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June 21, 2021

Hauser Insurance on Tax Liability Insurance: Its Role in Complex Business Transactions

Executing a multifaceted business transaction frequently requires navigation of issues surrounding previously identified tax exposures or tax-specific indemnities. In particular, preparing for a merger or acquisition (or M&A) requires intensive due diligence on numerous fronts, including tax liability issues for the parties involved. A well-crafted tax liability insurance policy enables the successful closing of these complex business transactions. Below, industry leading Hauser Insurance offers insights about the role of tax liability insurance within business transactions.

Primary Purpose of Tax Liability Insurance

When potential tax exposures exist, tax liability insurance may be supplemental to a seller indemnity. In this regard, tax liability insurance functions in a similar manner to a representation, warranty, and indemnity (or RWI) insurance policy.

However, RWI insurance and tax liability insurance differ in their treatment of a known vs unknown tax exposure. A RWI insurance policy generally excludes all known risks from coverage.

These known risks, or potential tax liabilities, are typically included in the schedules supporting the purchase agreement or are discovered during the tax due diligence period. With careful planning, the tax liability insurance policy’s targeted coverage can begin at the point at which the RWI policy coverage ceases.

Additional M&A Transaction Usage

Representation, warranty and indemnity (or RWI) insurance is often used to facilitate M&A transactions. When RWI insurance is not available, however, tax liability insurance provides another method of buyer protection with respect to known tax matters.

Offset or Replacement Function

A tax liability insurance policy may offset or replace the need for a seller special indemnity, a purchase price adjustment, or an escrow. To illustrate, a buyer may only require escrow related to a known tax exposure for the tax liability insurance policy’s retention amount.

Strategic Pre-Transaction Purchase

Additionally, sellers who anticipate a merger or acquisition could also obtain tax liability insurance. Before the transaction, the seller would purchase a policy for known risks with the goal of providing potential buyers with a more attractive bidding environment.

Policy Utilization in Non-M&A Transactions

Outside of an M&A transaction framework, tax liability insurance can be employed in respect to internal tax restructurings. A tax liability insurance policy may also be useful for other tax indemnity-related transactions.

Issuance of Deferred Compensation

To illustrate, consider the issuance of deferred compensation. Here, a company provides an indemnity to compensation recipients for any excise taxes specified in Section 409A. In this case, tax liability insurance could backstop the issuer’s indemnity to the compensation recipients. This coverage would be useful in the event of an IRS audit.

Loss Coverage and Retention Parameters

Tax liability insurance is designed to cover loss items such as taxes, related tax interest, and related tax penalties. These insurance policies also cover related contest expenses.

Finally, a typical tax liability insurance policy covers the policy’s gross-up amount. This figure reflects the insured’s increase in taxes owed due to prior amounts received under the policy.

The Final Adjudication Concept

The “final adjudication” concept is a basic tenet of tax liability insurance. This principle states that a policyholder does not have the right to receive insurance proceeds until a court of appeals has finally adjudicated the related tax assessment. To settle a tax case before the final adjudication, the insurer must generally provide a consent to that effect.

Retention for Contest Costs

Tax liability insurance also incorporates the concept of “retentions.” This term refers to the insured’s required policy deductible. The insured must satisfy (e.g. pay) the policy deductible before they can access their insurance proceeds.

It is common to see a “retention for contest costs only” clause in tax liability insurance policies. Stated another way, this means the insured must pay their own contest costs up to a certain point. However, the insured is not responsible for paying any of the tax liability, penalties, or interest related to the insured tax positions.

Despite the prevalence of the “retention for contest costs only” provision, the retentions concept may also apply to other situations. Specifically, a tax liability insurance policy may require a retention for one or more additional types of losses.

Tax Liability Insurance Policy Exclusions

A tax liability insurance policy typically excludes four types of losses from coverage: (i) a change in applicable insurance law following the coverage’s effective date; (ii) the insured’s filed tax returns containing positions inconsistent with the insured tax positions; (iii) revised transaction documentation to the insured tax positions without insurer consent and (iv) the insured’s misrepresentations or fraud of any kind.

