Chapter 6 deals with the question of the relevant accounts to be considered for the tax covenant: the reason for this being the first issue addressed after introducing the tax covenant is very simple: it is in this area that the greatest number of errors are made by practitioners in the drafting of tax covenants from the standard precedents that they hold. If firms of solicitors have two standard precedents then the number of errors in the first draft is likely to decline markedly. However, the differences involved in respect of the relevant accounts are so important that this matter is explored in some detail. It is our aim that the documents should be fully understood: we are not seeking a band of slavish followers to any particular form of words.
Thereafter the chapters are structured in line with a specimen tax covenant. The relevant parts of the tax covenant are included in italics within each chapter: the various clauses are therefore explained in the same order in which they tend to be encountered in the document itself.
We very much hope that this approach of dissecting a tax covenant will provide a simple and logical way of navigating through this publication.
There are a number of important assumptions which underlie the classic tax covenants. Some of these are:
the Buyer expects to receive protection, on a basis similar to an indemnity, in respect of unforeseen tax liabilities, but not other liabilities;
the losses to the Buyer are computed by reference to the cash flow implications on the Company, not the accounting implications of reductions in net assets;
the Buyer accepts responsibility for the risks associated with rate changes and other tax risks which arise after completion, as part of the general risks associated with being in business. He should therefore also gain the benefit of such changes;
the Buyer receives protection in respect of overstated deferred tax assets, but he does not have the same protection in respect of underprovided deferred tax liabilities;
the Buyer is to be reimbursed for his cash flow losses. The tax Covenant is not designed to provide a profit to the Buyer;
overprovisions, recoveries, understatements and corresponding savings do not produce a pool of cash to be paid to the Sellers as they arise: rather they represent a contingent asset for the Sellers, which can be used to absorb all or part of the impact of any claims that may arise under the tax covenant;
the Covenantors should be protected from any tax which arises from the Buyer’s Group (excluding the Company)
Throughout this publication we comment on the intricacies of deferred taxation accounting and some of the inconsistencies that arise from the current approach: put simply the current versions of the tax covenant assume that the Buyer obtains protection under the tax covenant
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