Ambridge Partners’ InterpretationGap Tax Insurance product provides insurance to reduce or eliminate the uncertainty relating to the outcome of one or more tax issues by providing reimbursement for financial loss incurred as a result of a successful challenge by the relevant tax authority.
The most common applications for InterpretationGap Tax Insurance are in situations where:
- no clear guidance from the applicable tax authority or tax law precedent is available;
- a taxpayer is unable or unwilling to tolerate uncertainty because of the magnitude of the financial exposure relative to the size of a transaction;
- a buyer has not identified any specific tax issue, but wants to prudently minimize risk relating to the seller’s pre-closing tax issues; and
- parties to a transaction cannot agree on the allocation of potential pre-closing tax liabilities.
InterpretationGap Tax Insurance can also be an effective complement to private letter rulings. Since such rulings are issued in reliance upon representations made in the ruling request, InterpretationGap Tax Insurance can be utilised to provide a taxpayer with protection for certain representations that it has made in reliance upon statements made by a third party, such as the party that sold the asset or business. In the United Kingdom, the significance of the reliability of rulings is likely to increase as the United Kingdom rolls out its extended clearances and advance rulings programme.
InterpretationGap Tax Insurance can be designed to include coverage for the following components of financial loss:
- additional tax;
- interest and penalties imposed on such additional tax; and
- the amount by which the taxpayer’s taxes are increased as a result of the payment of proceeds under the InterpretationGap policy (i.e. “gross-up” coverage).>
In addition, to further align the policy with the specific tax issue(s), the policy can be designed to:
- cover the subject matter of a tax opinion or tax indemnity, although an opinion or indemnity is not required for the insurance to be put in place to provide coverage for the specific tax issue(s); and
- match the statute of limitations for the specific tax issue(s), up to eighty-four (84) months. Longer policy terms may be available on a case-by-case basis.
Regardless of the situation that requires certainty with respect to a specific tax issue, Ambridge Partners’ experienced underwriting team will work with you to provide your clients with the InterpretationGap Tax Insurance solution they require.
Please note that InterpretationGap Tax Insurance is not available in connection with tax shelters or transactions that the relevant tax authority has deemed to be abusive.
Uses by Deal Point
Some examples of where InterpretationGap Tax Insurance is responsive include:
- Extended limitation period required
- One of the largest shareholders of the target company in a proposed sale is a private equity fund. While the fund is willing to provide a tax indemnity in the form of a tax deed for any exposure that is identified during the first twelve months after the transaction closes, the buyer has required an indemnity that survives for seven years as respects all pre-closing tax liabilities. Providing an indemnity of this length will prevent the private investment fund from proceeding with its planned liquidation soon after the twelve month anniversary of the proposed transaction's close.
- Degrouping relief may not apply
- The board of a company, engaged in both the manufacture of office supplies and the development of business software, has determined that its two business segments could operate more efficiently as separate entities. It is intended that the office supply business will be demerged. While the company has received a tax opinion from a reputable law firm that the demerger should be tax free, the analysis is a "facts and circumstances" analysis. As such, the board is concerned that the HMRC unexpectedly will contend that there is an insufficient business purpose or trading benefit to support the tax free demerger. While the risk of such a finding is remote, neither the demerged business, nor the remaining business have the ability to incur the approximately £20 million in unexpected tax and interest that would become due if there was a determination that the demerger was not tax free.
- Independent consultants may be recharacterized as employees
- The target company in a pending transaction has historically engaged a number of individuals as independent consultants to provide accountancy services in respect of the target's business. Following due diligence, the buyer is concerned that the individuals may be found to have been in employment with the target company, giving rise to potential liabilities to PAYE and National Insurance Contributions (including interest). The seller is confident in its tax analysis and is unwilling to provide any security or "hold back" from the sale price in respect of this identified risk.
- Available relief for inadvertent failure to make required election may be denied
- During the due diligence process for a pending acquisition, it is discovered that the target company inadvertently did not make a required tax election. The regulations of the relevant tax authority provide that relief for such an inadvertent error may be sought, however, the timeframe for receiving the relief is approximately six months. If the relief is denied, the target company could face significant additional tax liabilities. Tax advisors to both the proposed target and buyer agree that given the facts, the risk of relief being denied is very low. However, the buyer is neither willing to assume the risk nor agree to delay the transaction for six months. An InterpretationGap policy is purchased by the buyer to respond in the event the tax authority refuses to provide relief for the inadvertent error.
