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Private REITs: Facilitating a Cleaner Exit with Tax Insurance


Private REITs: Facilitating a Cleaner Exit with Tax Insurance


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May 7, 2015 | by Gary P. Blitz and Daniel Schoenberg


Nonpublic real estate investment trusts (REITs) have been a popular vehicle for investing in US real estate. When it is time to exit the investment, the seller faces a challenge to get the buyer -- who likely wants only the hard assets (the bricks and mortar) -- to buy the corporate entity and take on the entity's actual and contingent tax and other liabilities. The traditional solution resembled the sale of a private company with the attendant escrow-based indemnification obligations. It can be particularly onerous for private equity sellers to leave behind up to 10% of the proceeds in an escrow and remain liable under the long-term tax indemnity.

Enter Tax Insurance

Similar to the representations and warranties (R&W) insurance wave sweeping the worldwide private M&A market -- where the impact of R&W insurance for buyers is replacing the use of escrows to support indemnification for breaches of representations and warranties -- tax insurance can offer the seller of a private REIT a clean exit.

A private REIT seller will typically provide R&W about, among other things, the REIT's qualification as a REIT from the REIT's inception through the contract signing date. Seller will also make the customary suite of R&W related to tax matters. These representations generally are brought forward to closing. There is a custom tax policy that is being increasingly used in REIT deals that cuts across product lines as a hybrid of R&W insurance and tax insurance – which covers the insured in the event that the REIT(s) are determined post-closing to not have qualified for a pre-closing period, and that also protects the insured in the event that a breach of a tax representation was discovered post-closing. There are also broader, more traditional R&W insurance solutions that cover these risks and more, albeit generally at slightly more cost and retention.

Nonpublic real estate investment trusts (REITs) have been a popular vehicle for investing in US real estate. When it is time to exit the investment, the seller faces a challenge to get the buyer -- who likely wants only the hard assets (the bricks and mortar) -- to buy the corporate entity and take on the entity's actual and contingent tax and other liabilities. The traditional solution resembled the sale of a private company with the attendant escrow-based indemnification obligations. It can be particularly onerous for private equity sellers to leave behind up to 10% of the proceeds in an escrow and remain liable under the long-term tax indemnity.

Enter Tax Insurance

Similar to the representations and warranties (R&W) insurance wave sweeping the worldwide private M&A market -- where the impact of R&W insurance for buyers is replacing the use of escrows to support indemnification for breaches of representations and warranties -- tax insurance can offer the seller of a private REIT a clean exit.

A private REIT seller will typically provide R&W about, among other things, the REIT's qualification as a REIT from the REIT's inception through the contract signing date. Seller will also make the customary suite of R&W related to tax matters. These representations generally are brought forward to closing. There is a custom tax policy that is being increasingly used in REIT deals that cuts across product lines as a hybrid of R&W insurance and tax insurance – which covers the insured in the event that the REIT(s) are determined post-closing to not have qualified for a pre-closing period, and that also protects the insured in the event that a breach of a tax representation was discovered post-closing. There are also broader, more traditional R&W insurance solutions that cover these risks and more, albeit generally at slightly more cost and retention.

The insurance policy can come in several varieties:

  • Buyer policy: REIT/tax R&W only. In this version, the buyer is covered for a breach of the REIT representations and covenants addressing REIT qualification pre-closing, as well as a breach of the other tax R&W. The buyer is the first party insured and is entitled to make a claim directly to the insurers in the event of an IRS challenge. From the seller's perspective, the buyer's reliance on insurance allows the seller to provide minimal or no indemnity and escrow for the REIT qualification and tax matters. It should also be noted that if preferable, instead of tying to the R&W in the purchase agreement, the coverage can be structured as a stand-alone tax insurance policy covering REIT qualification without regard to any seller representations.
  • Buyer policy: All seller R&W (including the REIT/tax R&W) This version is similar to the buyer policy described above in that the buyer is the first party insured. However, the scope of the coverage is broader. In this version, the policy would cover a breach of any R&W provided by the seller to the buyer. These include such matters as corporate authority to sell the REIT's shares, validity of financial statements, taxes (including the REIT representations), undisclosed liabilities, environmental matters, and regulatory matters. This version is more like a traditional R&W policy used for an operating business. However, because a REIT is generally a much simpler operation to underwrite, the full R&W policy for REITs tends to be less expensive and the retention options more attractive (though not quite as low as the REIT/tax R&W only product).
  • Seller policy: REIT/tax R&W only. The seller policies are comparable in scope to the buyer version described above that insures buyer for the REIT and tax representations only. The key difference is where the policy fits in the transaction structure and the benefit it confers on the seller compared to the situations where a buyer is insured. By definition, a seller policy insures the seller, not the buyer. In these cases, the seller has provided an escrow and indemnity to the buyer and the policy in turn protects the seller if the buyer makes a claim under that indemnity. The objective generally is for the seller policy to be back to back with the seller's indemnity to the buyer, but that is not required. A seller may be happy to retain some risk beyond the insurer's minimum requirements, and achieve even more favorable pricing and terms and conditions.
  • Seller policy: All seller R&W (including the REIT/tax R&W). This version is similar to the comparable buyer policy in scope, and like the seller REIT/tax R&W only policy discussed above, insures the seller as a backstop to its indemnification of a buyer of a private REIT against breaches of any of the seller's R&W.
  • A case study: Sale of Private REIT - Buyer Coverage. In one of the first private REIT sales where transactional liability insurance was used, a private equity seller was committed to selling certain real estate assets held in a private REIT vehicle through a transaction structured with minimal post-closing indemnities. In that case, the seller told prospective bidders that no indemnity would be provided. Most prospects declined to bid. The ultimate purchaser had been exposed to transaction liability insurance previously and had its counsel investigate using insurance as a means to address the seller's no indemnity requirement.

