Representation and Warranty Insurance (RWI) is an increasingly important tool for managing transactional risk in technology-sector M&A. In the concluding instalment of our three-part series, we look at tax-related risks that have emerged as areas of heightened scrutiny by insurers in their assessment of risks in M&A within the technology sector.

Misclassification of Employees

Use of contractors is common in the technology sector. Depending on the nature of these arrangements, there may be a risk that these workers have been misclassified as contractors instead of as employees. This could result in a withholding and payroll tax liability for the target.

Applicability of Sales Tax

Depending on the nature of the product or service provided and the fee structure (e.g. subscription fees for a service, royalties, license fees etc.), sales tax may be applicable on fees charged by a target. An additional complexity is that sales tax can also be levied at the provincial level in Canada (and in the U.S., at the state level) and may vary across jurisdictions.

In late 2020, the Canadian government announced that starting July 1, 2021, Netflix, Spotify, Airbnb and other similar digital goods and services suppliers will have an obligation to register and collect the sales tax (GST/HST) from their Canadian customers (including individual Canadian consumers) that are not GST/HST registered. Companies with no physical or significant presence in Canada but which supply Canadian consumers directly, would generally be required to register for and collect GST/HST.

Investment Tax Credits (“ITCs”)

For Canadian technology companies, applicable federal and provincial Scientific Research & Experimental Development (“SR&ED”) Tax Incentive Programs may provide investment tax credits to claimants. Targets that qualify may receive benefits in the form of a refundable investment tax credit (i.e. a cash payment even if there is no tax to reduce), a reduction in taxes payable, or both. In addition to the federal SR&ED program, all provinces except Prince Edward Island have parallel programs.

These ITCs translate to real dollars and may have an impact on the valuation of the target. As a result, where ITCs materially impact the valuation of a target (and correspondingly could impact the quantum of losses claimed), insurers tend to review closely a purchaser’s diligence efforts to verify and validate these ITCs in the M&A process.

Impact on Coverage

To the extent that any tax diligence reports identify any specific tax issues, including any of those mentioned above, an insurer would typically:

  • assess the extent and scope of the diligence conducted, including during the underwriting session; and
  • take into account the quantum of the risk relative to the retention.

The result of this exercise may be that the insurer proposes to limit and/or exclude coverage.