Business protection: Tax Liability Insurance and Arbitration for effective risk management

Since Germany is not exactly known for its clear and easily applicable tax law, it is ultimately no surprise that a special form of hedging against known tax risks is becoming increasingly important, particularly in connection with M&A transactions. This is the so-called tax liability insurance, tax risk insurance or tax insurance. The following article sheds light on this newer insurance product and provides an overview of its main functions as well as potential coverage topics. It also discusses the role of arbitration in resolving disputes in this context.

Definition, scope and purpose of tax liability insurance

Tax Liability Insurance is a special type of insurance that insures a known but uncertain tax liability risk. The insurance compensates the policyholder for financial losses that may arise from tax liabilities or interest (including penalties or fines, if insurable) due to errors or irregularities in tax returns or tax audits, together with related litigation and legal defense costs (subject to an agreed deductible, if applicable). Companies are thus protected against the financial risks and costs that may arise in connection with tax matters. In this way, tax liability insurance also covers a gap in the insurance coverage of W&I insurance policies, which usually only cover unknown tax risks.

Tax liability insurance can be concluded in connection with an M&A transaction, but it can also take on independent significance, for example in the case of intra-group restructurings or prior to an IPO. In the case of an M&A transaction, the interested acquiring company will first carry out, among other things, a comprehensive tax due diligence. If any tax risks are identified or if there is a (slight) risk of such risks latently materializing – for example, because the interpretation of the relevant tax law with regard to the specific tax matter is not entirely clear and there is no case law from the highest courts, so that this assessment could be challenged by the tax authorities in the event of a future review – it may be worth taking out tax liability insurance. If any tax risks materialize, this can quickly lead to high additional claims by the tax authorities.

The tax risks covered are specifically defined in the respective policies and flanked by corresponding general or special coverage exclusions (for example, if the policyholder has intentionally or knowingly violated the law). All common types of taxes, for example value added tax, business tax, real estate transfer tax, etc., can be covered. Particular care should be taken when defining the insured tax risk, as in claims practice this is the linchpin of the coverage review. The insured event usually occurs according to the claims made (and reported) principle, whereby the respective policies contain special regulations as to when a loss must be specifically reported to the insurer.

Legal basis of tax liability insurance

Tax liability insurance is generally governed by the general provisions of insurance contract law. The relevant provisions of the German Insurance Contract Act (Versicherungsvertragsgesetz, VVG) and the contractual agreements between the insurer and the policyholder apply. Whether the Tax Liability Insurance is functionally a liability insurance or a damage insurance in the sense of the VVG must be examined in each individual case. If the tax liability insurance, like a liability insurance, also covers the defense costs against a deviating tax assessment in addition to the indemnification with regard to the legally binding tax debt, there is much to be said for it being a liability insurance, so that the respective regulations in §§ 100 ff. VVG are also applicable. In this respect, it is therefore not surprising that the policies provide for comprehensive rights of the insurers to provide information or to cooperate.

Similar to W&I insurance policies, tax liability policies generally include certain warranties. These warranties may cover various aspects, such as the accuracy and completeness of the information and documents provided, compliance with all relevant tax laws and regulations, and disclosure of all relevant information to the tax authorities. In most cases, the parties will have linked risk exclusions to a breach of these given warranties. The legal consequences regime from Sections 19, 21 VVG must further be observed. The effects on the insurance cover of a breach of the guarantees therefore depend on the underlying insurance conditions. It is therefore important for the policyholder to carefully review all relevant information and documents and ensure that they comply with the guarantees set out in the policy. Insurers, on the other hand, should draft precise warranties and legal consequence provisions.

Disputes arising from tax liability policies before arbitration courts

Due to the complexity of German tax law and the large number of tax regulations that may be relevant to the interpretation of a tax liability policy in individual cases, disputes often arise between policyholders and insurance companies regarding the scope of coverage and the interpretation of the policy. In such cases, arbitration is often the way to go in order to resolve these disputes. This is because most tax liability policies (as well as W&I policies) contain arbitration clauses that prohibit the recourse to the ordinary courts.

Against this background, arbitration plays a significant role in resolving disputes relating to tax liability policies. Arbitration courts are independent and neutral decision bodies set up specifically to resolve disputes between parties. Compared to ordinary court proceedings, arbitration proceedings offer several advantages: They are usually faster, more confidential and more flexible. In addition, they allow the parties to choose experts with extensive knowledge of tax law as arbitrators, resulting in sound and specialized decisions.

Arbitration thus enables the parties to resolve their disputes in an efficient and focused manner. Arbitrators take into account the specific provisions of the policy, as well as relevant tax laws and regulations, to reach a fair decision. By choosing arbitration as a dispute resolution mechanism, parties can save time and money while ensuring that their disputes are handled by knowledgeable experts in the field of tax liability or insurance law.

Conclusion

Overall, tax liability insurance offers suitable protection against identified tax risks and can therefore be very helpful in corporate transactions or reorganizations. Whether tax liability insurance can offer sufficient coverage and protection in the event of a specific claim depends on various factors. Therefore, a thorough analysis of tax risks and exposures should be carried out in the underwriting process and the insured tax risks and warranties should be clearly described in the insurance terms and conditions. Should a claim ultimately arise, depending on the damage potential and complexity, it may also be helpful to involve legal advisors at an early stage in order to avoid arbitration proceedings if necessary or to ensure that they are handled competently and efficiently.