8 Steps to facilitate better protection against tax risks in share purchase agreements when making an acquisition in Russia.
The AEB guide to theory and practical advice for making an investment in Russia in 2011.
Even if every precaution is taken, tax risks are still likely to feature in any Russian deal made by European investors in Russia. In most cases, the risks involved are difficult to eliminate completely; therefore, extensive use of proper sale purchase agreement covenants, warranties and indemnities is crucial.
Although it is not possible to outline all the potential nuances of obtaining contractual protection against tax risks in deals, I have tried to summarise below certain core elements of such protection in share purchase agreements (SPA) that are essential when making acquisitions in Russia.
These observations are primarily with regard to SPAs made under English law (the use of which is common in many large- and medium-sized deals in Russia), but with some modifications, may also apply to SPAs made within the framework of a different law.
1. Start with structural protection
The first step in protecting your new acquisition from tax risks is to try to minimise the number of potential risks you take when acquiring a business.
This may potentially involve excluding some legal entities from the target structure, transferring some parts of the acquired business to new legal entities prior to acquisition, or requiring the vendor to discontinue dubious tax practices prior to acquisition.
This will reduce and limit the number of potential problems. In my experience, a significant number of acquisitions of non-public Russian companies include implementing some form of the above measures prior to acquisition; indeed, these steps are often given as “conditions precedent” in SPA.
2. Ask for explicit “euro-for-euro” tax indemnity
You should always try to obtain an explicit tax indemnity for all tax risks that may crystallise post-completion as a result of events occurring or deemed to have occurred prior to completion. Such indemnity should give you “euro-for-euro” compensation for any tax costs that crystallise post-completion – with minimal exceptions. Such tax indemnity should be the focal point of any proper contractual protection against pre-completion tax risks.
It is important to understand that having a set of tax warranties does not necessarily constitute a substitute for proper indemnity for two reasons:
making claims under warranties is more difficult procedurally; and
warranties can typically be limited by disclosure of information prior to signing/completion; such limitation by disclosure should generally not apply to indemnity.
Small and medium-sized businesses, however, tend to resist providing comprehensive tax indemnity and often accept indemnity only against individual risks identified as part of tax due diligence.
3. Limitation period for tax indemnity
Russian tax law allows tax authorities to perform an audit three calendar years preceding the year when the audit is initiated. This means that, for example, for a deal completed in October 2009, the tax authorities may initiate a tax audit as late as 31 December, 2012, covering some periods pre-completion. In addition, related tax audit proceedings may extend into 2013 (and occasionally even further).
It is also important to understand that, in the majority of cases, periods already audited may technically be re-audited again in the future by a higher level tax authority. Therefore, having a particular tax period already covered by a tax audit does not necessarily give you, as the purchaser, complete protection.For this reason, it is market practice in major transactions to request that any tax indemnity should apply to at least four calendar years postcompletion.
Small and medium-sized businesses, however, tend to insist on shorter limitation period (one-two years). In this case, proper pre-deal tax due diligence becomes extremely important.
4. Be selective as to who gives indemnity and properly choose the compensation (indemnity) mechanism
It is not uncommon for Russian vendors to have holding structures that include foreign vehicles. Such a foreign holding vehicle may be the formal party to the deal, but own no assets post-completion, and may therefore, have insufficient funds to cover any potential tax claims.
Therefore, in many cases, the indemnity mechanism in a Russian deal is more comprehensive and diverse compared to deals in certain other jurisdictions. It often uses several elements, for example, deferred compensation, escrow accounts, and personal guarantees from the ultimate owners etc. as additional protection.
5. Ensure that proper tax gross-up clauses are included
Russian tax law does not specifically address how payment under indemnities should be treated. Therefore, it is important to make sure that you, as the purchaser, are properly compensated on an after-tax basis. In order to achieve this, you should place on the vendor the burden of any potential tax costs related to paying compensation for postcompletion tax claims. This may be achieved by including an appropriate tax gross-up clause into the SPA applicable to payments under indemnities.
6. Ask for a comprehensive and detailed set of tax warranties
Although, as mentioned above, you should always try to obtain proper tax indemnity (covenant) in an SPA (with minimal limitations and exceptions), it is still advisable to have the vendor give an extensive set of tax warranties as additional protection.
A sophisticated Russian vendor would typically try to have tax warranties that concentrate on confirming only that the tax returns are true and accurate and that tax has been fully paid under these tax returns, rather than accepting full responsibility for tax relating to pre-completion periods.
Such a narrow approach potentially allows the vendor to attempt to rely on formalistic arguments in resisting warranty claims, and thus, exposes the purchaser to risk in a variety of situations, for example:
a) Russian tax law is notorious for being open to interpretation; there may be situations where a tax assessment is made, but arguments to support the vendor’s position nevertheless remain; and thus, constitute a basis for the vendor to dispute any warranty claims;
b) the tax assessment can be initiated directly by the tax office rather than by the taxpayer through a tax return (as may be the case with transfer pricing or the reclassification of aggressive tax schemes), in which case there will be no technical breach of warranty; or
c) tax for the pre-completion period may arise as a result of a post-completion event (e.g., as a result of the allocation of revenue under a multi-period contract).
7. Insist that disclosures be specific and quantifiable
It is common for Russian vendors and their lawyers to attempt to provide numerous documents as disclosures prior to completion that are often only vaguely relevant, not sufficiently explicit, not necessarily quantifiable, or which include very general
references to “areas of exposure”.
It is important to resist such disclosures, and insist that only disclosures that are sufficiently specific and quantifiable will be accepted.
Some sophisticated vendors also try to include provisions limiting any liability under tax indemnity with disclosures. Such an approach should be resisted:
by definition, only tax warranties should be subject to limitation by disclosures.
8. Make collection against tax claims under indemnity easy for you
Tax assessments issued by Russian tax authorities are often disputed in court, and court proceedings may take a year or more.
In this context, it is important to ensure that if such a tax assessment is raised, you as the purchaser are entitled to bring a claim against the vendor immediately upon receipt of such assessment –you are not required to wait until the issue is finally settled in court.
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