M&A and Transaction Solutions
Tax Liability Insurance 101
If a company’s tax position is successfully challenged, tax liability insurance can protect its finances.
February 26, 2024
WorldCo Manufacturing purchased an offshore supplier that provided critical components to its U.S. assembly facility, eliminating a potential supply chain weakness. The company assigned a transfer value to the shipped parts for accounting and tax purposes.
However, the IRS challenged the company’s financial treatment of the shipped components, arguing that the parts were “sold” rather than “transferred” between the two facilities and, therefore, were subject to tax. If the IRS challenge were successful, WorldCo would owe taxes, fines and penalties … unless WorldCo’s tax position was protected by tax liability insurance.
What Is Tax Liability Insurance?
Tax liability insurance, also sometimes called tax insurance or tax indemnity insurance, protects the insured when a federal, state, local or foreign taxing authority successfully challenges a specific tax position it has taken. These challenges often arise during M&A transactions and divestitures, but companies that employ transfer pricing, move products across borders, are involved in complex reorganizations or leverage tax credits for renewable energy initiatives are often subject to increased scrutiny and audits.
Costs covered by tax insurance include the following:
- Legal consultation and defense
- Fines and penalties
- Taxes owed
- One-time tax gross-ups
How Is Tax Liability Insurance Used?
Each tax liability policy is tailored to a specific tax position. Here are some examples of how tax insurance has been used.
Spin-off
A corporation took the position that the spin-off of a subsidiary would qualify as non-taxable under section 355. The company used tax liability insurance to cover its risk if a taxing authority challenged the position managing any residual risk to the taxpayer.
Transfer Pricing Controversy
A company took the position that the Canada Revenue Agency would respect a cross-border hybrid debt/equity financing arrangement despite being under audit. It purchased tax insurance as protection.
Asset Sale Election 338(h)(10)
An organization took the position that New York would respect a valid section 338(h)(10) election despite differences in reporting for the New York and federal consolidated groups, facilitating its clean exit from the investment. The organization insured its position with a tax liability policy.
CODI 108(e)(6)
A company used tax liability insurance to insure its position that the contribution of an intercompany note would not result in the cancellation of debt income due to the application of section 108(e)(6), facilitating the execution of an M&A transaction without an escrow where a buyer may establish an uncertain tax position.
Partnership Liquidation 752(c)
A company took the position that terminating a distressed partnership would not step down the tax basis of the partnership’s underlying tax basis, maximizing value for the remaining partner and facilitating the company’s exit from a Chapter 11 bankruptcy.
No two tax liability insurance policies are alike, and coverage is highly technical. Therefore, working with a knowledgeable broker and underwriter for this type of protection is important.
What Risks Can Be Covered by Tax Liability Insurance?
Unlike most types of insurance, tax insurance can be purchased after an issue (here, a tax challenge) arises. However, it cannot be purchased after the outcome of a challenge is known. The types of risks that can be considered include the following.
Corporate Tax Planning |
Section 355, tax-free reorganization, debt equity, 9100 relief, bespoke tax planning, withholding tax, interest deductibility, worthless stock deduction, treaty eligibility, ECI/trading safe harbor, SECA and active limited partners, foreign exchange trading strategies, capital versus ordinary treatment |
Tax Controversies |
Positions currently under audit or challenged by a taxing authority (insurance can be purchased after a challenge is raised but before the outcome of the challenge is known) |
Transfer Pricing |
Positions on cross-border transactions between controlled affiliates |
M&A Risks |
S-corporation, REIT, employee versus independent contractor, taxable Canadian property, pre-transaction reorganization, valuation, tax basis calculation, section 338(h)(10) calculation, and sales and use tax |
Renewable Energy Tax Credits |
ITCs, PTCs and 45Q, including structure and allocation, qualified basis/valuation (including begun construction/placement in service) and recapture |
This technical coverage must be designed to address specific risk scenarios. Rely on an experienced broker to make sure you receive the proper coverage.
Who Can Help?
Corporate tax laws have become increasingly complex. It isn’t unusual for taxing authorities—whether federal, state, local or foreign—to challenge the tax positions companies take. Contact Hylant M&A and Transaction Solutions to learn more about how tax liability insurance can help you protect your company's finances.
Related Reading: Transfer Pricing Considerations for Private Equity Funds
The above information does not constitute advice. Always contact your insurance broker or trusted advisor for insurance-related questions.
Authored By
Kip Irle
Global M&A | Transaction Solutions Leader
Chicago
Kip joined Hylant in 2013 and has over three decades of experience in the industry. Kip provides strong leadership to his team and clients. Kip's expertise includes mergers & acquisitions, structured finance and insurance, and alternative risk financing.
