Underpaid tax: Buyers beware of tax surprises

Buying the shares in a company can be risky. The new owner is buying a corporate box with the potential of unknown liabilities hidden in it and there can be nasty surprises around underpaid tax.

Any sensible buyer of a company should ensure that they get a “tax covenant” from the sellers. The tax covenant (also called the tax deed) is a way of adjusting the purchase price for the shares by reference to tax liabilities of the company being bought.

A buyer will also ask for tax warranties, which are contractual promises about the tax history of the company.

Sellers often find it curious that a buyer wants tax warranties and a tax covenant for the same deal, but this is not merely belt and braces as tax is different to other risk areas (apart from the fact it is complicated!) for several reasons:

1. It can be difficult to establish the level of loss suffered for a breach of tax warranty;

2. Buyers do not want their awareness of tax problems to prevent claims against the sellers in respect of them. Disclosure (which is the process by which a seller can protect itself from a breach of warranty claim by providing information to the buyer) usually has no place in a tax covenant; and

3. The company can have secondary liabilities that arise after it is bought, which might not be captured by warranties alone.

Tax covenants are usually drafted in a very powerful way and sellers of shares should get professional advice to ensure that it does not work unfairly against them.

Tax covenants are an active area and there have been recent court cases. Also, they are having to adapt as new situations develop, such as the increasing use of insurance against risks in buying a company.

If you have any questions about tax covenants or any other legal aspects of buying or selling companies, please contact Russell Eke.