Tax Covenants in UK Share Purchase Agreements

A tax covenant (sometimes called a tax deed) is a key protection for buyers in UK share purchase agreements (SPAs).

Its purpose is to allocate responsibility for tax liabilities that arise from events occurring before completion, but which may not become payable until after the buyer has acquired the target company.

Because a buyer acquires a company together with all of its historical liabilities, tax risk is a significant concern in any share sale. The tax covenant provides a contractual mechanism requiring the seller to reimburse the buyer for certain tax liabilities attributable to the pre-completion period.

Why Tax Covenants Are Necessary

When a buyer acquires shares in a company, it steps into ownership of a legal entity with an existing tax history. Tax liabilities may arise long after the relevant transactions took place. For example:

• HMRC may commence an enquiry after completion.
• A corporation tax liability may not have been identified during due diligence.
• PAYE, VAT or National Insurance issues may emerge following an HMRC audit.
• Tax reliefs previously claimed by the target may be challenged.

Although some protection may be available through warranties and indemnities, a tax covenant is generally regarded as the buyer’s primary protection against historic tax liabilities.

How a Tax Covenant Works

The covenant typically requires the sellers to indemnify the buyer for tax liabilities arising from:

• Income, profits or gains earned before completion;
• Transactions occurring before completion;
• Breaches of tax legislation before completion; and
• The failure to pay tax due prior to completion.

If a covered tax liability arises, the buyer can seek reimbursement directly from the sellers on a pound-for-pound basis.

Unlike a warranty claim, the buyer generally does not need to prove a diminution in the value of the shares. Instead, the seller’s liability under the covenant is usually based on the actual amount of tax suffered.

For this reason, buyers commonly regard the tax covenant as their principal form of tax protection.

Common Exclusions

A seller will usually seek to limit the scope of the covenant. Common exclusions include:

• Tax liabilities already provided for elsewhere in the transaction documentation.
• Liabilities arising from changes in tax law after completion.
• Tax arising from transactions undertaken by the buyer after completion.
• Tax resulting from changes in accounting policies after completion.
• Liabilities disclosed during due diligence and specifically reflected in the purchase price.
• Tax that would not have arisen but for voluntary actions taken by the buyer after completion.

These exclusions seek to ensure that sellers remain responsible only for historic tax risks and not for matters created by the buyer’s post-completion conduct.

Seller Protections

Sellers typically seek a number of safeguards, including provisions stating that they will not be liable where the tax liability arises from:

• A change in law after completion;
• A change in HMRC practice after completion;
• The buyer’s voluntary acts or omissions;
• Failure by the buyer to claim available tax reliefs; or
• A tax liability that has already been recovered from another source.

These provisions are designed to prevent the tax covenant from becoming an open-ended guarantee of the target’s future tax affairs.

Practical Importance

Tax covenants are among the most heavily negotiated provisions in UK share purchase agreements. They can have significant financial consequences years after completion, particularly where HMRC opens an enquiry into historic periods.

For buyers, the covenant provides a direct and effective means of recovering unexpected historic tax liabilities. For sellers, careful drafting is essential to ensure that responsibility for tax is allocated fairly and does not extend beyond risks properly attributable to the pre-completion period.

Conclusion

A tax covenant is a fundamental risk-allocation mechanism in a UK share purchase agreement. Its purpose is to protect the buyer against historic tax liabilities while ensuring that the seller remains responsible for taxes arising from the period during which it owned the target company. Given the potentially substantial sums involved and the complexity of UK tax legislation, careful drafting and negotiation of the tax covenant is often one of the most important aspects of an M&A transaction.

How Can We Help?

The Corporate and Commercial team at Wilson Browne Solicitors is ideally placed to advise on all aspects of drafting and negotiating tax covenants in share purchase agreements, whether acting for a seller or a buyer.

For a confidential and no-obligation initial discussion about how we may be able to help, please contact the Corporate and Commercial team at 0800 088 6004.