Tax liability insurance
Smolnik, Danny M
Post-Enron executive responsibilities heighten the need for coverage
Recent actions on the federal level have made it clear that tax liability issues will receive great attention during the next few years.
The Tax Relief Act, which was signed by President Bush on June 7, 2001, makes changes to the already complex tax law, many of which will be phased in and out over the next 10 years. The act itself is scheduled to “sunset,” be withdrawn in its entirety, in 2011.
Less than a year later, on March 7, 2002, President Bush announced his plan to implement enforcement tools. Specifically, these tools would make corporate executives personally liable if their employers issue financial statements that, due to a tax strategy later disapproved by the IRS or other financial problem, prove to be “grossly inaccurate” or the result of “misconduct.” (Both terms remain undefined.)
These actions set the stage for a tax roller coaster ride over the next decade. Fortunately, there is now a way to smooth that ride-with tax liability insurance.
The ability of taxpayers to comply with the law is and always has been more of an issue than their willingness to comply. In 2001, the IRS received more than $151 billion in corporate income taxes. More than $210 billion is budgeted to be collected from corporations for 2002an increase of about 39%. This compares to a 4.5% projected tax decrease to be collected from individuals this year. It is clear that corporate taxpayers will be facing considerable enforcement initiatives from the IRS.
More important, it also is clear that the IRS intends to aggressively pursue field enforcement efforts against corporations. By instituting a strategy of broad enforcement, the IRS hopes to “persuade” corporate taxpayers to settle rather than go through the time and expense of litigation-even when it involves weak IRS claims. This use of the “fear of the unknown” has built the IRS into the most effective tax collection agency in the world. Taxpayers now face such enormous potential penalties and cost that, more frequently than not, they take the most moderate approach possible to their taxes.
This policy of discouraging taxpayers from using the tax law to their own advantage certainly improves the IRS’s rate of collection, at least in the short term. However, this is at the expense of honest corporations who labor under the complexity of a tax code that the Secretary of the Treasury recently referred to as “an abomination” and “an unbelievable mess.” The costs of not taking advantage of the opportunities provided in the tax law are enormous.
The most common costs of taking the more expensive, but less-likely-to-be– challenged route include:
Unnecessary hits to earnings as the company pays to the IRS money that Congress intended for the taxpayer (and its shareholders) to keep
Posting of and maintenance of contingent reserves to pay possible tax losses in the event the IRS challenges the company’s tax position-this money ought be reflected as earnings and paid accordingly, but the uncertainty sowed by the IRS keeps the money locked up
Increased cost of capital, as companies who use ambiguous or uncertain principles in the tax law to their shareholders’ advantage will have to pay a risk premium to investors who are also uncertain about the tax risk.
These examples do not address the cost of board inaction arising out of directors’ uncertainty over the tax consequences of a proposal, or the drag of shareholder dissatisfaction in decisions that also may present some risk
In summary, the uncertainty created by the tax law causes corporations to overpay their taxes in order to feel comfortable enough to actually operate their business.
Tax liability insurance is designed to fill the risk gap that results from uncertainty about the tax law. Perhaps most important, as a risk transfer product, the coverage has immediate value in that it enables the company both to free up and to attract capital.
Selling the product
Striking the balance between the risks of potential tax disputes and the value of undertaking certain
transactions is most often the realm of the CFO. It is the strategic conversion of risk to profit on which the CFO builds his or her career, and it is the CFO who will most clearly understand the value of tax liability coverage.
The potential scope for tax insurance covers the entire range of tax liability, deductions, and credits. In the last 48 years, the size of the tax law in this country has more than doubled. The tax law alone consists of nearly 1.4 million words, and the Treasury’s “explanation” of the law is 13,000 pages long. In addition, court and IRS pronouncements number in the hundreds of thousands. The courts, the Congress and the IRS create new tax rules every business day.
Several examples of how the product has been applied to date illustrate the breadth of its utility.
