M&A tax risk on the rise: inside the hot market for tax liability insurance

By Jon Hutchens, Global Head of Tax, Transactional Liability 

Demand for tax liability insurance reached unprecedented levels in the first half of 2024, with submissions up by about 65 percent over the same period the year before—which was itself a high-water mark for the industry. Such a spike may seem surprising given deal-making activity has cooled markedly since record-breaking activity three years ago. At Mosaic, we are seeing three principal drivers.

First, the buoyant seller’s market of 2021—when global deal volume reached $5.9 trillion, according to Dealogic data—has now become a buyer’s market. Higher interest rates have made it more expensive to finance deals, and buyers have become pickier in a period of global macroeconomic uncertainty. A higher cost of capital has put downward pressure on valuations amid more thorough scrutiny of target companies.

In an environment where buyers have greater bargaining power, sellers are seeking ways to maximize value of targets they are putting up for auction by pre-emptively taking certain risks off the table. In 2021, buyers may have been more comfortable, for example, bearing an identified tax risk as part of the deal. That seems to be less true today, and this change in perspective is certainly generating interest in tax liability insurance.

Second, tax authorities around the world are signalling added determination to scrutinise large taxpayers and corporations. The US Internal Revenue Service (IRS) has been especially vocal about its intentions and has invested in increasing its capacity to carry out audits. In May, Danny Werfel, the IRS Commissioner, said the agency plans to “nearly triple audit rates” on large corporations with assets of more than $250 million, in line with the Treasury Department’s focus on perceived tax fairness. This, like the ongoing implementation of a global minimum tax rate under the Organisation for Economic Cooperation and Development’s (OECD) BEPS Pillar 2 initiative, reflects a growing international consensus that large corporations should pay their fair share. For M&A dealmakers facing the possibility of a tax audit, the protection of tax liability insurance in a transaction carries genuine value.

Third, the US Inflation Reduction Act (2022), which was designed to drive investment in renewable energy production through an expanded system of tax credits, has proved a catalyst for tax-insurance demand. Investors seeking confidence in the value of those credits have increasingly purchased insurance to provide certainty. This area, alone, is driving more than half of the current US tax-insurance market, and Canada may be the next frontier in this regard, as its government earlier this year set out a framework for an investment tax credit regime for the country.

In basic terms, the life of a tax risk can be marked with five possible milestones:

1. Action is taken (or omitted) that gives rise to the tax risk
2. Tax return is filed for the year relevant to the potential liability
3. Revenue authority selects the tax return for audit
4. Revenue authority imposes assessment/proposed adjustment
5. Case is argued in courts

A buyer in an M&A transaction may enter the picture at any point, and insurance (whether or not in a deal context) may be available at each stage, including before milestone (1) and after milestone (5). However, with each step forward in this chain of events, the availability of insurance decreases and price of coverage increases, because flexibility is reduced, contest costs are more certain, and an adverse outcome grows likelier. Also, once a tax position has been challenged by the tax authority, non-tax and extra-legal factors like agency settlement authority and judicial temperament take on a larger role. For these reasons, the greatest value to an insured comes from a policy obtained as early as possible once a risk has been identified.

Nevertheless, at Mosaic, we decide whether or not to provide a tax-insurance policy on the basis of the legal strength of the risk. Mosaic has six experienced tax underwriters, three in the US and three in the UK, providing global coverage. All of us have a background as tax advisers, either for top accounting or global law firms. That expertise enables us to view each risk on its merits, from the perspective of a tax adviser as well as an underwriter. We use our own deep well of knowledge and experience to assess analysis of the risk provided by tax advisers to the prospective insured, and we supplement our analysis with counsel from outside advisers who have relevant subject matter and jurisdictional expertise.

Our job, put simply, is to help taxpayers sleep better at night. A typical scenario in which we may be able to provide coverage is when a taxpayer has gone through a transaction, believes from an advised position that they have applied the tax law correctly, but recognizes there is some possibility the tax authority may take a different view. The taxpayer may be highly confident in their position, but because the stakes are so high and the potential tax liability is so great, they may consider it worthwhile to buy insurance. For example, the target company may have undergone a reorganization two years before and in the belief it was tax-free—but maybe it wasn’t. Or perhaps the company had been operating in a foreign jurisdiction and not paying taxes there that arguably, or only in the view of an aggressive tax authority, were due.

When specific tax risks such as these are identified, they will usually be carved out of a standard representations and warranties (RWI)/warranty and indemnity (W&I) insurance that covers many aspects of M&A transaction risk. Instead, they can be covered by tax insurance. Sometimes—provided we are sufficiently confident in the outcome—we will agree to cover a tax position that has been challenged. But we will not cover anything we consider a bad risk, at any of the life stages. A high level of confidence in the merits of the covered tax position is critical to insurability.

Regardless of whether factors spurring current demand continue to fuel the tax liability insurance market, there is reason to believe the growth rate we’ve seen over the past 18 months will continue, because awareness of tax insurance as a risk-management tool is still in its infancy. Many taxpayers remain unfamiliar with the product, or don’t realize how it might be applied to their situation by an underwriter willing to fashion a bespoke solution, providing certainty in transactions and fiscal planning.

The taxation landscape has become increasingly uncertain over the past decade. And whenever uncertainty grows, so does the role of insurance.