Company Share Sales - Get The Paperwork Right!

In the third of a series of four articles by Burges Salmon relating to the sale of shares in private companies, YVONNE TRIPLETT discusses the tax documentation necessary.

IT IS VITALLY  important for a purchaser to seek as much protection as possible when buying shares in a private company. Often the vendors make grandiose claims about the state of the company during negotiations. These need to be reduced to writing and warranted in the contract!

Protection may be gained from due diligence enquiries, express warranties, including tax warranties, and a tax covenant. The commercial principle behind the inclusion of these is that the purchaser will usually have decided to buy on the basis of financial information in which there will usually be a provision for taxation. The parties generally accept that tax on pre-sale activities is borne by the vendor, and on post sale activities by the purchaser. If however a tax charge arises after completion in respect of a pre-completion event, and the tax is not provided for, the purchaser has paid too much and will require compensating.

The warranties

A warranty is a contractual representation made by the vendor. The purchaser will have a claim for breach of contract if a warranty proves untrue. Fair disclosure by the vendor against the warranties will prevent such a claim and, consequently, a vendor should disclose any matters that could affect the truth of the warranty given. The information disclosed, together with that obtained through the due diligence process could result in a reduction in the share purchase price or even a decision not to proceed with the acquisition. Because of this, the purpose of warranties is as much to drive out information as to provide contractual protection.

When claiming under the warranties the purchaser must be able to show that the warranty has been breached, that loss has been suffered by way of a reduction in the value of the target's shares and that the breach has caused the loss and that the loss is not remote. The purchaser also has a general duty to mitigate any loss suffered.

The tax covenant

It is market practice for a purchaser to take a covenant in addition to tax warranties. The covenant is usually contained in a separate tax deed, but might be included as a schedule in the share sale agreement, the typical provisions of both being considered in this article.

Before the decision in Zim Properties Ltd v Proctor [1985] STC 90, the position was generally covered by way of an indemnity given by the vendor to the target in respect of any loss suffered by the target because of a claim made against it by a tax authority. However, in Zim it was held that a right of action against professional advisers for negligence was a chargeable asset for capital gains purposes and, there being no acquisition cost, the sum received was subject to tax. Following Inland Revenue Extra-statutory Concession ESC D33, it is now usual for there to be a covenant by the vendor to pay the purchaser an amount equal to the tax suffered by the target, or to the target 'at the direction of the purchaser'.

If the purchaser insists on payment to the target, the vendor should be advised to refuse to give a gross-up clause. The purchaser's position would then be worse since the target would have to bear tax arising on payments made to it.

The advantages of the covenant are that basically it works by providing a £1 for £1 reimbursement to the purchaser in respect of any unforeseen pre-completion tax liabilities of the target. Generally a purchaser will not accept disclosure against the covenant and there is no general duty to mitigate any loss. Some matters may, however, be covered by the tax warranties, but not the covenant. For example, the warranties may seek disclosure regarding claims for rollover relief. If an asset was sold after completion with a lower base cost than thought, then there would probably be no redress under a generally worded covenant since liabilities arising after completion are not normally covered. We often include a specific covenant for base cost issues which stays in until the disclosure process has been completed and the clients can assess the risk. Thus, its deletion is often last 'last minute'!

Tax liabilities covered

Actual tax liabilities of the target relating to events occurring on or before completion will be covered. Obviously it is crucial to cover off any section 179, Taxation of Chargeable Gains Act 1992 liability. This is triggered by completion, and thus the drafting must be tight. The purchaser will also want compensation where certain reliefs are lost or used to mitigate tax liabilities for which the vendor would otherwise be liable. For example, where a relief is lost that has been deducted from a provision for tax in the accounts (a relief is an asset whether it is set out as an asset or is used to decrease a liability) or has been treated as an asset in the reference accounts (either last accounts published prior to completion or completion accounts). Equally the purchaser will also require compensation where a relief arising in respect of events after the accounts date is used to mitigate what would otherwise have resulted in an actual tax liability for which a claim could be made under the covenant.

Where the purchaser has paid for reliefs available to the target at completion, for example trading losses, the covenant should also provide the purchaser with compensation should these reliefs be lost or unavailable. The covenant may also cover liabilities that arise not only as a result of the target being a member of the vendor's VAT group (see Commissioners of Customs and Excise v Barclays Bank plc [2000] STC 665) but also any other taxation consequences of group membership. For example, the target may have surrendered losses to the vendor or another company within the vendor's group and may be required to repay monies received for the surrender. The purchaser would expect to be compensated for any such repayment. The purchaser might also want compensation where a surrender been made in the past to the target and that group relief is subsequently lost.

