Liquidation Stymies Tax Indemnity

When a deal is done by which one side gives the other a covenant or guarantee which applies for a period after completion, the value of that covenant or guarantee will depend on a number of factors, the principal one of which is probably the financial well-being of the other party.

One of the most common guarantees given in takeovers is a tax indemnity in which the vendor of a company gives a guarantee that it will meet any as yet undiscovered tax liabilities that arise after the sale but which relate to the pre-sale period.

A recent case shows the potential frailty of such agreements.

It involved a company, the purchase of which was accompanied by a tax indemnity given to the purchaser by the vendor. The indemnity was to last for seven years. The vendor was put into liquidation three years after the sale, with an unresolved tax issue outstanding.

The purchaser estimated that the tax liability could be as much as €11 million – nearly 50 times the amount estimated by the vendor. The liquidators decided to distribute the assets of the vendor to its creditors and the liquidators’ proposal assumed that the smaller estimate of the tax liability was correct. The purchaser went to court to obtain an order that the liquidators should retain sufficient funds to meet the entire €11 million contingent liability, as it could otherwise be severely out of pocket.

The case reached the Court of Appeal, which ruled that the liquidators had conducted their valuation of the contingent liability on a ‘genuine and fair’ estimate of the likelihood that the event triggering the tax liability would occur. Liquidators are not bound to ‘wait and see’ or to retain funds in such circumstances.

Accordingly, the liquidators could distribute the assets, leaving the purchaser with an essentially worthless indemnity.