“The hardest thing in the world to understand is the income tax.” Albert Einstein
As we all know, tax rules are inherently complex because they are designed by lawmakers to outwit the seemly natural tendency humans have for tax avoidance (unless you are Scandinavian, obviously). To make the legislator’s job even harder, most countries have very strict legality principles in place for establishing their tax bases, which means that anything and everything that falls outside the scope of those rules will not be taxed.
This means that even the smallest loophole in a tax law can have a significant impact in a Government’s tax revenue.
This complexity exponentially increases when dealing with tax law designed to govern (i) business operations spanning multiple jurisdictions and/or (ii) complex corporate and financial operations like group restructurings or M&A.
Even with the best expert advice (which sometimes is nothing more than an educated guess), tax authorities might simply have a different (unforeseen) judgement about how the very same tax rules apply in a given case, which means taxpayers, most often than not, need to simply make leaps of faith.
Since lawyers are great risk managers (or risk avoiders, some would say), they have come up with several smart ways to reduce or eliminate their clients’ exposure to identified tax risk (unidentified risks are, by definition, unmanageable), most notably:
- Representation/Warranty clauses: A promise, assurance, or statement made by the warrantor regarding the existence or accuracy of specific facts or the condition, quality, quantity, or nature of a good or property, which can either be expressed or implied, but both of which are legally binding commitments, under penalty of breach of warranty.
- Indemnity clauses: An indemnity clause is a contractual transfer of risk between two or more contractual parties generally to prevent loss or compensate for a loss which may occur as a result of a specified event, typically stemming from third-party claims (which sets it apart from Warranties, which are designed to provide assurances about the status of a party’s affairs).
- Covenants: A contractual statement pursuant to which a party promises a future action or inaction during a certain period of time (often the term of the agreement), the breach of which leads to compensatory damages or possibly excuse from the future performance of contractual obligations.
- Price retention / Escrow arrangements: Aretention of part of the purchase price, either as security for the buyer in respect of potential breaches of warranty or indemnity or to secure the parties’ payment (or repayment) obligations under a price adjustment mechanism. Where a retention is agreed, the retained amount is often paid into an escrow account.
- Limitations: Also known as a liability clauses, they are contractual provision that limit one or both parties’ liability in the event of damages or injury, either by specifying a total amount or percentage of total damages, or it may state that no party will be liable for any damages.
However, legal drafting can only get you so far, especially when neither party is willing to take the risk.
Such a predicament demands more extreme solutions, namely:
- Tax rulings: Tax rulingsoffer certainty and predictability regarding the manner in which taxpayers will be treated in matters of taxation. Better yet, they are usually binding and offer penalty protection if the Tax Authorities come to change its stance on a given ruling. Tax rulings come in all shapes and sizes. The most common ones are:
- Tax framework rulings: Tax rulings pursuant to which Tax Authorities establish their understanding of the tax framework applicable to the case described by the applicant. These tax rulings are based on the applicable law at the time of issuance and consequently are not – by any means – an arbitrarily determined tax framework tailor-made to align with the applicant needs.
- Tax base rulings: Tax rulings pursuant to which Tax Authorities establish the base of a given tax regime (most commonly the tax value of real estate for property tax purposes).
- Tax agreements (a.k.a. tax bargaining): These extreme forms of tax rulings allow for tailor-made tax frameworks (in the form of tax incentives basically) to be made available to the applicant, usually for a short period of time and in exchange for investment commitments and minimum job creation thresholds. Very few countries (at least in the OECD) have these forms of tax rulings – most famous case are the Luxembourg tax rulings, which have been greatly reduced in number in the last few years –, albeit many countries also have them, in some form or other, as R&D tax incentives.
- Tax clearances: A tax clearance certificate is a confirmation from a Tax Authority that an applicant’s tax affairs are in order. Tax clearances are a very common requirement to apply for certain grants, incentives and public sector contracts. However, for M&A operations and other complex transactions, these tax clearance certificates do not make for great assurances of non-liability, since they only state that, at the time of issuance, the applicant did not have any known overdue tax debts. It does not assure, in any way, that the applicant might not become liable, in the future, for overdue tax debts, even pertaining to past tax years following a tax audit (within the boundaries set by the applicable statute of limitations, naturally).
When tax rulings are not a viable solution – because either the timing isn’t right (tax rulings take months to be issued), asking for one is too expensive (not all tax rulings come for free) or the taxpayer just isn’t comfortable in asking for one (if you don’t want to receive a bad ruling, don’t ask for one) – there is only one last resource (still very much unknown by most tax practitioners):
Tax insurance.
“People who live in glass houses should buy insurance” Unknown
Tax insurance is designed to transfer a known, but uncertain, tax liability from a company’s balance sheet to an insurance company. The insurance indemnifies the policyholder for financial loss arising from a successful challenge from a tax authority, removing uncertainty around potential tax liabilities.
Tax insurance is normally bought in the context of investments or M&A transactions where there are questions over the validity of a tax position, usually uncovered during the due diligence process.
Examples where tax liability insurance can be provided include:
- Availability of substantial shareholding exemption(s) in relation to a disposal of shares
- Categorization of asset sale versus business sale
- Residency issues
- Debt for equity swaps
- Secondary tax liabilities (including VAT groups)
- Stamp duty land tax group relief
- Tax charges arising on the disposal of loan notes
- Tax-exempt demergers
- Withholding tax on overseas dividend payments
- Trading versus investment risk
- Tax residency
- Transfer pricing
Although in most countries in northern Europe tax insurances are becoming more and more common, for countries in the south it is still very much an exotic concept.
But maybe (old) lawyers can still learn new tricks?
Luís Castilho
February 2023