Rep and warranties insurance proceeds in M&A: Key tax considerations for buyers
Executive summary: Representations and warranties insurance and M&A transactions
With the condensed timeline of many mergers and acquisitions (M&A) transactions over the past few years, parties have commonly used representations and warranties insurance (RWI) in place of detailed transaction diligence and escrows and holdbacks. Under RWI arrangements, a third-party insurance company, not the seller, pays damages for a breach of the terms of the purchase agreement.
Taxpayers that utilize RWI policies in conjunction with M&A transactions should carefully assess how the involvement of a third-party insurer affects the characterization of subsequent payments: as an adjustment to purchase price (return of basis), or as a current income inclusion. The analysis and its resulting tax effect are fact sensitive and depend on various factors.
Tax treatment of post-transaction RWI payments
In an M&A transaction, the buying and selling parties each agree to various representations, warranties and covenants as part of the transaction agreement. For example, the seller often agrees to transfer the assets in good working condition or accurately disclose financial statements or earnings information relating to the condition of the company. These terms often also relate to post-acquisition activity; e.g., the seller promises not to compete with the buyer or solicit its customer base. After the transaction, disputes can and often do arise over a party’s breach of these terms, which may be resolved through a payment for damages, or settlement.
When the seller makes a settlement payment directly to the buyer related to a breach of the transaction agreement, the payment often constitutes a purchase price reduction rather than income to the buyer, assuming the claim itself relates to the purchase price of the company rather than future lost income. (See United States v. Gilmore, 372 U.S. 39 (1963) and Arrowsmith v. Comm’r, 344 U.S. 6 (1952).)
By contrast, if the parties to an M&A transaction obtain RWI, then the third-party insurer will pay damages when a seller or other party to the transaction breaches the terms of the purchase agreement. In this case, the core tax question is whether those payments from a third-party insurance company can constitute a nontaxable reduction to the stock or asset basis of the purchased company, instead of gross income to the recipient.
Case law has allowed a taxpayer to treat an indemnification payment from a third-party broker as a reduction to purchase price. (See Freedom Newspapers, Inc. v. Comm’r, T.C. Memo 1977-429.) Further, IRS authority indicates that a disaster relief or insurance payment compensating a taxpayer for a property casualty loss is a return of capital and is not included in income. (See Rev. Rul. 71-161, 1971-1 C.B. 76; and Reg. section 1.1016-2.)
However, there is no case law or IRS authority directly addressing the treatment of post-acquisition settlement payments made by a third-party insurer. Whether the receipt of RWI proceeds is a purchase price adjustment rather than a gross income inclusion is therefore uncertain, fact-sensitive, and dependent on a variety of factors. Factors to consider include:
- Whether obtaining RWI was a term in the purchase agreement (or integrally connected to the transaction)
- Which entity or parties are covered by the RWI policy and entitled to any proceeds (e.g., buyer, target, or ultimate investors)
- Whether the settlement payment compensates the buyer for lost profits or damages related to the goodwill or tangible assets of the company
- Whether the premiums and other costs associated with the RWI policy are properly capitalized to the assets or stock acquired under section 263(a) or treated as an ordinary and necessary business expense under section 162
Consider the potential effect of RWI payments in various M&A contexts. What are the consequences of treating an RWI payment as a reduction in basis instead of a current inclusion in gross income? One possible difference is whether the amount is characterized as capital versus ordinary. Another key consideration is the timing of income or gain recognition.
Holding LP, a partnership formed by various investors to facilitate the acquisition of Target, forms Parent, a corporation. Parent acquires all of the stock of Target from sellers for $100 million (without a section 338 or 336(e) election). As part of the purchase agreement, Parent agrees to obtain RWI and is a named insured. Subsequently, Parent files a claim with the RWI insurer that the sellers made a misrepresentation that led to the inflation of the purchase price of Target stock. In settlement of this claim, the insurer makes a $5 million payment to Parent pursuant to the RWI policy. Assume Parent and Target elect to file as a consolidated group.
Parent’s RWI claim relates back to the purchase price of Target. As the direct buyer, and named insured, Parent receives the $5 million payment. As a result, Parent is potentially able to treat the $5 million payment as a reduction to its basis in Target stock from $100 million to $95 million.
If Parent contributes that $5 million back into Target, there is no net effect on the basis of Target stock, which is an important consideration when Target or Parent is sold. Conversely, if Parent distributes the $5 million back to Holding LP’s investors, then that distribution may reduce the basis of Parent stock or generate a dividend depending on the relevant facts and E&P profile.
The facts are identical, except that Target is an LLC and treated as a disregarded entity instead of a corporation. Parent acquires all of the LLC units of Target in a transaction treated as a taxable asset acquisition. Assume Parent’s initial cost basis in goodwill far exceeds the subsequent $5 million RWI payment.
If Parent treats the RWI payment as a reduction in basis, it reduces the basis of its goodwill by $5 million instead of including the full amount in its gross income. Over the 15-year amortization period for section 197 intangibles, Parent amortizes $5 million less of goodwill.
Planning considerations before resolving an RWI claim
Before settling an RWI claim, buyers can avoid unexpected tax liability or loss of value by taking the following steps:
- Review the purchase agreement and policy to determine whether the RWI coverage is linked to the acquisition economics.
- Identify the named insured and the party legally entitled to proceeds.
- Document whether the claim relates to purchase price overstatement, damaged assets, lost profits or post-closing operations.
- Model the difference between current income inclusion and basis reduction.
- Consider how any proceeds will be retained, contributed, distributed or otherwise used after receipt.
Concluding thoughts
Parties to M&A transactions increasingly use RWI in place of escrows and holdbacks. When third-party insurers make payments under an RWI policy, it is not entirely clear whether buyers may treat the receipt of those payments as purchase price reductions or, alternatively, must treat them as includible in gross income. Although it appears reasonable to treat those payments as purchase price reductions in many cases, the answer is ultimately fact sensitive.
Additionally, the tax effect of treating RWI payments as a reduction in basis instead of a current inclusion depends on several transaction-specific factors, including whether the transaction was a stock or asset purchase, how the buyer arranges its acquisition structure, and the extent of any distributions the buyer makes to investors. Modeling and planning potential outcomes before settling an RWI claim can therefore have a material impact on future taxable income.