Protecting buyers’ value in M&A: Part 3 – Tax covenant claims

In recent articles, available here and here we’ve considered in some detail the protection that the warranties and indemnities in a share purchase agreement provide for buyers. The conclusion was that detailed warranties don’t negate the need for a buyer to conduct a detailed due diligence exercise, with the articles highlighting that where a buyer identifies areas of specific risk during due diligence, it should seek specific indemnities from the seller in the share purchase agreement so as to allocate risk appropriately.

In addition to warranties and indemnities, buyers also generally have protection in the form of a tax covenant in the share purchase agreement. So, when there are already warranties covering the target’s tax affairs, and the option of including specific indemnities where risks are identified during due diligence, what purpose does a tax covenant serve?

What are the basic principles of a tax covenant?

At a headline level a tax covenant provides the right for a buyer to recover on a £ for £ basis any unexpected tax liabilities of the target company, particularly those relating to pre-completion profits or other events occurring prior to completion. Given their wide scope, tax covenants are generally limited by a number of very specific exclusions. They differ from warranties and indemnities and are a form of “covenant to pay”, an express promise by the seller to pay to the buyer a specific sum which is, in the context of a tax covenant, calculated by reference to a tax liability or tax event occurring in relation to the target.

Why are tax covenants used and what liabilities do they cover?

Tax covenants are used to provide a buyer with comfort that the target does not have unexpected tax liabilities relating to the pre-completion period. A broad covenant is generally included whereby the seller covenants to pay to the buyer an amount equal to any tax liability of the target arising in respect of any income, profits or gains of the target earned, received or accrued before completion. Additionally, tax liabilities such as PAYE and NICs on employee share options granted prior to completion are also often included together with liabilities of third parties that fall on the target after completion. Tax covenants also cover losses of reliefs that are available to the target and taken into account by the buyer when agreeing the purchase price.

At a practical level, the tax covenant will also usually deal with matters such as who is responsible for filing the target’s tax returns for accounting periods ended on or prior to completion, giving input rights to the seller if the buyer is to file them and vice versa.

What exclusions apply to a seller’s liability?

As detailed above, tax covenants tend be very broad in scope. They therefore tend to include a number of specific exclusions of the seller’s liability including:

• where the purchase price is adjustable by reference to completion accounts, if the tax liability is provided for in the completion accounts then the seller is not liable under the tax covenant (as the liability is already factored into the purchase price);

• where the transaction is on a locked box basis, perhaps by reference to the most recent annual accounts of the target, if the tax liability is provided for in those accounts or arises in the ordinary course of business post-completion then the seller is not liable under the tax covenant (as the buyer will benefit from the profits in this period, it is fair that it bears the tax liabilities associated with them);

• where the tax liability arises as a result of a voluntary action of the buyer or the target after completion outside the ordinary course of business; and

• where the tax liability arises as a result of a change in law or published HMRC practice, it is market practice that the buyer bears the risk of this.

A tax covenant works alongside the warranties and indemnities in a share purchase agreement to manage a buyer’s transaction risk. An unexpected tax liability, or the unavailability of reliefs, if known by a buyer prior to completion may well prompt a reassessment of the price that the buyer is willing to pay. The tax covenant forms a crucial part of the buyer’s contractual protection and serves to protect the buyer against various tax risks associated with an acquisition.