Meaning
A contractual guarantee in a purchase agreement requires the seller to protect the buyer from any undisclosed or unpaid tax liabilities incurred prior to the closing of the transaction. The tax indemnity covenant is a standard feature of corporate acquisitions, establishing a clear division of tax responsibility. If a tax authority conducts an audit after the transaction and assesses additional taxes for the pre-closing period, the seller must reimburse the buyer for these costs.
This provision is designed to ensure that the buyer does not inherit the historical tax debts of the acquired company.
Risk Allocation
Mergers and acquisitions involve a transfer of corporate history, including potential tax liabilities that have not yet been discovered. The indemnity covenant acts as a risk allocation mechanism, shifts the burden of pre-closing tax errors back to the seller. Buyers routinely demand this protection to safeguard their investment from hidden tax exposures.
This clause is highly negotiated, with parties agreeing on the duration of the indemnity and any financial limits or deductibles that apply.
Claim Procedure
Corporate agreements establish specific protocols that the buyer must follow to make a claim under the covenant. When the buyer receives a tax assessment from an authority, it must notify the seller within a specified number of days. The seller usually holds the right to participate in or control the defense against the tax audit to minimize the potential payout.
This collaborative or defensive process must be managed carefully to avoid violating the terms of the purchase agreement.
Financial Backup
Sellers are often required to provide collateral to back up their indemnity obligations. This is frequently achieved by placing a portion of the purchase price in an escrow account for a specified period, often matching the statute of limitations for tax audits. This escrow ensures that funds are readily available to satisfy any tax claims that arise.
