Trends in warranty and indemnity insurance – tax risks
The Moore Kingston Smith M&A tax team supports specialist warranty and indemnity (W&I) underwriters in assessing tax risk as part of policy underwrites. Our recent experience has identified emerging trends as W&I insurance is increasingly used across transactions.
Standard exclusions in W&I insurance
It is market practice to include standard exclusions regarding tax matters that are not covered in a W&I policy, such as:
Secondary liabilities
These are potential tax liabilities falling on a target insured, arising because of an exposure or unpaid liability in the seller’s group which tax law enables to be put on a target as a secondary liability. An unpaid VAT liability due to being a member of an existing VAT group is a good example. It is not always obvious what secondary exposures may exist, hence the standard exclusion. That said, it can often be possible with a few targeted underwriting questions to get comfortable on the secondary liabilities position. This is particularly true in smaller deals where the selling group is not complex.
Transfer pricing
Transfer pricing risks have long been excluded from W&I coverage, primarily because they can be difficult to diligence and are often subjective. However, as with secondary liabilities, it can sometimes be possible to get to an acceptable position on risk by understanding a bit more about a target and historic intercompany transactions. For instance, is the target exempt from applying transfer pricing by virtue of size? Are relevant transactions all in the same jurisdiction and therefore practically of little risk? With a good diligence pack, it is possible to give a positive assurance on transfer pricing.
Pillar 2
Arising from the OECD base erosion profits shifting (BEPS) initiative, Pillar 2 is a global action to impose a minimum effective tax on profits of very large multi-national entities. It is relatively new (applying in the UK for accounting periods commencing after 31 December 2023). We are starting to see Pillar 2 exposures considered in tax diligence exercises. The regime can be extremely complex, and exposures are not yet widely understood. For relevant deals, it is advisable to consider a standard exclusion regarding these unless or until sufficient comfort can be obtained. Opportunities may exist to cover Pillar 2 risks outside W&I insurance.
Summary
With secondary liabilities and transfer pricing in particular, we are increasingly seeing brokers and their clients or lawyers asking for a relaxation of standard exclusions. Without specialist knowledge, it can be difficult, if not impossible, to make a risk assessment here. We help our clients quickly and cost effectively decide on these points to enable them to be competitive at NBI stage and then through the underwriting process.
Affirmative cover
Our clients are seeing increasing requests for affirmative cover. This applies where known risks are brought within W&I coverage despite an identification in a tax diligence report and/or falling to be excluded by virtue of an existing knowledge exclusion. Examples might include a tax residency risk on a Jersey property SPV or a pre-transaction restructure that the insured wishes to include in the W&I policy.
Without specialist knowledge, it can be difficult to assess requests for affirmative cover and potentially be at a commercial disadvantage in terms of cover level which can be offered. We help our clients quickly reach an informed view on these matters to enhance their coverage offering. We also help our clients critically assess risks which may be described as low or negligible in a tax diligence report, so on the face of it might be suitable for affirmative cover but are often anything but.
A good example would be possible payroll taxes exposure regarding off-payroll workers. Depending on circumstances and how this is presented in a tax diligence report, it may be difficult for a non-specialist to form a view. In our experience, it is rare for this particular type of risk to be wrapped up in a W&I policy. It is often more appropriate for a bespoke policy to be sought if protection is desired. This mitigates risk on the W&I policy and drives revenue for insurers who can also separately cover bespoke tax risks.
Tax due diligence
A comprehensive diligence exercise supports all aspects of a W&I underwrite, and the tax component of a policy is no different. A well written and comprehensive tax due diligence report prepared by advisers who understand what their work will be used for makes assessing coverage much easier. However, in our experience, there is a wide variation in quality of tax due diligence reporting, particularly on smaller deals.
A non-specialist tax underwriter is unlikely to be able to spot potential risks in a lower-quality report and either have to insist on extensive exclusions or worse, proceed without full knowledge of the risks they are insuring. Our team is expert in reviewing tax diligence reports. They routinely produce a suite of concise and targeted underwriting questions to help clients gain the necessary knowledge when initially presented with lower-quality or non-comprehensive tax due diligence reports.
Help from the experts
We are not underwriters or insurers, but the Moore Kingston Smith M&A tax team is expert in tax risk matters. We know how to effectively communicate these to our insurance clients who can use our advice to make informed decisions, protect themselves from risk and be competitive. We know the market and understand that our input needs to be quick, cost-effective and grounded in commercial quantification of risk. We support insurers who already have tax expertise but need additional scale and those without in-house tax experts.
If you would like to explore how our team can help your business, please contact one of our experts.