What is a Tax Covenant?
A tax covenant provides protection to a buyer of shares against unforeseen tax liabilities of the target company on a similar basis to an indemnity. The inclusion of a tax deed of covenant in an agreement therefore means that tax liabilities are treated on a very different basis to other liabilities. For other liabilities which are found to be understated, the general rule is that it is necessary for the buyer to prove that a loss has arisen from the breach of the relevant warranties. Under the Tax Covenant the seller normally has an obligation to pay once it is clear that an unforeseen tax liability has arisen.
A large part of the challenge in the drafting and negotiating of tax covenants is to capture the essence of “unforeseen tax liabilities” in respect of each transaction.
The Buyer is concerned to ensure that the tax covenant provides protection in respect of two specific matters: firstly, if unforeseen tax liabilities arise after Completion in respect of events before Completion, he is concerned that these liabilities are effectively the responsibility of the Sellers; secondly he seeks recovery from the Sellers to the extent that any of the tax assets in the Company do not materialise.
In contrast to warranties, disclosures made do not normally mitigate the absolute obligation to pay that exists under the tax covenant.
A simple example can be given to illustrate the difference between warranties and the tax covenant: the shareholders of Stowmarket Warehousing Limited sell their shares to a third party. The agreement is in the form of a standard share purchase agreement and tax covenant. After Completion the following matters are identified, all of which relate to pre- completion events: the Company has not been dealing properly with National Insurance Contributions in respect of some Lithuanian temporary staff and employer contributions are payable of £2,800;
the Company has been incorrectly reclaiming VAT on entertaining expenditure and is obliged to repay VAT of £6,500 as a result;
one of the Lithuanian workers was injured by a fork lift truck and the company faces a fine of £80,000 and also an uninsured personal injury claim of £50,000. Total costs in respect of this incident therefore amount to £130,000.
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