W&I insurance and taxes in Germany

In German M&A transactions with warranty and indemnity insurance (W&I insurance), special attention must be paid to tax issues due to reciprocal effects in the liability concept concerning the purchase agreement and the insurance policy.

With company acquisitions, the sellers' liability for historic-tax risks in the form of tax indemnities and tax warranties plays a significant role and is subject to a special regulatory regime. In combination with W&I insurance, unique particularities exist in Germany, especially regarding taxes.

Tax insurance has a wide range of applications

Two types of tax insurance can be considered in the context of M&A transactions. The purpose of traditional W&I insurance is to protect against unknown historical risks, whereas tax risks that have been specifically identified (i.e. historic or future-oriented), such as from tax due diligence, can be covered by special tax insurance (i.e. tax liability insurance or contingent risk insurance). A combination of these types of insurance can also be useful.

While insuring against unknown tax risks within the scope of W&I insurance does not trigger any extra costs (and excluding taxes from the scope of insurance does not usually lead to a reduction in the insurance premium), additional costs between 0.5% and 10% of the insurance volume can be expected to insure against a known tax risk.

With W&I insurance, the buyer is usually the policyholder and beneficiary (i.e. buy-side policy). A sell-side policy entered into by the seller is the exception. Negotiations between the seller and the insurance company with subsequent transfer to the buyer (i.e. seller-buyer flip or hard stapled insurance) are also rare. The target company is generally the policyholder for special tax insurance.

Transfer of risk for tax warranty or tax indemnity claims to the W&I insurer not watertight

The basic idea behind W&I insurance is to transfer the risk of tax risks to the insurance company with the aim of a "clean exit" without any remaining seller liability (zero liability concept or liability for a symbolic euro) and without retaining the purchase price or parking it in an escrow account to secure liability claims.

Like other liability risks, tax risks which are known to the buyer and identified or disclosed during tax due diligence are not insurable. As a result, tax risks are not fully covered by W&I insurance in practice. There are also the following special aspects regarding taxes:

• Tax due diligence: The scope of the insurance is generally based on the scope of the tax due diligence (i.e. the types of taxes, tax periods, taxable entities and the relevant legal system). A tax due diligence review of a certain depth is required. Weak points in tax due diligence are openly addressed and discussed in an underwriter call. Coverage is generally not granted for tax matters that were not audited or were audited inadequately (i.e. blind spots). Coverage for such blind spots can be secured at best under the condition of a top-up tax due diligence (possibly after signing/closing). This is "conditional coverage", such as for the current financial year (if a bring-down declaration is not sufficient for the insurance company) or for inadequate audit procedures. 
  
  Often, the tax due diligence only covers the last three full tax periods. Hence, open tax years can fall through the cracks, especially if the insurance coverage is determined by a list of insured tax items (i.e. positive list) rather than a negative delimitation of insured tax items. It can also lead to a gap in insurance cover if individual types of tax are only handled superficially (e.g. in a systematic, sometimes merely descriptive approach from a management interview without carrying out independent audit activities). Red flag reports are sometimes viewed critically by W&I insurers and a top-up tax due diligence may be necessary. W&I insurance is not a substitute for a careful and comprehensive tax due diligence review.
  
  Against this background, it is advisable to clarify at the beginning of the tax due diligence whether the tax due diligence report will form the basis of a W&I insurance policy to align the scope of the audit with the level of detail and the presentation of the risks identified by the due diligence provider. An overly cautious or risk-averse assessment can lead to risks not being insured.
   
•  Standard exclusions: There are standard exclusions specifically for taxes. In particular, this concerns issues relating to transfer pricing, the existence of tax assets, reclaiming fiscal aid and secondary tax liability (including liability as a party liable to pay wage tax, social security contributions or capital gains tax, joint and several liability under section 44 German Fiscal Code, liability as the acquirer of a business under section 75 German Fiscal Code or liability as a former fiscal unity under section 73 German Fiscal Code. Pillar 2 is currently being discussed as a further standard exclusion. 
  
  If a comprehensive tax due diligence is carried out by specialised teams (e.g. substantive review of transfer pricing documentation with benchmarking or in-depth review of wage tax and social security contributions), the standard exclusion can be negotiated away. From the policyholder's point of view, it is important to ensure that the standard exclusions in the insurance policy are not formulated too broadly.
   
•  De minimis and deductible: Unlike in the SPA, a de minimis applies to the tax indemnification (generally between EUR 50,000 and EUR 100,000 per item). Furthermore, tax indemnification claims run against the general retention (similar to a deductible for breaches of warranty). In this respect, the buyer is not indemnified by the insurance company, even though it would have a contractual claim for indemnification under the SPA.
   
• Corresponding tax benefits: As the insurance company only settles the actual damage incurred, corresponding tax benefits are usually offset against the claim. Offsetting tax benefits can sometimes go further than agreed in the SPA. Under certain circumstances, it can lead to a competitive situation regarding reimbursement of tax refunds to the seller.
   
