Tax issues with SPAs and Warranty & Indemnity insurance policies

1. Introduction

In recent years, M&A transactions have increasingly been concluded with so-called Warranty & Indemnity Insurances. On the one hand, the insurance solution allows the seller a "clean exit", i.e. a sale without (or with limited) liability from the sale of the company. This is particularly advantageous for private equity sellers because it enables the distribution of the sale proceeds to the investors without having to retain funds for uncertain risks and possible warranty claims of the buyer. Likewise, private individuals as sellers often have an interest in no longer being exposed to warranty risks and protracted legal disputes after the sale. The buyer has a solvent and professional counterparty in the form of an insurance policy to cover his risks from the business purchase. In practice, of course, it is necessary to pay close attention to which risks are actually covered at what cost / with which insurance exclusions, and to what extent any obligations to cooperate or the like nevertheless exist. The case studies will focus on the insurability of tax risks on the one hand and the tax treatment of insurance benefits on the other.

Let's start with some statistics to better understand the role of taxes in S&I insurance:

Basically, a distinction must be made between two types of insurance: General S&I insurance and special insurance:

• Warranty & Indemnity Insurance (often Representation & Warranty Insurance in the US) covers representations and warranties in the purchase contract and is limited to unidentified risks.
• Specialty insurance covers a specific area identified as risky or areas excluded from general S&I insurance. The "classics" of special insurance are, for example, environmental risks. Increasingly, however, certain tax risks are also covered by special insurance.

In the meantime, one mainly finds buyer-side insurances, i.e. insurances that pay directly to the buyer (pecuniary loss insurance), with the buyer as the policyholder. Seller-side insurance policies, which first pay the seller and then the seller in turn pays the buyer, are hardly ever found any more (such liability insurance policies are also not very practical, especially as they often only intervene after the buyer's claim has been established in court). As a rule, insurance policies are arranged through specialised brokers. If an insurance solution is considered, the broker should be involved in the process at an early stage in order to explore the insurance options for the specific case.

Due to the increased competition among insurance providers in the market mentioned above, the premiums for tax guarantee insurance have fallen in recent years. The premium is usually determined by the sum insured, which is often based on the enterprise value (≥10% of the EV). In Europe and Switzerland, premiums for S&I insurance are around 1-2% of the sum insured, for special insurance up to 10% of the sum insured. Insurers usually require a minimum premium, which in Europe and Switzerland is usually in the range of about EUR or CHF 80,000-100,000. Because of this minimum premium, it is usually only worthwhile for a buyer to take out warranty insurance above a certain transaction value. The amount of the insurance premium ultimately always depends on the individual transaction, as the respective industry and geographical activity as well as the regulations in the SPA have an influence on it.

Case 1: S&I Insurance

A, resident in Switzerland, would like to sell his company, A AG with various subsidiaries in Switzerland and abroad ("A Group"), in order to use the proceeds of the sale to enable himself to enjoy a nice and quiet retirement abroad. He therefore does not want to have anything more to do with the company after the sale and, above all, he does not want to be able to be held financially liable. He has heard from his insurance broker about W&I Insurance as a solution: this would in particular exempt him from any liability. In view of the costs, he is still undecided whether insurance is worthwhile for him.

Questions

1. What are the advantages and disadvantages of insurance for the seller, but also for a buyer in an M&A transaction?
2. Should A consider W&I insurance?
3. Should he use a broker for this or can he save himself these costs?

Case 2: Impact on tax due diligence and SPA

A decides to approach the sale with a S&I insurance. He finds the preparation of the due diligence with the compilation of all contracts, balance sheets, tax documents etc. of the last 5 years far too time-consuming and wonders why he has to do this at all if there is an insurance company. A also does not understand why he should read the warranties in the SPA at all, as they are none of his business if the insurance company is liable for them.

Questions

1. The broker explains to A that the due diligence must be prepared and carried out even more precisely than without an insurance solution. Why?
2. Why does A still have to deal with the warranties and indemnity rules in the SPA?
3. Why does this apply equally to the buyer who is to be indemnified by the insurance?

Case 3: Insurability of risks

Bidder B wants to buy the A-Group and has, among other things, carried out a tax due diligence. Various risks have come to light in the process:

• The tax returns 2020-2021 have not yet been assessed and it cannot be ruled out that certain positions will be objected to by the tax authorities (no concrete indications). In fact, an asset was depreciated too high, but this cannot be seen from the annual financial statement and the tax returns.
• The management fees that the German subsidiary has been paying to the Swiss parent company for years could be excessive and objected to by the German tax authorities. Tax risk around CHF 200,000 for the last 3 years.
• Retained earnings of the Swiss subsidiary could qualify as "old reserves" as all shares had been purchased from a seller in Monaco. The possible amount of non-refundable withholding tax is CHF 2 million.
• The Austrian distribution company has only X registered as managing director with residence in Germany. There is a risk that the actual management of the company is in Germany.

Questions

1. Which risks can B have covered by S&I and which by special insurance?
2. How else can it deal with the identified risks in the transaction?

Case 4: Settlement of the insurance

A and B reached an agreement and B bought the A group from A through its B AG. Together with the SPA, B AG took out a S&I insurance policy with a premium of CHF 200,000 (deductible of CHF 20,000).

One year after closing, the 2020 tax return of A AG is assessed and a correction is made by the tax authorities for excessive provisions in the amount of CHF 150,000 (tax burden: 15% = CHF 22,500).

B demands the tax amount of CHF 22,500 from the insurance company.

Questions

1. Is the insurance subject to the tax on insurance premiums? Does it make a difference whether the insurance is taken out by B (Switzerland) or its foreign acquisition company B AG?
2. B has the insurance premium paid by the target company (A AG in Switzerland), since from his point of view the insurance benefits the group. How do you assess this from a tax point of view?
3. How should the insurance premium be treated for tax purposes if it is borne by B AG as a domestic legal entity?
4. The insurance company pays CHF 2,500 after deducting the deductible of CHF 20,000 to the domestic B AG (variant: A AG). Explain the accounting treatment and the tax consequences at B AG and at A AG.
5. There is a gross up clause in the insurance conditions. B wants to know what it means.

Case 5: Post-Closing Disputes

Another year later, a tax audit is carried out at A AG. The responsible tax office wants to carry out various offsets in the tax periods prior to the sale.

Questions

1. A, B, the A AG and the B AG as well as the insurance company agree that the offsets may not be made. How do they proceed? Who conducts the proceedings, who bears the costs?
2. B is of the opinion that he does not have to worry about the offsets of the tax office, as the insurance company has to indemnify him (or B AG) anyway. Can he have the tax assessments with the possibly unjustified offsets become legally binding and demand payment from the insurance company?

Case 6: Interaction of post-declaration obligation and insurance cover

After closing, B discovers that in 2019 hidden equity and interest charges at the Swiss subsidiary of A AG are legally assessed for profit and capital tax purposes of 2017, but no declaration for withholding tax purposes has been made (lender and service recipient is the German sister company). B's tax advisor recommends making a subsequent declaration and payment of withholding tax. C, who has been a board member of the Swiss subsidiary since 2021, would also like to implement this immediately.

Questions

1. Is C or the Swiss subsidiary of A AG restricted here by the SPA?
2. Does such a restriction result from the insurance policy?
3. How does C's intended action affect the indemnity for B AG / the insurance cover?