    In the course of negotiations, the seller ultimately agreed to escrow $2.5m (out of the $500m purchase price) for 12 months. Per the acquisition agreement, the R&W did not survive closing beyond that period. The buyer then agreed to take on an insurance policy, which conferred a huge benefit to the seller by allowing it to sell the REIT shares, as opposed to merely the assets. A buyer policy covering all of the seller's R&W was put in place to protect the buyer for a breach of the tax representations and any of the other representations. The policy had a $50m limit of liability and a term of 6 years. The self-insured retention under the policy equaled the $2.5m seller escrow (i.e., 50bps). After 12 months (when the escrow expired), the retention dropped to $1m (or 20bps). The all-in cost of the policy was about 0.3% (or 30bps) of the sales price.

    For obvious reasons, we have seen a number of clients adopt a similar strategy, i.e., using insurance to provide the seller with a cleaner exit. The bottom line is that, in this transaction, by incorporating insurance the seller was able to take over 99% of the purchase price home at closing, net of the escrow. Compare this to the situation had the seller provided a $52.5m escrow to the buyer. Under that structure, the seller would have taken home only $447.5m or 89.5% of enterprise value. It is clear that the differential had a materially positive impact on the seller's IRR from that investment -- a very important metric for a private equity seller.

    What about the buyer? Was this a good tradeoff for them? Is that buyer in as good a position as it would be with a seller indemnity? This buyer and many buyers since have concluded yes. 2014 marked the biggest year for transactional insurance to date with an estimated 500 transactions in North America relying on insurance . As noted above, this is a trend that's continuing to take hold on a global basis. Buyers have been influenced by a number of factors, including a mature, insured-friendly policy form, a streamlined underwriting process that permits policies to be implemented in deal time, good claims paying practices by insurers and a sensible price for the coverage. These features have led buyers (and their advisors) to conclude that the product will protect them on a par with a seller escrow and indemnity package. Perhaps more importantly, the market has come to acknowledge that the process is minimally invasive and will allow the buyer and seller to get the deal done on a comparable basis and timeline to that which would transpire if the insurers were not present.

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    More on Tax Insurance


    What is tax insurance?

    Tax insurance is one of a suite of risk-transfer insurance products -- along with R&W insurance, litigation buyout insurance, and environmental insurance -- that are aimed at addressing deal risks. Tax insurance offers protection to a taxpayer in the event that a tax position it has taken is challenged by the IRS or a state, local, or foreign taxing authority. The policy can cover additions to tax or lost tax benefits, interest, penalties, contest costs, and a tax gross-up (for any tax owed on the receipt of the insurance proceeds).

    In concept, it's quite simple. The policy works in a manner similar to a private letter ruling from the IRS. The facts underlying a tax exposure are laid out for the insurer and the policy covers that the tax law will apply to those facts in the manner intended. The insured taxpayer sets the limit of liability it buys. Typically, this amount is based on potential tax liability, interest, penalties, contest costs, and tax gross-ups. Some insured parties will seek to cover the maximum possible amount of all of these potential costs. Others seek to insure only a portion (by taking into account potential settlement value or otherwise). In that case, the premium costs are smaller because less insurance is purchased.

    Is tax insurance different from "tax opinion insurance"?

