Indemnification Recoveries in M&A: Drafting Tax Benefit Offset Provisions

Description

M&A sellers often argue that the amount of any indemnification claim made by a buyer for a breach of a representation should be reduced to the extent the buyer can benefit from a deduction for the amount related to the loss or damage for tax purposes. This might result in the inclusion of a tax-benefit offset (TBO) provision in the acquisition agreement. Care must be taken to ensure that if a TBO provision is included in the agreement that it is correctly conceived and effectively implemented.

There can be uncertainty in calculating the value of a purported tax benefit to a buyer. A variety of competing tax reporting positions can reasonably be taken, and the opinions of tax experts can differ. Different reporting positions could lead to different outcomes and different tax-effected indemnification amounts.

Tax accounting issues must also be considered. A buyer's outlay to address a negative event or condition will not, in and of itself, generate an expense that the buyer can immediately deduct for federal income tax purposes. The actual tax benefit can vary depending on the tax year in which it is recognized and whether it occurs in the context of an asset or stock deal.

In practice, TBO provisions effectively call for subtracting the amount of actual tax paid by the buyer from the amount of tax that would have been paid without the tax-reducing item. But this raises several questions: When must the tax-saving be actually realized by the buyer? Should the buyer be required to seek tax benefits? What role does the seller have in the buyer's tax strategy? Is the buyer protected from future tax audits or liability?

Listen as our authoritative panel discusses the key issues in drafting TBO provisions and the arguments for and against including them in a merger agreement.