What is a tax indemnity?

When purchasing a company, a buyer will go through all the usual due diligence proceedings: reviewing financial statements, evaluating legal liabilities, valuations, and so on. Both the buyer and seller would hope that no circumstances arise in the future that were missed during the due diligence process, but sometimes tax liabilities will surface. A tax indemnity (sometimes referred to as a tax covenant) protects the buyer from unexpected liabilities that are revealed after the sale is completed. It’s an agreement between both the buyer and the seller – the seller can absolve all responsibility for potential tax issues, or those liabilities can be apportioned between both parties.

A tax indemnity is commonly seen in a share purchase agreement, which is a formal contract outlining the terms and conditions of the company’s sale and purchase.

What is the difference between a tax warranty and tax indemnity?

A buyer will typically outline contingencies and warranties in a share purchase agreement. The warranties are contractually binding promises the seller makes to the buyer about the company’s affairs, financial statements, tax liabilities, etc. While some of these warranties might relate to tax, the buyer might still seek to establish a tax indemnity claim for extra protection. Warranties alone don’t completely protect the buyer in terms of financial compensation.

If a tax liability is missed during the due diligence process, and the seller hasn’t outlined a potential liability on the share purchase agreement, then a tax indemnity gives the buyer significantly better financial compensation. This results in a pound-for-pound claim for the buyer, even if the value of the company did not decrease. However, if the buyer only has a warranty as protection and that warranty is breached, they will have to prove that the company decreased in value to get compensation. The duty is on the buyer to mitigate the loss, whereas claimants under tax indemnity do not have to prove that they have mitigated or reduced their losses. In the case of a breach of warranty, buyers are not usually allowed to claim under both a tax warranty and tax indemnity.

What is typically covered in a tax indemnity?

Tax liabilities

A tax indemnity will cover the company’s tax liabilities that occurred before the sale was completed, but that might have come to light after completion. For example, if the seller did not pay enough tax in the previous financial year (before the sale was complete), then a tax indemnity puts the duty on the seller to cover the difference and any subsequent fines.

Secondary liabilities

If a company is associated with another company, there are certain instances where both parties are liable for the other. If one company encounters a tax liability and does not pay it, then the other company might be considered liable for that tax owed. This is considered a secondary liability. A buyer will typically want an indemnity in place to include secondary tax liabilities.

What is typically not covered in a tax indemnity?

While tax indemnity coverage seems one-sided towards the buyer, there are some instances where it would be unreasonable to expect the seller to cover the cost.

Tax liabilities that the seller has disclosed and are reflected in the company’s accounts

If a tax liability has been disclosed, is shown on the company’s accounts, and is even reflected on the sale purchase agreement, then tax indemnity coverage is typically not valid. The buyer could have raised this tax liability with the seller before purchasing the company and therefore agreed to a new purchase price if the liability affected the company’s valuation.

Changes to HMRC practices and laws

If retrospective changes to HMRC’s laws and regulations implicate a tax liability, the duty would typically fall to the buyer. Even if the changes affect the company’s tax liability before the sale, it is not the seller’s responsibility – so long as the changes come into place after the sale is completed.

What are the benefits of a tax indemnity?

• A tax indemnity manages the buyer’s risk.
• A seller agreeing to an indemnity can make the company more appealing to the buyer.
• Claiming under a tax indemnity is usually more straightforward and quicker than claiming under a tax warranty.
• Ensuring the tax affairs of the company are up to date and in good order should help the sale process run smoothly.

How long does the buyer have to claim for a tax liability under a tax indemnity?

Tax issues can take months or years to come to light, therefore tax claims have a longer time limit than non-tax warranty claims. HMRC can reopen tax cases and make new assessments for years after the specific accounting period. In general, a buyer will have between four and seven years to claim tax indemnity. There is a longer limitation period to account for tax-related issues cropping up in the future which gives the buyer enough time to make a claim.

If this is your first time selling or buying a business, then the legal frameworks can be confusing to navigate. At Finerva, our team of trusted experts and founders can help with all things tax or are available to simply offer clear and actionable advice. Please get in touch to speak to one of our team.