detail”. What level of detail is reasonable is always a fact specific question, sensitive to the precise wording used and relevant facts. Given the purpose of such clauses is to provide information that the seller/indemnitor can act on, providing high level or unspecific information is unlikely to be sufficient to satisfy the requirements of the clause.
The Court of Appeal has recently held that1 that the purpose of such clauses is to: “enable the recipient to make [inquiries] into the factual circumstances giving rise to the claim, with a view to gathering or preserving evidence; to assess so far as possible the merits of the claim; to participate in the tax investigation to the extent desirable or possible with a view to influencing the outcome; and to take into account the nature and scope of the claim in its future business dealings…”.
It can be tempting to only provide high level information, particularly where the tax issue relates to an issue which existed pre-completion, i.e. matters of which the seller/indemnitor should already be aware. However, whether or not the seller/indemnitor is already aware, it is advisable to set out fully what the claim relates to and any key developments to date.
5. Quantum estimates
Generally, it is advisable to include an estimate of quantum in any notice. A notice requirement may or may not expressly require an estimate of quantum, but any requirement to include reasonable detail may be interpreted as requiring the notice to say something about quantum.
This does not mean that a notice must provide a detailed estimate, but it should ideally identify the heads of loss and give an estimate of the total amount in monetary terms. In many cases, this is not possible and there is a balance between notifying the seller promptly and waiting until the tax authority’s position is clearer.
Both parties should consider at an early stage whether any claim exclusions, caps etc could apply. From a buyer perspective, anticipating potential exclusions is relevant to how the claim is couched in the notice (and ultimately to the outcome of the claim). From a seller perspective, when a notification is received, sometimes there can be a natural tendency to focus on the substantive merits of the claim. Don’t overlook what exclusions could apply. Even if there is scope for argument on the application, at the very least, potential exclusions will be relevant to settlement value.
Serving the notification
7. Notice formalities and service
A notification will invariably be subject to the contractual notice provisions under the relevant transaction document, which involves formalities and service requirements. The burden of proving compliance with the notice provisions is on the party seeking to rely on the notice. Under English law, failure to comply strictly with the contractual notice provisions is likely to render the notification invalid.
As a result, it is critical to follow the formalities in the contractual notice requirements exactly (including to notify all parties specified in the notice clause, use the correct delivery method, etc.). Remember that ‘over-compliance’ will not affect the validity of the notice, but failing to comply with the formalities may well do so.
Conduct of tax claims
8. Consultation and conduct of claim requirements
Usually, the buyer will be required to consult with the seller regarding the conduct of the underlying tax claim. It is important to note that the obligation to consult with the seller may be separate from the terms of the obligation to notify; a notice of the claim must be made even if the seller is already being consulted as to how the claim may be conducted with the tax authority.
The seller may have certain rights during the course of the claim, such as a right to provide comments on documents before submission to the tax authority. In some cases, the seller may have a right to elect to take control of the claim.
This means that managing the claim will invariably involve multiple parties, i.e. the tax authorities, the target company, the buyer and the seller, each with competing interests. This invariably leads to differences of approach. The seller will tend to favour a defence strategy to minimise its potential liability under the indemnity whereas for the target company and buyer, relationship and reputational considerations will be in play.
While it is common for disagreements between seller and buyer/target company to emerge, parties should try to reach consensus. Disagreement about the basic conduct of the claim will distract from the resolution of the substantive tax claim, which is unlikely to benefit any party.
Where a seller elects to exercise its conduct rights, the buyer should ensure that it has proper processes/reporting lines to ensure that the seller’s directions are followed (unless there is a basis under the indemnity to reject them). If the seller’s lawful directions are not followed, then the seller may seek to raise arguments that this adversely affected the ability to defend/settle the claim and its liability under the indemnity. It is important that all group companies are aware of this issue even before a claim is made; if a tax authority raises a concern about pre-sale tax matters, any response should be neutral and factual so that there is no room for the seller to argue its rights have not been respected.
9. Information flows and privilege
Given the multi-party nature of tax claims, parties need to consider processes for managing information flows and exchanging documents up front.
It is very important to ensure separation between information streams relating to (a) defending the substantive tax claim against the target company (i.e. which may be shared between buyer and seller); and (b) analysis of the seller’s potential liability under the indemnity (which should not be shared). The best way to do this is usually to put in place a protocol supervised by the legal team.
Parties should consider whether litigation privilege may apply in relation to documents created concerning the conduct of the underlying tax claim. Litigation privilege requires litigation to be in reasonable contemplation and documents to have been created for the dominant purpose of that litigation. Unlike legal advice privilege, it may cover documents created by non-lawyers, which is valuable given tax disputes frequently involve accountants and non-legally qualified tax advisers. In the context of tax disputes, it has been held that receipt of a letter from HMRC making a demand for contested tax may be sufficient to make litigation in contemplation, but this is very fact-specific2. If litigation privilege does apply, then privileged documents can potentially be shared on a common interest or limited waiver basis without loss of privilege generally.
Where a seller assumes conduct of a claim, do not assume that litigation privilege will necessarily apply as against the buyer. The High Court3 has held that a claim for privilege by a seller against a buyer, in respect of documents relating to a claim against the target company for which the seller had assumed conduct, failed because it was the target company rather than the seller that was party to the claim.