    Not really. The names often are used interchangeably. The typical tax insurance scenario involves a policy that covers a risk that a tax expert has opined or advised on in some fashion. Tax insurance is broader than mere tax opinion insurance because situations can be covered in which opinions may not be issued, such as recapture of historic tax credits due to physical damage or foreclosure.

    Why do acquirers buy tax insurance?

    The reasons vary as do the type of user of the product. Private equity firms often use the product to avoid a large unanticipated tax payment that was not modeled in the acquired company's cash flow or that could compromise the economic upside of a deal. As noted above, for a buyer it is a way to be protected for a known tax exposure of target, yet allow a seller to have a clean exit. For example, a buyer and a seller might disagree over the treatment of a tax attribute of a target company, say with respect to 409A deferred compensation issues. The insurance addresses buyer's concerns if the seller's view of its tax position does not pan out post-closing. Another example might be the inability of a seller to provide an indemnity at all, perhaps because it is a private equity fund winding up and returning funds to investors. Tax insurance is a mechanism for providing the comfort of an indemnity to a buyer – without the seller's having to stay around to address the contingent liability associated with the tax issue at hand.

    Do sellers buy coverage?

    Absolutely, although the buyer may be the insured party. Deal dynamics often dictate who makes the decision to buy the insurance. It may be the seller who is seeking to address an issue raised by a potential buyer so the seller doesn't have to provide an indemnity for that issue. Another scenario we see is a seller seeking to prepare a company or asset for sale and using tax insurance to simplify the due diligence process by taking those tax issues out of the deal. In either scenario, the cost of the insurance may fall on the seller in practical terms, either as a direct premium payment or an actual or implicit price adjustment by the buyer to defray the cost.

    Who else uses the coverage?

    A fast-growing part of the tax insurance market is companies using the product simply to manage a large contingent exposure outside of a live deal context. Tax insurance can be an excellent risk management tool. We also see institutional tax equity investors relying on the product as a means to achieve comfort that an anticipated tax credit, say the Solar Investment Tax Credit, will be available as projected and not recaptured.

    Why not simply get a private letter ruling (PLR) from the IRS?

    There are various reasons why a taxpayer might forego the ruling process and opt for insurance. First, a ruling may be unavailable under IRS ruling policies. The list of issues the IRS will not rule on in the corporate area is extensive. For example, rulings for vanilla Section 355 tax-free spinoffs are no longer being considered by the IRS. Tax insurance is an excellent means to protect the parties that the spin-off will be respected as a tax-free transaction. Confidentiality and timing concerns relating to getting a pending deal closed also frequently come into play.

    What sort of situations can be insured?

    Policies have been used to cover a broad range of tax risks. Insurers are very comfortable writing insurance for sound business transactions with tax implications. Some examples of insurable situations are tax-free reorganizations, tax-free spin-offs, treatment of redemptions, loss of Section 338 (h)(10) election due to defective S corporation status, REIT qualification, net operating loss carryforwards, and transfer pricing. Basically, if a tax expert is able to provide written analysis for a tax issue, it probably is insurable.

    How about tax shelters or aggressive transactions?

    No and no. Neither tax shelters nor aggressive deals are the sort of transactions insurers want to insure. They are looking to provide comfort where there is sound tax planning and a strong business purpose. Generally speaking, insurers look for a "should" level of comfort with the tax advice provided as part of the insurance submission (though "more likely than not advice" can lend itself to tax insurance in certain situations).

    Does tax insurance trigger IRS reporting requirements?

    Buying tax insurance does not trigger reporting requirements. There was briefly such a requirement in a draft regulation that was dropped by the Treasury after learning that the tax insurance industry focused on business transactions, not marketed tax shelters. More recently in Rev. Proc. 2014-12, the IRS indicated that in historic tax credit transactions it is impermissible for a sponsor to guaranty that the tax benefits will be available; however, tax insurance is viewed as a permissible means for a tax equity investor to obtain comfort.

    Can tax insurance protect the insured for the statute of limitations?

    Yes. Tax insurance policies typically run for a six or seven-year term, and can define "Claim" made within the policy period to include a request by the tax authority to extend the statute of limitations.

    How do insurers underwrite the policy? Is a legal opinion required to obtain insurance?