Other coverage exclusions may apply based on specific insured tax positions. The underwriter would clearly outline those exclusions in the quotation provided to the insured. Finally, the underwriter could name additional exclusions based on factual inconsistencies or discrepancies identified during the tax liability insurance underwriting process.

Insurance Premium Calculation Guidelines

Each tax liability insurance premium is based on two integrated factors. The amount of desired coverage (e.g. the limit) is multiplied by the “rate on line” (or ROL) supplied by the tax insurance underwriter. As one might expect, a lower ROL translates to the insured tax position’s lower perceived risk.

The insured tax position can substantially influence the ROL. However, when taking commonly insured risks into consideration, an insurance broker should be able to provide an estimated ROL. In turn, this enables the broker to estimate the policy’s final cost.

Coverage Quotation Requirements 

To obtain a tax liability insurance quotation, the insured should provide a tax analysis that explains the insured tax positions. In the case of common issues addressed by well-established legal precedent, the underwriter may agree to provide a quotation with only a summary of the relevant facts.

As a best practice, and to facilitate the tax liability insurance underwriter’s ability to underwrite the risk and provide a coverage quotation, the insured should provide a memorandum from its legal counsel or accountant. Lack of a memorandum may mean that outstanding facts or analysis may prevent the underwriter from providing a tax liability insurance quote.

Where the tax law’s factual or technical application is more complex, a law firm or accounting firm should provide a formal legal opinion. With that said, a thorough, up-front tax analysis is preferred over tax insurance policies and tax insurance underwriting.

Ideally, an underwriter will be presented with a credible formal legal analysis. This proactive step improves the likelihood that the insured can obtain several competitive tax liability insurance quotes.

Some insureds will anticipate the need for tax liability insurance and will ask their tax advisors to prepare a relevant memorandum or opinion. If the need for such a policy arises, a well-prepared insured will likely experience a more streamlined quotation process.

How Tax Liability Insurance Underwriting Works

After the selection of the insurance carrier and underwriter, the policy underwriting process begins. In some respects, underwriting resembles a tax due diligence exercise. However, underwriting is focused on the tax liability insurance policy’s discrete insured tax positions.

During the evaluation process, the underwriter may provide the insured with a questions list or document request list. In addition, the insured and its tax advisors should expect a tax underwriting call. As a courtesy, the underwriter will typically provide an agenda beforehand.

At the start of the underwriting process, every tax liability insurance applicant must remit an underwriting fee to the underwriter. This non-refundable fee applies regardless of whether the applicant ultimately purchases the policy.

Tax Liability Insurance Recap

A carefully crafted tax liability insurance policy is well positioned to facilitate the closing of a merger or acquisition. Tax liability insurance may also play a key role in the successful execution of other transactions with known/identified tax exposures or tax-specific indemnities.

Like most insurance products, the tax liability insurance policy’s specific terms, costs, and exclusions will differ according to the requested coverage. Applicants should obtain pre-quotation legal tax analysis and relevant factual summaries. An initial discussion with an insurance broker will enable an improved understanding of potential coverage options and costs.

The number of tax liability insurance carriers and underwriting markets continues to increase. With more complex business transactions, and more taxpayers requiring this type of coverage, higher product utilization is expected in the future.

About Hauser Insurance Group

Hauser Insurance Group is a privately held insurance company with its headquarters in Cincinnati, Ohio. Established in 1971, this diversified firm provides risk management, insurance solutions, and employee benefits services to businesses of all sizes.

The Hauser Insurance Group client base includes family-owned industrial companies, publicly traded retail entities, and multinational corporations. Specifically, Hauser maintains a strong focus on private equity firms, their respective portfolio companies, and their targeted acquisition subjects.

The Hauser Group has demonstrated deep competencies in due diligence related to insurance and employee benefits. Risk management, transactional support, and insurance brokerage are additional areas of expertise.

Hauser Insurance Group’s consultative approach facilitates optimum results for its clients. By identifying each company’s needs, and recommending the appropriate product(s), the client will be well positioned for successful merger, acquisition, or other transaction execution.

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