Inheritance tax may also affect the target due to pre-completion events even though no actual liability on the target exists at completion. It is advisable to ensure that a clause is included dealing with the liabilities that could arise. The inheritance tax provisions may impose the tax on not only the transferor of the property but also on the transferee. In certain circumstances they may not treat the transferee as liable until the transferor has failed to pay on the due date. In addition, the provisions may give to the transferee a power to raise the tax by sale of, mortgage of or charge on the property in respect of which the charge arose and which is no longer in its possession and can give to the Revenue a charge for unpaid tax over the property concerned or the proceeds of its sale. Such a clause is regarded as necessary whether the target company is close or not.

The covenant may also cover specific risks identified through the due diligence process or disclosures by the vendor. Whilst it may be argued that these are already covered elsewhere in the covenant, it does no public relations harm for solicitors to show clients and reporting accountants that the document is being 'tailor made' for their specific deal. It is also recommended that specific tax liabilities be covered, for example, transfer pricing, controlled foreign companies, company purchase schemes, in appropriate circumstances.

The covenant should also cover secondary tax liabilities that arise in the target where the vendor or a company within the vendor's group is primarily liable. This may arise if that company does not pay the tax.

The parties' liabilities

If there is more than one vendor, then the issue of the degree of liability attaching to them should be addressed. It may be the case that not all the vendors will want to be liable under the covenant, for example, a minority shareholder not involved with the target's management or a venture capitalist. In addition, a decision will have to be taken as to whether or not the vendors who are a party to the covenant should be jointly and severally liable or just severally liable. Trustees, for example, may only want several liability and therefore only liable for the amount of consideration they receive. A guarantor may also be included as a party.

Definitions

The deed or schedule to the agreement usually commences with a definitions clause, generally followed by the covenant. This will commonly incorporate the definitions from the agreement (if these are appropriate) and add further definitions and it is important to check for consistency.

The definitions are important and should be given particular attention. Many of the definitions will be drafted widely, for example, the definition of 'Event' to ensure that all liabilities to taxation of the target are covered. Frequently this definition will include the sale of the shares in target pursuant to the agreement. In addition, the definition may include a combination of two or more events, one of which took place prior to completion and the other after. These combined events clauses attempt to cover tax liabilities that arise on post-completion events which are connected with pre-completion events.

An example is the tax liability (referred to above) that arises when a claim for rollover relief has been made. The usual argument in their favour is that the purchaser will not be aware of pre-completion events and may therefore suffer 'innocently' by his own post-completion actions. A common compromise is to provide that the second event after completion should be in the ordinary course of business. Generally, a vendor ought to resist a combined events clause, insisting that the purchaser rely on a warranty claim instead. Alternatively, the purchaser could specify the liabilities that he wishes to cover.

The definition of 'Tax' will also be drafted widely and will usually include stamp duty, although concern has been expressed that section 117, Stamp Act 1891 might render the provision in respect of stamp duty void. The general view however is that section 117 would not be applied. The definition should also include taxes in foreign jurisdictions.

Limitations and exclusions

Clauses containing reasonable limitations and exclusions to the vendor's liability are standard practice, particularly since the covenant will be drafted widely. Some examples of the usual limitation and exclusion clauses are as follows.

Financial limits

Breach of the warranties is often subject to financial limitations and the vendor will usually want these to apply to the covenant.

A de minimis limit might apply to prevent the purchaser from making a claim where the amount of the claim is less than a specified figure, thus preventing claims that might cost more to deal with than the value of the claim itself. However, the purchaser should be cautious to ensure that the de minimis limit will not prevent a greater liability arising. This may occur where an amount is made up of a number of small individual claims relating to the same subject matter.

A cushion might operate so that when the aggregate of claims exceeds a specified amount the purchaser would be entitled to make a claim in respect of the excess over that amount. A threshold operates in the same way except that the vendor would be liable for the entire amount, not just the excess, once the specified figure had been reached.

It is usually accepted that the vendor will not be liable for an amount that exceeds the price paid for the shares by the purchaser, which should include any loans repaid at completion if applicable.

Time limits

The time limit for claims under a deed is twelve years unless provided for otherwise. Usually claims in respect of tax matters are restricted to within seven years of completion or within six years from the end of the accounting period in which completion takes place. Sometimes these limits are deemed not to apply if the vendor has been fraudulent or has made deliberate misstatements.

The reference accounts

Where the accounts for the acquisition are the last set of audited accounts, it is usual for the vendor to be excluded from liability for tax that arises in respect of ordinary course of business activities from that accounts date until completion. This is because the purchaser will receive the benefit of any profits during this period and therefore should be responsible for the consequent tax. Tax arising from transactions outside the ordinary course of its business should still remain a liability for the vendor. The purchaser may want to include provisions identifying transactions that are not to be regarded as in the ordinary course of business.

Where there are completion accounts to determine the share purchase price, then this limitation should not be used. This is because the vendor will receive the benefit of profits arising from the accounts date because they will increase the net assets of the target and the tax liabilities arising will also be reflected. It is therefore also common for tax liabilities reflected in the completion accounts (or the last set of audited accounts there being no completion accounts) to be excluded from the covenant.

