“The power to tax involves the power to destroy.” Chief Justice John Marshall, McCulloch v. Maryland, 17 U.S. 316, 431 (1819).
Business decisions are becoming increasingly more complex in part due to the implications of a global tax system. Taxpayers can limit the power of destruction with tax insurance. Tax insurance provides protection to private equity, strategics, individuals, and virtually any other taxpayer should a transaction fail to qualify for its intended tax treatment. As many may be aware, tax insurance can cover additional taxes, interest, penalties, contest costs, and gross-ups that arise when a taxpayer’s intended tax treatment fails to be respected by a tax authority. However, many individuals considering the product might not be aware of all its benefits. Below are four generally unknown features of tax insurance.
Those familiar with the tax insurance product know that tax insurance routinely covers tax-free reorganizations, S corporation qualifications, debt vs. equity treatment, net operating loss (NOL) limitations, real estate investment trust (REIT) status, and tax credit transactions. It is less widely known that tax insurance can be used for taxable reorganizations, where the insurance market, as opposed to the taxpayer, bears the risk that the taxable gain calculation is reviewed and increased.
Taxable reorganization insurance policies provide coverage to the taxpayer that the amount of taxable gain reported from a transaction will be respected by the taxing authority. In order to provide this coverage, the insurance market generally requires advice from legal and valuation/accounting advisors. Coverage will be easier to obtain if the taxpayer’s auditor does not require the taxpayer to include a financial reserve for the tax liability associated with the gain and the taxpayer is willing to sign the tax return (indicating the gain) without any related disclosure.
This is an exciting new area for taxpayers as the tax insurance market is now able to bring additional certainty to taxpayers involved in taxable reorganizations, protecting the value of their transaction. Several taxable reorganizations have already been insured, and these types of transactions appear to be a mainstay in the tax insurance market.
2. Coverage for RWI Tax Exclusions on Deal Time
Consider this: A major deal is pending and well underway—the buyer’s due diligence has identified a material tax risk associated with a prior restructuring of the target’s business. The seller is winding down its fund and is unwilling to retain any liabilities or provide an escrow. The buyer’s valuation proposition would be destroyed if, post-close, the target’s restructuring fails to qualify for its intended tax treatment. The representations and warranties insurance (RWI) policy, procured in connection with the transaction to protect the buyer against unknown breaches of the representations of the target and seller, has excluded the known tax position from coverage, placing the entire deal at risk of falling apart.
Known, material issues are routinely carved out of the coverage provided by RWI policies. These known, material issues are often identified tax matters associated with the M&A transaction or historical positions taken by the target company. These large tax risks carved out of RWI policies can destroy the deal, require the buyer to bear to risk of the position post-close, or necessitate the seller tie up sale proceeds in an escrow. None of these options are particularly attractive from a transaction party perspective.
Alternatively, the parties could negotiate the procurement of a tax insurance policy to cover the known, supportable tax position. At its core, tax insurance was designed for these scenarios (i.e., the transfer of a known, material tax risk from the buyer or the seller to the insurance market).
The tax insurance market, when called upon, moves at the same fast pace as M&A transactions (even late stage deal time) enabling the parties to sign the deal on their anticipated timeline. While the typical, expedited timeframe to underwrite and bind coverage is approximately one week, we have (with the devoted assistance of the insurance broker, buyer, seller, and their respective counsel) completed the entire process in less than 48 hours in order to save the parties’ deal.
3. Coverage for Tax Positions Under Review/Audit
Today’s tax structures—and the associated business, financial, and legal implications—are complex, and the associated uncertainly can handcuff decision makers. This uncertainty becomes even more prevalent when the tax position is being questioned, audited, or reviewed by the applicable taxing authority. Tax payers can utilize the benefits of tax insurance in these instances too.
For example, a taxpayer was recently able to insure a past reorganization being questioned by the taxing authority as part of an ongoing audit. In another matter, a taxpayer participating in the Internal Revenue Service’s Compliance Assurance Process (CAP) program was able to procure insurance covering a complex transaction questioned as part of the CAP program process.
In situations like these, the true benefit of tax insurance can be immediately realized. Taxpayers can reduce or eliminate the pending uncertainty surrounding an under review, supportable tax position via the utilization of tax insurance, freeing up capital to continue growing the business.
4. Some History: Tax Insurance was Nearly a Reportable Transaction
Concerned with the abusive tax transactions, in 2002, the IRS included “tax insurance” in the definition of “transactions with contractual protections” associated with reportable transactions under tax code Section 6011. Temporary Regulation 1.6001-4T (Oct. 22, 2002). The inclusion of tax insurance in this definition would have required taxpayers utilizing tax insurance to report transactions to the IRS solely as a result of the insurance. This mandatory disclosure had the potential to significantly hinder, and perhaps destroy, the tax insurance market.
In response to the temporary regulations, commentators indicated that it was inappropriate to require the reporting of a transaction for which a taxpayer obtains tax insurance. It was noted that tax insurance provides much needed certainty to taxpayers that tend to be conservative and risk adverse. Additionally, tax insurance is underwritten by, and with the support of, tax attorneys, who carefully review the risk with the goal of selecting the most supportable positions. REG-103735-00 BERRY.
It was pointed out that insurers are tasked with selecting positions that will be supported by the taxing authority, which should appease the concerns of the Service that insurance would support tax shelters and abusive tax schemes. Id.
The IRS listened and, in 2003, amended the regulations to exclude “tax insurance” from the transactions covered by the regulations. T.D. 9046. In doing so, the IRS changed its focus of the contractual protection factor to whether fees are refundable or contingent, but indicated that it would monitor the use of tax insurance and potentially amend the regulations in the future if it was determined that tax insurance was supporting abusive tax transactions. Id.
Now 16 years later, the position of the commentators has proven true and the IRS holds its position—tax insurance was designed to, and remains a vital tool to help taxpayers obtain certainty regarding their supportable tax positions in the complex and ever-changing tax arena.
The tax insurance market is constantly evolving to support the needs of the taxpayer. Tax insurance has become an economic and efficient tool for taxpayers to deal with high severity, low probability tax risks providing insureds with certainty and freeing up capital to be deployed in more useful means.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Justin Pierce Berutich is Sr. Vice President - Head of Tax at Euclid Transactional. He is a former M&A and transactional tax attorney. He can be contacted at firstname.lastname@example.org.