A share transfer is typically preceded by extensive negotiations regarding the representations and warranties that the seller must provide concerning the transferred shares and the (legal, financial, tax, operational, and other) condition of the company involved, as well as the associated indemnification mechanisms.
These discussions address not only the matters for which the seller is liable, but also the limitations applicable to the seller’s liability under the representations and warranties. In practice, parties – rightly – tend to focus on financial liability limitations, such as a maximum amount (the so-called cap), minimum thresholds that must be exceeded before a claim can be made against the seller (such as a de minimis or basket), and the time limits within which the buyer must bring a claim against the seller.
Another important point, which in practice – wrongly – receives much less attention, concerns the identity of the compensation beneficiary. Traditionally, most SPA’s include a provision allowing the buyer of the shares to choose whether the compensation must be paid by the seller to the acquired company or to the buyer itself. While this may appear to be a seller-neutral provision at first glance, a closer examination reveals that it may have a material financial impact on the seller’s liability exposure.
Intuitively, one might think that it does not matter to whom the seller pays the compensation, as long as it is not paid twice: once to the buyer and once to the company (which is typically expressly excluded in most acquisition agreements). Nevertheless, a seller who must pay the compensation to the acquired company will usually incur a higher cost than if the same compensation were paid directly to the buyer, while for the buyer this makes essentially no difference.
The reason lies in how the compensation is taxed in the hands of the recipient[1]:
- If the claim for compensation is made by the company, the compensation received by the company will in principle constitute taxable income, for which no specific exemption applies. However, if the damage suffered by the company is, in principle, tax-deductible (for example: (a) an employee who has not been properly compensated and is entitled to back pay from the company, or (b) a receivable of the company that proves to be uncollectible), there will be no net taxable base, since both amounts offset each other. In that case, a compensation payment of 100 will not lead to additional taxation, and the seller will owe 100 to the company.
If, however, the damage is not a tax-deductible expense for the company (a typical example being an additional tax assessment), the compensation amount will need to be grossed up (which is usually expressly provided for in the acquisition agreement), so that the net amount received by the company – after deduction of corporate income tax – is sufficient to compensate for the non-deductible damage. For example, if the company owes an additional tax assessment of 100, the compensation must be grossed up to 133.33 (assuming a corporate tax rate of 25%), so that after taxation a net amount of 100 remains.
- If the claim for compensation is made by the buyer[2] in the form of a price reduction (which, in order to avoid tax disputes, should also be expressly provided for in the acquisition agreement), the compensation received by the buyer will in principle not qualify as taxable income. If the damage suffered by the company results in a tax-deductible expense, the company benefits from a tax advantage. For a deductible loss of 100, the tax benefit amounts to 25 (assuming a corporate tax rate of 25%), meaning the company effectively suffers a net loss of 75, and the buyer is therefore entitled to compensation of 75.
If the damage incurred by the company is not tax-deductible, the company does not benefit from any tax advantage, and the net damage equals the nominal amount, which also constitutes the damage suffered by the buyer.
In both cases – whether the damage is tax-deductible at company level or not – the amount payable to the buyer is significantly lower than when the compensation is paid to the company.
In other words, the above clearly demonstrates that the seller has a strong interest in paying compensation to the buyer in the event of a breach of representations and warranties. For the buyer, this makes no difference, as the compensation is tax-neutral. A prudent seller should therefore ensure during negotiations that the acquisition agreement designates the buyer as the exclusive claimant for compensation.
[1] For the purposes of this contribution, it is assumed that both the buyer and the company concerned are Belgian taxpayers.
[2] This assumes that the acquisition agreement provides that any damage suffered by the company is deemed to have been suffered by the buyer on a “euro-for-euro” basis, as otherwise it could, strictly speaking, be open to discussion whether the buyer has suffered its own loss where the damage occurs at the level of the company.