What Is Tax Indemnity and How Does It Work?
Learn how tax indemnity functions as a risk management tool in business deals, allocating financial responsibility for pre-existing tax liabilities.
A tax indemnity is a contractual agreement where one party agrees to compensate another for specific tax-related losses. It is a risk management tool commonly used in business transactions like mergers and acquisitions (M&A), where a buyer inherits the target company’s history and potential tax liabilities. An indemnity clause shifts the financial responsibility for certain tax issues from the buyer to the seller. This protection allows the buyer to be reimbursed for unexpected tax costs that arise after the transaction but relate to a time when the seller was in control, providing greater financial certainty.
Scope of Tax Indemnity Coverage
The specific scope of a tax indemnity is a point of negotiation between the buyer and seller, but it centers on clearly defined categories of taxes and time periods. The goal is to protect the buyer from historical tax problems of the business they are acquiring.
A primary function of the indemnity is to cover taxes related to the seller’s period of ownership, known as pre-closing taxes. This ensures the buyer is not responsible for tax liabilities that originated before they took control. The types of taxes covered are comprehensive and can include:
- Federal, state, and local income taxes
- Sales and use taxes
- Payroll taxes
- Property taxes
The coverage also distinguishes between known and unknown tax liabilities. During the pre-transaction due diligence process, a buyer may uncover specific, identifiable tax risks, such as an ongoing audit or a failure to file certain returns. The indemnity can be structured to provide recovery for these known issues, and it also covers general, unknown liabilities that were not discovered during due diligence but may surface later.
Key Provisions in a Tax Indemnity Clause
The effectiveness of a tax indemnity hinges on the specific provisions within the contractual clause. These terms define the agreement’s mechanics and dictate how and when a party can seek compensation.
Central to the clause are precise definitions of “Taxes” and “Loss.” The definition of “Taxes” specifies the types of liabilities covered, such as income, sales, or payroll taxes. A “Loss” is defined broadly to include not just the tax amount itself, but also any associated interest, penalties, and the professional fees required to contest the tax claim, such as legal or accounting costs.
The “survival period” is a provision establishing a timeframe during which a claim can be made. This period is negotiated to extend until the relevant statute of limitations for the tax authority to assess the tax has expired. For example, the IRS has three years to assess additional tax, so the survival period for federal income tax matters might be set to align with that window, plus a short additional period for the parties to process the claim.
Agreements also include limitations on indemnification. A “cap” sets a maximum limit on the seller’s total financial liability. A “basket” acts like a deductible, requiring the buyer’s losses to exceed a certain threshold before a claim can be made. For instance, with a $50,000 basket, if a tax loss of $40,000 arises, the buyer cannot make a claim; if the loss is $60,000, the buyer may be able to claim the full amount or only the excess $10,000, depending on the basket’s structure.
A tax “gross-up” provision addresses the possibility that the indemnity payment itself could be considered taxable income to the recipient. A gross-up provision requires the paying party to make an additional payment to cover that tax liability, ensuring the recipient receives the full, after-tax benefit of the indemnity. For a $100,000 loss and a 25% tax rate, the indemnifying party would pay $133,333, so that after the recipient pays $33,333 in taxes, they are left with the full $100,000.
The Tax Indemnity Claim Process
Once a potential tax liability is identified, a formal, procedural process is set in motion. This process is governed by the terms of the indemnity agreement and outlines the specific actions each party must take.
The first step is the “Notice of Claim.” The indemnified party must formally notify the indemnifying party that a potential claim has arisen. Agreements require this notice to be delivered promptly, often within a 30 to 60-day period of discovering the issue, and to describe the matter in reasonable detail.
A procedural element is determining who has “Control of the Tax Contest.” Since the indemnifying party is financially responsible for the outcome, the agreement grants them the right to manage the audit or litigation with the tax authority. This allows the seller to control the defense strategy, settlement negotiations, and communications with the tax agency.
Regardless of who controls the contest, the agreement will require both parties to cooperate. This involves sharing relevant documents, providing access to employees for interviews or testimony, and keeping the other party informed of progress and key decisions. This prevents one party from undermining the defense of the tax claim.
The final step is the payment of the claim. After the tax liability is finally determined, either through a settlement with the tax authority or a final court decision, the indemnifying party pays the agreed-upon loss to the indemnified party. The payment must be made according to the terms specified in the agreement, which may also dictate the source of funds, such as from an escrow account.