Uses by Transaction Type
Potential uses of the product include:
- Financings and Investments
Potential tax exposure of borrower prevents lender from extending credit
The credit committee of a lender has approved all aspects of a loan to a company but has reserved final sign-off until it is satisfied that the crystallization of a potential tax exposure will not impair the company's ability to repay the loan. The potential tax exposure relates to the spin-off by the company of its office supply business in a tax-free spin-off. While the company has received a tax opinion from a reputable law firm that the spin-off should be tax-free, the analysis is a "facts and circumstances" analysis. As such, the lender is concerned that the IRS unexpectedly will contend that the business of the spun-off entity and the remaining business of the company should have simply been operated as two separate subsidiaries, and may determine that there is insufficient business purpose to support the tax-free spin-off. An InterpretationGap policy is purchased by the company, with the lender as a "loss payee", in the event the tax authority challenges the tax-free nature of the spin-off and the company cannot repay the loan.
Potential tax exposure at company prevents investor from making an investment
A potential investor in a distressed company has identified the reclassification of a large number of independent contractors retained by the company as employees as a risk factor. While the company has several legal opinions concluding that its independent contractors are properly classified pursuant to the guidance given by tax authorities on the subject as well as case law, given the political climate, there remains a risk that an attempt will be made to reclassify the independent contractors as employees. The company will not be able to withstand the financial impact of such a recharacterization. As a condition to the investment in the company, an InterpretationGap policy is purchased by the company to respond in the event the tax authority challenges the classification of the company's independent contractors.
- Licensing Agreements
Potential challenge to transfer pricing
All intellectual property of a business is held in the subsidiary of the target company in an acquisition. The effective tax rate in the jurisdiction in which the subsidiary is domiciled is lower than that of the jurisdiction in which manufacturing subsidiaries that license much of the target company's intellectual property. Despite the fact that the target company has demonstrated a significant business purpose for the location of the subsidiary holding the licenses, as well as significant documentation relating to the similar licensing agreements entered into by unrelated third parties that would show that the terms of the licensing agreements are arms-length, the buyer has concerns about the financial impact of a challenge by the relevant tax authority. In order to close the transaction, the seller provides an indemnity to the buyer to respond in the event the tax authority challenges the tax treatment and purchases an InterpretationGap policy to protect itself from the tax exposure it has provided under the indemnity.
Required survival period of tax indemnity prevents liquidation of a fund
One of the largest shareholders of the target company in a proposed sale is a private equity fund. While the fund is willing to provide an indemnity for any exposure that is identified during the first twelve months after the transaction closes, the buyer requires an indemnity that survives for six years as respects all pre-closing tax liabilities. Providing an indemnity of this size will prevent the private equity fund from proceeding with its planned liquidation soon after the twelve month anniversary of the close of the proposed transaction. The buyer purchases an InterpretationGap policy to respond to any pre-closing tax liabilities of the target company.
- Mergers and Acquisitions
Tax position agreed with auditor may be by review board
The target company in a transaction has just concluded a federal income tax audit and the examining agent from the tax authority has agreed that the target company is due a refund. However, given the amount of the refund in question, the examining agent's decision must be submitted to a supervisory panel for approval. The risk of a significant adjustment after review by this panel is viewed as remote, but the buyer will not proceed unless the seller provides a significant escrow (as the examining agent's initial position (reversed after discussion with the target company) was that significant additional taxes were due. Sign-off by the supervisory panel may take up to six months. The transaction dynamics are such that unless the purchase is concluded immediately, negotiations will be abandoned. The seller is unwilling to post the required escrow as it views the risk to be remote and requires immediate liquidity. In order to facilitate the closing of the transaction, an InterpretationGap policy is purchased in lieu of the escrow to respond in the event the supervisory panel refuses to sign-off on the refund.
Potential recharacterization of transaction treated as asset sale for tax purposes
The shareholders of an S Corporation target and the acquiring corporation agree to make a Sec. 338(h)(10) election whereby the stock sale is ignored for income tax purposes and treated as an asset sale instead. The buyer's tax advisors identified a risk that the target could fail to qualify as an S corporation as a result of certain circumstances which existed prior to the transaction (such as excessive salaries or perquisites to employee/shareholders or non-proportional dividends) that are deemed to have resulted in the issuance of a second class of stock. Tax advisors to both the target and buyer agree that given the facts, the risk of the Section 338(h)(10) election being successfully challenged is very low. However, neither the buyer nor the selling shareholders are willing to assume the risk. An InterpretationGap policy is purchased by the buyer to respond in the event the tax authority challenges the Section 338(h)(10) election allowing the transaction to close.