One area in which tax liability insurance has been deployed is corporate reorganizations and recapitalizations. The Internal Revenue Code specifically provides for corporations to be able to undertake a wide variety of reorganizations without incurring any immediate tax exposure. These provisions are among the most widely used tax deferral devices in the law and are the foundation for countless deals in the United States. Because of the intricacies of the law, however, the IRS may interpret it quite differently than did the corporation when it was undertaking the reorganization. In the last 30 years, the appeals courts have decided more than 50 substantive cases in which the taxpayers and the IRS were completely at odds over how to interpret the reorganization provisions. Thus, there remains substantial risk of honest error leading to tax disaster.
Corporations often undertake such transactions in the ordinary course of business. In the current sluggish economy, CFOs feel even more pressure to generate profitability. Although, the CFO’s identification of tax savings strategies can boost the company’s bottom line, it often involves acceptance of the risk that the IRS may not agree and that the competing interpretations of the tax law may end up being resolved by a judge. If a large transaction is later determined to be taxable, the consequences can be catastrophic. A conservative board of directors or a CFO may choose to obtain insurance against such risk.
Another major area in which tax insurance policies have proved to be useful is in alternative fuel tax credits. Under Section 29 of the Internal Revenue Code, an owner of a facility producing synthetic fuel from coal is entitled to a tax credit (at the time of this writing, the credit is worth over $6 per barrel of oil equivalent). Also, under Section 45 of the Code, an alternative fuel credit is available for renewable energy generated by windmills. Insurance of the tax benefits of such credits not only protects the current owners but also makes investment in such facilities much more attractive to outside investors.
Other popular transactions with significant tax effects include sale and leaseback transactions, which enable a property owner to “cash out” its equity in a building or other asset while still maintaining control and use of such property for a substantial period of time. Frequently, a saleleaseback represents an alternative to long-term borrowing. Insurance can protect against the risk that the IRS might re-characterize the transaction as a financing arrangement.
Real estate investment trusts (REITs) offer tax benefits and can help banks to raise tier-one capital. However, complications such as contributions of built-in gain property can give rise to significant uncertainty.
Carefully structured like-kind exchanges can qualify for deferral of capital gains tax. Creative solutions are available to help taxpayers take advantage of this valuable benefit. However, in gray areas of the law, it may be advisable to insure against the risk of immediate tax.
Significant bankruptcy restructurings often result in ownership changes that limit the future use of NOL carry forwards, certain built-in losses and cost bases. The Internal Revenue Code offers ways to avoid these limitations. However, the more aggressive structures necessarily give rise to certain risks.
Some promoted tax shelter transactions may be perfectly legal. Recent case law has opened up corporate access to many more taxsaving opportunities, but the IRS has announced in internal documents its continued intent to oppose many forms of these opportunities.
The transactions described above illustrate some of the major situations where tax liability insurance policies have been issued in recent years. However, new uses for the coverage are constantly evolving as a result of court and IRS interpretations.
The policy is a “claims-made” policy with a term typically encompassing no more than six years. An extended reporting period option may be agreed upon for additional premium. Changes in the law cannot be insured against, but current compliance can be underwritten. The insured can be any entity or person, and in the case of programs where the transaction is syndicated, additional investors can be added after the policy has been bound.
The tax law is constantly changing and is difficult to understand completely. As the risks for non-compliance get steeper and it becomes more imperative to use the advantages that the tax law provides, companies will certainly find themselves facing unexpected IRS enforcement actions. The cost of defending against such enforcement is high, and the cost of losing a tax challenge can be devastating. Insurance against tax liability can be attractive for the large and mediumsized business market. It can be an important tool for CFOs-whose task is to make the taking of business risk pay off.
Danny M. Smolnik is an assistant vice president on Chubb Professional’s Mergers & Acquisitions Underwriting Team. He has 15 years in tax and M&A private law practice in Connecticut and has served as legal counsel to several regional, national and foreign corporations. He is a frequent speaker before professional organizations and has published several papers on tax liability. He can be reached at Chubb Professional Insurance, Simsbury, Connecticut at (860) 408-2939, or e-mail: email@example.com.
Bruce LaRoche and Roy Reynolds of the ChubbPro Mergers and Acquisitions Group also contributed to this article.
Copyright Rough Notes Co., Inc. May 2002
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