Retrospective changes to taxation

It is usual for the vendor to be excluded from liability where this arises or is increased as a result of retrospective changes in tax law and Inland Revenue practice, for example, a retrospective change in the rates of tax.

Voluntary acts after completion

There will often be a limitation of liability if the purchaser or the target does or fails to do something after completion that causes a tax liability under the covenant to arise or increase. There may be a general clause covering such actions (or omissions) which commonly will exclude actions carried out in the normal course of business or done pursuant to legally binding commitments created on or before completion. The vendor may also want to include clauses dealing with specific actions or omissions.

These might deal with circumstances where the liability arises because of a withdrawal or amendment of any claims previously made by the target, for example capital allowances, or because the target fails to make claims, elections and surrenders taken into account in the accounts, or because there is a cessation of trade or major change in the nature and conduct of the target's trade or change in accounting policy.

A clause enabling the vendor and its group to make valid surrenders of group relief or surplus advance corporation tax for no consideration to mitigate pre-completion tax liabilities might also be included as will a clause preventing the purchaser making double recovery in respect of the same liability under the warranties and the covenant.

Other clauses

Over-provisions and corresponding benefits

An over-provisions and corresponding benefits clause may also be included. An over-provisions clause usually works so that where a provision for tax in accounts proves to be excessive, that over-provision can be set against any tax liability of the vendor arising under the covenant. The corresponding benefits clause will normally operate so that any relief that arises as a result of a payment made by the vendor pursuant to the covenant (e.g. non-recoverable VAT) will be set off against liabilities in the same way, although a repayment might also be required.

Third party claims

There may also be a provision requiring the purchaser to pursue a third party (e.g. its professional advisers) for a claim that the target may have in connection with a liability of the vendor under the covenant. The purchaser is usually prepared to do this provided the vendor has paid the amount due under the covenant and indemnifies (and secures) the purchaser against the cost of taking action.

Gross-up

The purchaser will want the vendor to 'gross-up' any payments under the covenant that are subject to tax. A gross-up clause is normally included although (as discussed above) taxation of payments in the purchaser's hands should not normally be an issue. This is because the purchaser requires protection to ensure that it receives reimbursement on a £1 for £1 basis. Whether a gross-up should survive an assignment of the benefit of the covenant to a third party is often the subject of heated debate.

Time for payment

Payment is usually required in time to enable the purchaser to pay any tax due. The vendor would be liable for any interest or penalties on late payments which are not down to the purchaser. However, where no actual payment of tax is required, for example, where there is the loss of a relief, notice of the liability may trigger the time for payment. A default interest clause may be included for late payments so as to encourage timely payment.

Purchaser's covenants

It is market practice for the purchaser to give a covenant in favour of the vendor in respect of tax assessed on the vendor arising from events occurring after completion, being a liability of the target. This normally involves a covenant being given in respect of sections 767A and 767AA, Taxes Act 1988 which enable the Inland Revenue to assess any unpaid corporation tax on previous company owners.

Conduct clauses

The vendor will want to be notified as soon as possible of any claim that could give rise to a liability under the covenant. The purchaser (since he now runs target) will normally want conduct of any tax claims subject to complying with the vendor's reasonable instructions. Alternatively, the vendor may be given conduct provided that the purchaser's position is sufficiently protected, for example, by preventing settlement of tax claims that will have an adverse affect on the future tax affairs of the target and by the vendor keeping the purchaser informed of progress. The purchaser will also require an indemnity for any costs incurred by it or the target in respect of a tax claim and may also require security for these costs.

In the absence of provision to the contrary, the purchaser will automatically have responsibility for dealing with the tax affairs of the target, including any outstanding tax computations. It is usual for the vendor to retain this responsibility in respect of all accounting periods ending on or before completion if the vendor's accountants have already done much of the work. If, however, completion occurs say one month into a new accounting period, it may be easier for the purchaser's accountants to do the computations. Target is usually required to make any claims and elections for these periods. If the vendor prepares a tax return, the purchaser will wish to ensure that it has some input and ensure that its reasonable comments and will be taken into account.

With regard to costs, where the vendor retains responsibility one should consider if such costs are reflected in the price by way of there being a provision for them in the accounts. If so, then these costs should be for the account of the target. The vendor might, however, resist payment of costs not reflected in the price arguing that these would be an expected future cost for the target.

With regard to current and subsequent accounting periods, the purchaser will usually have responsibility for these periods, the costs being borne by the target.

General

A number of clauses in the agreement might be incorporated without repeating the wording, although ensuring that any necessary changes are dealt with. Such clauses might deal with assignment, notices and governing law and jurisdiction.

Finally, whilst reference is made throughout this article to market and usual practice, one should always bear in mind that such practice might not apply where one party is in a strong bargaining position.

Yvonne Triplett is a solicitor at Burges Salmon who can be contacted on 0117 902 2704.

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