In this second installment of our periodic series related to taxes and purchase agreements, we discuss the function that tax representations and warranties serve in a share purchase agreement.
Representations and warranties are a critical element of most share purchase agreements. They are the assumptions on which the parties reached their agreement and agreed to pay the purchase price – a step that is of critical importance to the buyer, who will inherit the history (including any liabilities) of the target company.
To a certain extent, tax-related representations and warranties function in the same way as other representations and warranties, especially insofar as they:
- substantiate and supplement the due diligence process of the buyer,
- facilitate a discretionary “walk right” of the buyer should a representation or warranty be proven to be untrue or materially untrue after signing of the agreement but before closing (called the “interim period”), and
- provide, through the related indemnification provisions, a basis for recovery should a representation or warranty be untrue.
In at least one key respect, however, tax representations and warranties tend to differ from other representations and warranties: they tend not to play a significant role in facilitating an indemnification right for the buyer assuming a tax indemnity also exists. Because of this, the comprehensiveness of the tax representations and warranties in a share purchase agreement may take on a diminished importance for a buyer who is otherwise indemnified. We consider this in more detail below, before turning to two important roles that tax representations and warranties can play in the context of a share purchase agreement.
Tax Indemnities: The Primary Basis of Recovery
The fact that, in many share purchase agreements, tax representations and warranties do not play a significant role in the recovery process may be somewhat surprising. But this makes sense when you consider that, as discussed in the first post in this series, buyers typically negotiate and obtain a separate indemnity for all taxes of the target company related to periods which end on or before closing (generally referred to as “pre-closing” taxes). For a variety of non-tax reasons, this pre-closing tax indemnity is the primary recovery method under the share purchase agreement should unexpected tax obligations arise in the pre-closing period.
The result of this is that the buyer typically does not need to rely on the tax representations and warranties if the unexpected taxes arise in a pre-closing tax period. In such situations, the pre-closing tax indemnity will usually be the preferred basis for recovery. But what if a breach of the tax representations and warranties gives rise to taxes in a period that ends after closing? This can arise for a variety of reasons but most frequently arises when tax attributes which the buyer otherwise thought would be available are not. Consider the following example:
It is typical for a seller to give a representation and warranty that all of the tax returns filed by the target company are true and correct in all material respects. If the target company gets reassessed such that the usability of non-capital losses of the target company is compromised going forward, should this be an indemnifiable claim for the buyer?
In order for this to be an indemnifiable claim, the buyer will need to prove that it has suffered damages as a result of the breach of the tax representation or warranty. It cannot make a claim under the pre-closing tax indemnity, as there are no additional taxes which have arisen in the period prior to closing. As a result, the wording of the tax representations and warranties can be of critical importance to a buyer if they are seeking indemnification in such circumstances.
As an observation, many sellers are becoming more attuned to this issue and it is becoming increasingly common for sellers to prohibit any claim for indemnification in respect of a post-closing tax period of the target company on this basis. Consequently, in many share purchase agreements, the tax representations and warranties play little to no role in the indemnification process for the buyer.
Tax Representations and Warranties: Two Key Functions
While tax representations and warranties may not fulfil a significant indemnification role for a buyer in the purchase agreement, they do serve other important purposes, including aiding the due diligence process and providing a “walk right”.
As noted above, because the purchaser will inherit the target company’s tax history, it typically undertakes significant due diligence on the target company prior to signing the purchase agreement. This is done – even though the agreement will typically include a tax indemnity – since a buyer will generally prefer to understand any tax risks associated with the target in advance. With that knowledge in hand, the buyer can account for those risks through the negotiation of a reduction in the purchase price prior to closing, rather than relying upon the indemnity to (effectively) roll back the purchase price once an indemnity claim arises. Moreover, the purchaser will not need to worry about its own knowledge of any adverse fact potentially impacting its rights to an indemnity claim in the future (which can be the case depending upon the “sandbagging” provisions in the agreement and the applicable governing law).
Tax representations and warranties play an important role in the due diligence process. Specifically, they assist the buyer to elicit information about the target company from the seller, overcoming at least some of the information asymmetry between the two sides. The need to provide tax representations and warranties may focus a seller upon specific issues that would otherwise be overlooked and will give it a forum to disclose associated risks to the buyer.
The relative importance that a buyer places upon this function depends upon the degree in which it is otherwise able to obtain comfort on these matters through its own due diligence. In many transactions, the purchaser retains an accounting firm to provide a full “Quality of Earnings” report and to undertake a significant amount of diligence on the tax side.
While a seller may be liable to the buyer for all pre-closing taxes of the target through the pre-closing tax indemnity, this does not mean that a seller is indifferent towards overly broad and unqualified tax representations and warranties. Most purchase agreements provide a condition to the buyer’s closing that all of the representations and warranties of the seller be true and correct (or true and correct in all material respects) as of the closing date with the same force and effect as if such representations and warranties had been made on and as of such date. As such, a buyer typically has the right to not close the transaction (typically called a “walk right”) if a breach is discovered between the time of signing and closing of the transaction and if it is material. This gives the buyer leverage to either terminate the transaction or renegotiate the purchase price with the seller if breaches are found in the interim period. The tax representations and warranties, like those that are unrelated to tax, play a role in facilitating this right.
As can be seen, in many share purchase agreements the tax representations and warranties do not play a significant rule in the indemnification process for the buyer due to the existence of a specific tax indemnity. However, these tax representations and warranties may serve other important purposes, both by aiding in the due diligence process and providing a “walk right” in the event of a material breach of such provisions.