• Duty to mitigate damage/contributory negligence: The obligation under section 254 German Civil Code can also apply to tax indemnities and tax warranties in the context of W&I insurance. Provisions in the SPA where the buyer must only take action in tax proceedings if expressly instructed to do so by the seller and is not required to independently mitigate impending taxes on its own responsibility, are partially overridden by the W&I insurance concept.
   
• Limitation period: Liability is generally limited to seven years and can be extended to ten years for an additional charge.

In view of the aforementioned gaps in insurance coverage, depending on the specific negotiation situation (bidding process vs. exclusivity) residual liability for the seller is sometimes negotiated in practice. Concepts with graduated liability are conceivable:

• Seller's liability for risks that are (actually) uninsured, irrespective of the scope of the tax due diligence carried out by the buyer,
• Seller's liability for uninsurable risks (i.e. identified tax risks plus standard exclusions) often without de minimis or deductible; and
• Seller's liability only for tax risks specifically identified as material in the tax due diligence (i.e. no seller liability for standard exclusions and no de minimis or deductible).

Reciprocal effects between insurance policy and SPA

The scope of coverage of a W&I insurance policy is based on the respective provisions of the relevant SPA (i.e. tax definition, tax indemnities and tax warranties). The breach of a tax warranty or the existence of a tax indemnity generally leads to a claim by the buyer against the insurance company. A special variant is a synthetic tax insurance, which is negotiated between the buyer and the insurance company. In this case, the SPA does not include tax indemnities and the seller does not provide any tax warranties.

W&I insurers emphasise that the SPA should be negotiated seriously and on arm's length principles as if there was no W&I insurance for the company sale in question. W&I insurance is therefore not a free pass in SPA negotiations with overly generous concessions to the buyer. However, the tax clause tends to be buyer-friendly within the scope of the arm's length principle. If the tax clause as a whole or even individual provisions fall outside the standard framework (which is more likely if there is a complete exclusion of the seller's liability), the W&I insurer will make corresponding modifications to the SPA provisions in the annex to the insurance policy (warranty schedule). As a rule, a modification by the W&I insurer is less favourable than an SPA provision, which tends to be buyer-friendly but is still at arm's length.

Income tax treatment of insurance premium and insurance payouts for the buyer

Another point is the tax treatment of insurance premiums that are paid and insurance benefits that are received.

• Insurance premiums: In practice, the insurance premiums paid by the buyer are often deducted as business expenses for tax purposes. Recognising them as incidental acquisition costs for the acquired investment is rejected on the grounds of the finality of the concept of acquisition costs and the argument that a mere causal or temporal connection with the acquisition is not sufficient. It would appear that German courts have not yet addressed this issue.
• Insurance benefits: In the event of a claim, it is assumed in German practice that insurance benefits received by the policyholder (buyer) constitute taxable business income. This is the case irrespective of the fact that without W&I insurance, the assertion of warranty and indemnity agreements regularly results in a subsequent reduction in the purchase price at the level of the buyer, with no effect on income.
• Tax gross-up: If and to the extent that the insurance benefits received are taxable business income for the policyholder, the policyholder does not have the full amount of the claim at its disposal. To compensate for this disadvantage, most insurance policies provide for a tax gross-up as compensation for the difference by the insurer.

Experience with handling insurance claims

Currently, insurers in the German market have a high willingness to pay when settling claims. This may be due to ongoing competitive pressure among insurers. With taxes, back payments are sometimes associated with personal misconduct on the part of the target company's management. To protect the management from potential criminal prosecution and/or to avoid negative publicity, the policyholder often has an interest in settling the matter quietly by coming to an understanding with the tax authorities or settling without public court or administrative proceedings. According to the insurance conditions, this may mean that the buyer's insurance coverage is lost in this respect. In practice, an agreement is therefore often reached with the W&I insurer in such cases, which sometimes has a favourable effect for the W&I insurer (in extreme cases it even results in cancellation of the insurance coverage in return for repayment of the insurance premium or a certain amount).

Summary and practical recommendations

Although taxes do not play a special role in W&I insurance policies, they change the buyer's risk position in the way that provisions of the W&I insurance policy override provisions of the purchase agreement. This can lead to adjustments to the tax regulations in the SPA or renegotiations with the W&I insurer to expand the insurance policy in individual cases.

It may also be advisable to take out special tax insurance for risks not covered by W&I insurance if neither the buyer nor the seller is prepared to accept liability. Special tax insurance, however, can also be used in individual cases for critical issues in connection with acquisition structuring or subsequent measures in the context of post-merger integration (PMI). This applies in particular if it would take too long to obtain an advance ruling or an advance ruling is deliberately not obtained.

Overall, it is clearly necessary to involve tax experts to assess the complex, interdependent tax issues concerning the purchase agreement and the insurance policy in transactions with W&I liability insurance.

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