- Restructurings and Workouts
Potential limitation on use of net operating losses
During the due diligence process for a pending acquisition of a target company which is the subsidiary of a large financially distressed company undergoing a restructuring, the potential buyer's tax advisor identifies a remote risk that net operating losses ("NOLs") incurred by the company in years 2002 through 2006 could be limited as a result of a change in ownership. Tax advisors to both the proposed target company and the buyer agree that given the facts, the risk is low that the limitation on NOLs available to the target company following the transaction will be limited to a greater extent than if no change in ownership had occurred. However, due to the poor financial condition of the seller, a meaningful indemnification for the potential tax risk is not available. An InterpretationGap policy is purchased by the buyer to respond in the event the tax authority determines that the NOLs are limited as a result of a change in ownership, allowing the transaction to close.
- What types of taxes can be insured under Ambridge Partners InterpretationGap® policy?
- Our InterpretationGap policy can be offered to cover a wide variety of taxes in the United Kingdom, Canada, the European Union, Australia, New Zealand, South Africa and the United States. Please contact us if you seek insurance for tax exposures in other jurisdictions.
- Does Ambridge Partners require that a tax opinion be provided as part of its underwriting process?
- While a tax opinion is helpful, it is not required. A memorandum setting out the fact pattern associated with an analysis of the tax exposure by a professional tax advisor will generally provide Ambridge Partners with adequate information to provide you with preliminary terms.
- Will Ambridge Partners offer its InterpretationGap® policy in the absence of a transaction?
- Yes. Ambridge Partners sometimes will offer InterpretationGap Tax Insurance in situations where a taxpayer's auditors require that reserves be posted despite agreeing that the practical risk of a tax liability ultimately crystallizing is unlikely.
- What can be the components of covered “Loss” under an InterpretationGap® policy?
- "Loss" can include the taxes associated with the insured tax exposures, interest on those taxes, gross-up, and in some jurisdictions civil penalties where they are insurable by law.
- How can I advise my client what limit of liability they should purchase for their InterpretationGap® policy?
- As part of the underwriting process, Ambridge will request a description of how the requested limits have been calculated. This should be prepared by the Insured together with its tax advisor.
- How long does it take Ambridge Partners to perform a preliminary review of an InterpretationGap® Tax Insurance submission?
- Generally Ambridge Partners can provide preliminary terms within 24 to 48 hours. Completion of full underwriting is dependent upon how quickly detailed information is provided. Bindable terms can often be offered within several days after receipt of the initial submission.
- What type of underwriting submission does Ambridge Partners need so that an initial InterpretationGap® insurance proposal can be offered?
- A description of the tax exposure for which insurance is desired;
- An outline of all of the facts that the potential insured's tax advisors believe are relevant to analyzing the exposure;
- A calculation of the quantum of the potential tax exposure, the amount of insurance required, and the reason for requesting that amount of insurance;
- For tax exposures in the United States, confirmation that the tax exposure is not a "reportable transaction"; and
- Any analysis done by a professional tax advisor.
- If the client’s tax advisor provides Ambridge Partners with a memo outlining its views of the exposure will Ambridge Partners or the insurers under the policy have recourse against the tax advisor for advice provided?
- No. Ambridge Partners routinely executes hold harmless and non-reliance letters on behalf of itself and the insurers that it represents. Reviewing the conclusions of the proposed insured's tax advisors simply accelerates the underwriting process.
- Can an InterpretationGap® policy be offered as a tool to assist tax shelter promoters in selling their tax schemes or tax shelter products?
- No. Ambridge Partners' InterpretationGap Tax Insurance products are not designed to be sold in connection with, and do not provide insurance for taxes, interest or penalties associated with any tax shelter products.
- Will Ambridge Partners offer InterpretationGap® Tax Insurance where a client has taken an incorrect tax position and is concerned about this position being uncovered on audit?
- No. Ambridge Partners' InterpretationGap Tax Insurance product is only offered in connection with tax exposures where a taxpayer's filing position is consistent with what it believes to be proper based upon advice from its tax advisors.