Tax Liability Insurance: A Game Changer in Addressing Tax Ambiguity

By Eugene Lim, Head of Tax - Asia (Private Equity and M&A Services), Marsh Asia

Finance ministers from the G7 nations recently agreed on a landmark deal to establish a global minimum corporate tax rate of at least 15 per cent. Going forward, tax liability will likely become a significant cost for businesses that has to be closely monitored. This, together with the increasing complexity in tax legislation and policy design, will have a huge impact on how businesses assess tax risks relating to cross-border M&A transactions. We can expect that businesses will look for innovative solutions, such as tax liability insurance, to manage their tax risks.

Across Asia, I have seen a growing interest among clients in using tax liability insurance to manage their tax risks, and I have assisted many of them in obtaining these policies.  In this article, I discuss some frequently asked questions about tax liability insurance and also some common misconceptions about the product. 

a)      Definition of tax liability insurance

Tax Liability Insurance is an insurance solution designed to allow the insured to transfer specific and identified tax risks to the insurance markets.

With a tax liability insurance policy in place, the insured can claim from the insurers any financial losses suffered in the event that the tax authorities seek to impose the insured tax risks.  

b)      Items covered under a tax liability insurance policy

 The product provides coverage to the insured against losses arising from the insured tax risks, which includes:

·           Tax liability imposed by the tax authorities, inclusive of interest and penalties

·           Defense costs incurred by the insured to engage tax advisors to defend against a challenge from the tax authorities

·           If the proceeds received by the insured from the insurers are themselves subject to tax, the policy can also cover these additional taxes (i.e. tax gross-up)

In addition, tax liability insurance policies can include an advance tax payment feature pursuant to which the insurer would make tax payments on behalf of the insured at the outset of the tax authorities’ imposition of the identified tax risks, if the payments have to be made to the tax authorities in advance of any appeal (and cannot be deferred or postponed).

c)      Period of cover

The period of cover is flexible and is decided by the insured. The insured usually requires a policy period that mirrors the statute of limitation of the jurisdiction where the tax risk is located.

 For e.g. in Singapore, the statutory time limit for the Inland Revenue Authority of Singapore to raise an assessment or additional assessment is four years. Hence, for Singapore tax risks, insureds typically request a policy period of four years.

d)      Situations where tax liability insurance can be used

Theoretically, tax liability insurance can be used in all situations where there is a specific and identified tax risk against which the taxpayer requires coverage.

i) M&A Transactions

In our experience, tax liability insurance is most commonly used in M&A transactions. When negotiating a deal, it is in the buyer’s interests to take the most conservative view on all tax risks (although the risk may be low / remote) and request a specific tax indemnity from the seller for any potential tax risk, which could ultimately prove to be unnecessary.

If the seller is willing to provide such an indemnity, it would need to hold back cash to meet the potential tax liability and would not be able to distribute this cash to its investors. The need to hold back cash would affect the investors’ return on investment. Therefore, tax indemnities are usually negotiated extensively between both parties and often hold up the transaction. To speed up the negotiation process, tax liability insurance can be used either by sellers to back an indemnity, or by buyers if the sellers are unwilling to provide the desired indemnities. As the insurer would provide coverage for if the potential tax liability materialises, neither the seller nor the buyer would be taking on the tax risks.

Hence, the main benefits of obtaining a tax insurance in an M&A transaction include:

·           unlocking cash and increasing returns on investments; and

·           speeding up the deal execution process.

ii) Corporate Group Restructuring

Outside of M&A transactions, I have also seen businesses using tax liability insurance to cover tax risks that arise as a result of corporate group restructuring. If a potential tax risk is identified during the restructuring process, businesses can obtain a tax liability insurance policy to cover the risk so that they can proceed with the restructuring process without having to worry about the possibility that the potential tax liability might arise in the future. 

In certain countries, it may be possible to write to the tax authorities to seek an advance ruling on the correct interpretation of the relevant tax provisions before businesses undergo the restructuring steps. This is one way in which businesses would be able to obtain certainty on its tax exposure position.

However, seeking an advance ruling from the tax authorities is often not a straightforward process. The tax authorities typically need time to review all the relevant documents and often require follow-up questions to be answered before they provide a ruling. The whole process could take as long as six months to a year, which would inevitably delay the restructuring exercise. Most importantly, there is no guarantee that the tax authorities would come back with a positive ruling.

Instead of seeking an advance ruling with the tax authorities, businesses can use tax liability insurance as an alternative to obtain certainty on their exposure to tax risks. The process of obtaining tax liability insurance is comparatively straightforward and often can be completed within four weeks.

e)      Common misconceptions

Two of the common misconceptions about tax liability insurance are:

i) Insurers will handle challenge from the tax authorities

The insured would still be the party responsible to defend its tax position should there be any challenge from the tax authorities. The insured would need to engage their own tax advisors to draft responses to the tax authorities in relation to any questions raised. However, it is usually a condition of the tax insurance policy that insurers’ approval needs to be sought before any correspondence is sent to the tax authorities.

ii) All tax risks can be covered by a tax liability insurance

Tax liability insurance is only used to cover specific and identified tax risks. The insured tax risk is clearly defined in the policy and the insurers will only pay out claims relating to losses incurred on this particular risk.   

Further, given that the covered tax risk is a specific and identified risk, the insurers will only underwrite the tax risk if it is confident that the position taken can be sustained. Hence, at the proposal stage, the insurer often requires the insured’s tax advisor to provide a formal opinion concluding that the risk level is relatively low (also known as a “should” level opinion).

Conclusion

Globally, tax laws are getting more complex and are often open to interpretation. While businesses often prefer to adopt the positions and interpretations most advantageous to them (especially when the tax laws are not clear), the eventual tax liability if the authorities take a different approach (including penalties and interest) could be significant.

Rather than taking on the risks themselves, tax liability insurance allows businesses to transfer their tax risks to the insurers. This ensures that M&A transactions and/or corporate group restructuring can be accelerated, and the parties concerned would not need to be concerned if the eventual tax risks might materialise in the future. Further, with tax liability insurance, sellers (especially private equity funds) would be able to increase returns for their investors as they would then have the flexibility to distribute all the sales proceeds from the transaction.

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About the writer:

Eugene Lim is the head of tax risk for Private Equity and M&A in Marsh Asia. He advises clients on the efficient use of tax liability insurance as a solution to mitigate tax risks associated with acquisitions, operations, divestments and restructuring. Eugene was previously a senior tax manager with a Big Four Accounting Firm and has tax advisory experience relating to fund structuring and tax minimization for investments in the Asia Pacific Region. Eugene holds a Bachelor of Accountancy degree from the Singapore Management University and is also a member of CPA Australia.

Chat with the writer at:

eugene.lim@marsh.com or at +65 8725 5825