Tax Risk Management

A large tax exposure, particularly one that may take years to resolve, can be a difficult or even insurmountable obstacle in a deal negotiation.

Tax insurance can help provide certainty and allow a buyer and seller to move past a difficult negotiation over an uncertain issue and close a deal. As a strategic financial tool, tax insurance assists a seller looking to backstop its indemnity obligation for pre-close tax exposures or allows a buyer to insure itself against a sensitive tax issue rather than seek a special indemnity that can hinder the deal.

In a transaction, tax insurance complements representations and warranties insurance or warranty and indemnity insurance, which protects against unknown breaches of the tax representations and the pre-closing tax indemnity. Where a material, known tax risk has been identified that results in an exclusion to representations and warranties coverage, tax insurance can transfer that risk from the buyer and seller.

Tax reserves for uncertain tax positions maintained by companies are substantial. Over 25 Fortune 100 companies disclose such tax reserves with values exceeding $100 million. Uncertain tax positions can have a negative effect on earnings. Companies must reserve funds when the auditor is unable to get comfortable with a tax position, and this liability on the balance sheet drags earnings down and leave the company with a real possibility of an adverse view by the tax authority that can deplete the reserve for good.

The insurance market has matured allowing tax insurance to be used as simply a corporate risk management tool. Today, tax insurance can be used to protect a company from exposure from future challenges from tax authorities. With its expanded use, the accounting treatment for tax insurance also has become clearer. Aon has been advised by a Big Four firm that tax insurance can be a means to mitigate the financial statement impact of pre-existing reserve, allowing businesses to incorporate tax insurance into a company’s strategy. Instead, what might have had a negative P&L and balance sheet impact can be viewed as P&L and balance sheet positive.

Transfer pricing has been a key area of tax authority focus and occasional controversy over the last decade. Because of the subjective nature of transfer pricing positions, the risk of adjustments to taxable income, double taxation, and the potential for interest and penalties can be substantial. Even multinational enterprises secure specialist advice to be compliant with transfer pricing rules. The post-Base Erosion and Profit Shifting (BEPS) environment and the wide range of transfer pricing issues globally create a need for strategies that can help MNEs manage transfer pricing risk. Tax insurance is one of the strategies.

Traditionally a taxpayer would manage a transfer pricing risk by establishing transfer pricing policies, preparing relevant documentation and, in some cases, applying to local authorities for Advance Pricing Agreement (APA) or rulings. In the event of a dispute with the tax authorities, a conclusion could be obtained via the regular objection and appeal procedures, a negotiated settlement, an out
of court arbitration or a Mutual Agreement Procedure (a mechanism laid down in tax treaties to ensure that taxation is in accordance with the tax treaty and therefore, avoiding economic double taxation), a process that could take many years.

An alternative approach to these traditional processes is to leverage tax insurance to help protect taxpayers. Where a position can be considered reasonable and defensible, the insurance markets may step into the taxpayer’s shoes with respect to any loss caused by a tax authority challenge in the future making the taxpayer whole for economic loss including assessed taxes and defense costs. Businesses can benefit from the strategic use of tax insurance to manage their contingent transfer pricing tax exposures both in an M&A context and when there is no transaction involved.

For tax equity investors, a key incentive to investing in these projects is to monetize the associated tax credits, which in turn provides a source of funding for the development of the projects. Because tax equity investors are passive parties to the investment, they are subject to a number of tax risks, including: 

• The investment structure not being respected
• The transaction not qualifying for the projected tax benefits/credits
• The loss of tax benefits through recapture

Tax insurance helped manage these risks and was identified by the IRS in Rev. Proc. 2014-12 as a preferred vehicle over guarantees by transaction parties. Tax equity investors can also secure coverage to protect against retroactive changes in law and nonperformance by state and local governments with respect to refundable tax credits.