Tax Liabilities Present a Growing Threat to U.K. M&A Market, Study Says

February 21, 2006

Issues relating to taxation are the biggest cause of Warranty and Indemnity (W&I) claims in the UK according to latest research from Aon Limited.

The firm analysed the W&I deals underwritten between 1990 to 2002, a period of high levels of M&A activity in the UK, and found that:

* Almost a fifth (17%) of warranty claims brought against the seller in 1999 were a direct result of taxation liability. This figure more than tripled to 66% in 2002 and Aon predicts that taxation liability is of growing significance for UK businesses.

The most typical taxation issues that result in liabilities range from VAT to Corporation tax or PAYE issues. A seller is usually required by a buyer to provide an indemnity against the liability which relates to their period of ownership (i.e before the sale). In doing so, the seller draws a line in the sand in terms of where the responsibility for tax liability lies. Thereafter, once liability is uncovered, it very much depends which period the tax liability related to in determining where the responsibility lies and which party bears the cost. The seller can then insure their liability under this indemnity by taking out a standard W&I insurance policy, to cover these unknown or unidentified risks at the time of sale.

Aon’s research also reviewed deals underwritten in 2003 and 2004. However, due to the sharp decline in M&A activity during these two years, the subsequent decrease in the number of claims over these two years is not representative of the overall trend.

Commenting on taxation liability, Anka Taylor, director of Aon’s Transaction Liability Unit, said: “Our latest research highlights the steady rise in tax related claims over the past seven years. From a financial perspective there is no middle ground, you either have a tax liability or you don’t and you could end up paying out zero or – given the size of the potential risk involved – millions of pounds, thereby destroying the profit you may have made. Overlaying this, you have to think about legal and defence costs, which can also escalate into thousands of pounds. No company can afford to take the risk of financial ruin and that is why we’re seeing a corresponding increase in the number of businesses taking out some form of taxation insurance.”

Separately, it is not uncommon for the possibility of a known adverse tax issue arising to block a deal, especially when the seller is not prepared to indemnify the buyer against an unfavourable outcome.

Taylor added: “There is no substitute for the buyer to conduct a rigorous M&A due diligence process, and no excuse for leaving any stone unturned. Building upon this, insurance can play an important part in the completion of a deal by ring fencing a known taxation risk that neither party can otherwise allocate between themselves.”

Neil Cooke, partner at law firm Barlow Lyde & Gilbert commented: “We have witnessed an increasing volume of UK Claims under the tax warranties and the tax covenant, across a broad spectrum of transactions, over the past seven years. We have also seen a marked increase in the size of the claims being pursued. It is difficult to identify any common causes or trends in terms of why and how the claims arise which emphasises the potential importance of insuring against the wide variety of tax liabilities that might materialize.”

Examples of the type of taxation liability that an insurance policy can cover include:

* A lawful business restructuring which is carried out for commercial purposes and should result in a tax neutral position;
* Potential tax risks relating to a past acquisition, which the buyer is unwilling to take;
* Instances where the seller is unwilling to address the buyer’s primary concern: failure to provide an indemnity.

However, taxation insurance would not cover the following:
* Future change in law;
* Tax avoidance schemes

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