Tax liability insurance protects the insured when the IRS disagrees with a tax position they have taken. While representation and warranties insurance (R&W) is the most well-known of the transactional insurance products, we are seeing a large uptick in the availability and use of this coverage, which is also referred to as “tax insurance” or “tax opinion liability insurance” (TOL).
Reps & warranties can be used to smooth out negotiations, provide a clean exit, and reduce both escrow and potential friction with a newly acquired management team, while tax liability insurance is designed to address a very specific circumstance rather than provide general coverage. For companies transacting mergers and acquisitions, this can often be more “deal critical,” as tax has a large impact on the upside of any transaction.
What Does Tax Liability Insurance Cover?
Tax liability insurance or TOL protects a taxpayer against the failure of a tax position in connection with a transaction, reorganization, accounting treatment, investment, or other type of taxable event. Specifically, it covers your loss if the IRS or other applicable taxing authority deems you have a greater tax liability than what you’ve claimed. Tax liability insurance can cover a particular transaction, such as an investment in renewable energy, or the tax treatment of a spin-off, for example.
While more expensive than R&W, tax liability insurance ranges between 3% and 6% of the limit purchased. If a very large limit is required, we can usually employ “layering” (breaking the risk into layers with the highest layers being cheaper than the primary layers) to bring the overall price down.
The amount of risk the policyholder retains can depend on the standard of the opinion provided to the potential insured by their tax specialist (see the table below for examples of such opinion terms, which are not included in policies). If the way you set up your tax is likely to be challenged but the amount that could be claimed is unknown, the underwriters may choose to set the retention at a level where they believe the taxing authority would settle. In essence, they are only providing coverage for the worst-case scenario. Conversely, if it seems that the position is strong, the underwriters may require a small retention or no retention at all.
Relevant Tax Opinion Terms Not Found in TOL Policies
|Will||Generally 90% or greater probability of success if challenged by IRS|
|Should||Generally 70%–80% probability of success if challenged by IRS|
|More Likely than No (MLTN)||Greater than 50% probability of success if challenged by IRS|
|Substantial Authority||The weight of authorities in support of a position is substantial in relation to the weight of authorities in opposition to the position (40%)|
|Realistic Possibility of Success||1 in 3 possibility of success if challenged by IRS|
|Reasonable Basis||Significantly higher than not frivolous and lower than realistic possibility of success|
|Not Frivolous||Not patently improper; some merit to position|
Keep in mind that it would be extremely challenging to find a market interested in providing coverage for anything less than substantial authority.
The typical policy term is six years, but many markets can offer seven years if desired, with a one-time premium that covers the duration of the policy period.
The policy pays out as a result of a challenge to a corporation or individual’s (the taxpayer’s) covered tax position, which generally includes additional taxes, penalties, interest, claim expenses, and a gross-up. (A gross-up is an additional payment to the insured to offset the taxes due on the insurance recovery arising from a paid loss).
The policy generally defines a claim as a notification to the taxpayer by a taxing authority that a covered tax position is being investigated. The specifics of which costs erode the retention and when the policy begins to cover costs stemming from the investigation is negotiated as part of the policy placement process. It is worth noting that carriers don’t wish to be either responsible for, nor involved in, paying the cost of routine audits (nor does an insured want to be required to get an insurer’s consent to settle a routine audit matter).
Getting Started with Tax Liability Insurance
Tax liability insurance is complex and the market still has more demand than supply. In order to give yourself the best chance of a successful result, it’s critical to think through your underwriting submission. To get an initial indication of price and insurability, underwriters will need:
- The name and address of the Named Insured
- The covered tax position(s), including a concise description of the underlying transaction and the relevant tax issue(s) to be insured
- Sufficient detail in your description so that the underwriter can rely on it when preliminarily evaluating the risk
- Disclosure of a full set of facts—which may mean executing a non-disclosure or even a common interest agreement prior to issuing the submission
- A memorandum and/or draft opinion if one has been prepared by the tax advisor
- Limit of liability being requested by the Insured
- A potential loss calculation, including additional taxes, interest, penalties, claim expenses, and gross-up (if desired)
In the heat of a transaction, a very quick response is the norm and a good broker should be happy to work within a tight timeline. Take the time to clearly define the coverage need and gather the supporting facts; this will actually lead to quicker assessments.
Underwriters generally respond within three or four days. If the initial feedback is favorable and you want to proceed, it is typically best to arrange a call with the underwriter to set a timeline and determine next steps.
The Diligence Process
Once the submission has been reviewed and the broker and underwriters have conducted an initial call, we would expect the underwriter to produce a Non-Binding Indication Letter (NBIL) along with a specimen tax insurance policy. The proposal outlines the scope of coverage (including any key exclusions), limits, pricing, and retention (deductible).
If you want to move forward, you will need to execute the NBIL or proposal and pay an underwriting fee (generally around $40,000 but may be higher or lower depending on the covered tax position). This fee offsets the underwriter’s internal costs and helps pay for any third-party advisors. We recommend determining up front how long this part of the process is expected to take so that everyone has expectations set.
Examples of Insurable Tax Issues
There are a variety of insurable tax risks and each risk is unique. At the same time, there are areas of tax law and certain transactions that lend themselves to the effective use of tax insurance. This may give you an indication of what could be covered by tax insurance.
- Historic tax positions of a target entity in an M&A transaction
- Real Estate Investment Trusts (REIT) and their representations as to their REIT status in an acquisition
- Foreign tax credits
- Preservation of (or availability of exceptions to any limitations to) net operating losses and other tax attributes following a transaction
- Transfer pricing
- Tax treatment of reorganizations, recapitalizations, and/or spin-offs
- Debt versus equity analysis
- Capital gain versus ordinary income treatment
- Deductibility of expenses (as opposed to capitalization)
- Excessive compensation
- Deferred compensation
- Whether withholding taxes are imposed
- Whether distributions constitute a “disguised sale”
Tax liability insurance is a complex product but is being increasingly embraced. If you have further questions about these kinds of insurance products, the Woodruff Sawyer M&A Insurance Team would be happy to answer them.