    An insurer forms an independent view of the proper tax treatment of the covered tax position(s) and bases its underwriting decision on that view. Some insurers use outside counsel, others use in-house expertise. While information underlying the issues obviously has to be provided to insurers, it does not have to be in the form of a covered tax opinion and can be an outside advisor memorandum to the client or other materials such as a ruling request. We find that from the policyholder's viewpoint, there are benefits to providing an insurer with a well thought-out and credible roadmap to understanding the risk. It also is more cost effective and efficient than the insurer having to create its own analysis (if no opinion or memorandum is provided), because with the roadmap in hand, the insurer's task is limited to doing a second check on the work product provided. It should be noted that insurers generally do not seek to rely on this work product or to subrogate against the outside advisors for loss.

    Do these policies work when it comes to claims?

    An insured party clearly does not want to substitute a dispute with the IRS for a dispute with an insurer. Insurers have paid claims under tax insurance policies and the claims history has been favorable, but because the policies tend to protect against catastrophe in areas where loss is not expected, the claims history is not extensive. In the broader transaction liability insurance space -- specifically R&W insurance -- claims are more frequent and the client's experience has generally been equally favorable.

    There are two key reasons why a policyholder should be less likely to find itself in a dispute under a tax policy than a traditional insurance policy. First, the policy is very straightforward. It specifically refers to the deal or situation that is covered. It also clearly defines and refers by tax code section to the intended tax treatment. Contrast this with a traditional liability insurance policy, which covers something a company may do in the future. Such traditional policies, therefore, must devote pages of text to specify what is intended to be covered and what is not so intended. A tax insurance policy is relatively brief and has very limited exclusions. The second reason is that the policy itself is customized – what the insurance industry calls "manuscripted." This permits the insured party and its advisors to fully negotiate the language of the policy to address any concerns they might have. If the policy language is not satisfactory to the client, the client doesn't buy the coverage. Second, in a tax insurance policy the quantum of tax loss should be a known amount, and not subject to debate or different interpretation by the insured and the carrier.

    For more information:

    Gary Blitz
    Senior Managing Director
    Aon Transaction Solutions
    O: +1.212.441.1106
    M: +1.301.704.4640
    [email protected]

    Gary is a leader in the tax and transactional insurance business and throughout his career has played an instrumental role in the development of the insurance products and the growth of the field. Gary joined Aon after a twenty-year legal career at firms, including Mintz Levin and predecessors of DLA Piper and Katten Muchin Rosenman. As leader of the Financial Risks Practice, Gary became a nationally recognized expert in the insurance of financial and transactional risks, such as M&A insurance, insurance programs covering tax and regulatory risks, litigation buyouts, environmental insurance and credit enhancements. Gary also was a founder of ML Insurance Strategies, the insurance brokerage affiliate of Mintz Levin, and Kingswood Group, a tax credit insurance underwriter. Gary began his career as a tax lawyer and acted as legal counsel to U.S., London and international insurers, many of which regularly underwrite financial risks. Today, he advises clients purchasing such insurance programs, and is often called upon to create unique solutions where no "off the shelf" product exists.

    Daniel Schoenberg
    Managing Director
    Aon Transaction Solutions
    O: +1.212.441.2033
    M: +1.917.361.3478
    [email protected]

    Dan Schoenberg joined Aon in June 2013. Dan was most recently a Director at Deutsche Bank and served as tax counsel for the bank. Prior to joining Deutsche Bank, Dan was a senior tax associate at the international law firms Fulbright & Jaworski LLP (now Norton Rose Fulbright LLP) and Andrews Kurth LLP. Dan has advised on U.S.-based and European-based acquisitions and divestitures with total values in excess of $15 billion. Representative transactions include Deutsche Bank's staged acquisition of Deutsche Postbank, a leading global industrial company's sales of the assets and stock of its U.S. and foreign subsidiaries and Code Section 355 spin-offs, and the shelved 2008 takeover of Bell Canada Enterprises (which would have been the largest leveraged buyout in history). Dan also initiated, designed, negotiated and executed tax equity investor acquisitions of refined coal production facilities generating potentially $500 million of tax credits for Deutsche Bank.


  1. A great deal has been written and is available about R&W insurance for sales of businesses. It is beyond the scope of this article to provide that detail. However, readers interested in learning more about R&W insurance should contact the authors.
  2. This case study is loosely based on an actual transaction. Due to confidentially obligations, the facts have been changed but it informs the reader as to the important concepts.
  3. This is an estimate and includes both buyer and seller R&W and tax insurance solutions spanning a number of industries and different types of buyers and sellers. Of note, one corporate buyer (Alcoa Inc.) disclosed its reliance on a buyer policy in its Form 8-k filing regarding the transaction.
  4. This section of the article is an updated version of a 2005 Q&A authored by Gary Blitz, which appeared in M&A The Dealmaker's Journal.

 

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