Better safe than sorry: due diligence procedures and tax risks

M&A are always risky endeavours, but risk taking is simply part of doing business. One way to reduce the risk of a transaction is to perform a due diligence analysis. In this respect, it is crucial to include taxation, because the consequences of historical non-compliance can be dire.

Almost always, uncertainties are identified relating to historical tax positions but, luckily, investors have multiple instruments at their disposal to mitigate these risks.

Warranties and indemnities

The risk of potential additional tax assessments can be identified during the due diligence phase before the transaction. When risks are identified, the parties can include warranties and/or indemnities in the purchase agreement.

A warranty is simply a guarantee by the seller about the state of the company. If certain features of the company do not conform to the purchase agreement, the seller is liable to pay damages to the investor, unless the investor was aware of the inaccuracy of the warranty at the time of closing.

In addition to warranties, indemnities are agreements between the seller and the investor that provide that in the event of an unforeseen loss originating from before the transaction, the buyer will reimburse the loss.

It is important to note that warranties and indemnities are Anglo-Saxon legal terms, while most transactions in the Netherlands take place according to Dutch (civil) law. Given that Dutch judges are not bound to these terms, the meaning of provisions in Dutch written periodic declaration companies is of great importance.

An alternative that is becoming increasingly popular in the M&A community is insuring deals. The insurance is a product similar to original warranties and indemnities, but provided by a third party. As such, it is called W&I insurance (warranty and indemnity insurance).

The insurance is usually subscribed by the investor, and the insurance premium is often deducted from the purchase price. This premium is generally based on a percentage of the maximum liability covered by the insurance policy.

The advantage of such insurance is that the seller can fully exclude liability, while receiving the full purchase price (minus the premium). The investor also has an advantage, because it does not have to rely on the solvency of the seller post acquisition.

Still, it is important to ensure that the risks involved are covered by the insurance policy. An advantage of W&I insurance is that risks that have not been identified during a due diligence process often fall within the insurance policy.

Usually, the premium and insurance policy are determined after negotiations between the parties involved. However, differences in interpretation or changes in jurisprudence are generally not covered by the insurance.

Resolving during negotiations

The risks of potential additional tax assessments being raised should be identified by advisers during a tax due diligence process. Parties could then consider trying to manage the risks through discussions before closing, in so far as the risk can be managed by mutual agreement.

This could take the form of the execution of certain (acquisition) restructuring steps or including the risk in the pricing negotiations. This requires a problem-solving focus and collaboration by both parties and their advisers, but may, most of the time, be the most efficient way of managing potential risks. Here, the real deal-makers make all the difference.

Even though it is impossible to exclude all risk, there are several ways investors mitigate risks in business transactions. After reading the above, you should have a good impression of the ways in which tax risks are mitigated.

It is crucial to have these in your toolbox when carrying out mergers or acquisitions. After all, losses hurt you more than missed opportunities. That is why the saying goes: better safe than sorry.

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