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Regarding future tax losses, Companies take cover for cross-border M&As
December, 13th 2010

Learning from Vodafone's experience, companies and funds are buying special insurance covers and adding new conditions in cross-border deals to protect themselves from future tax losses .

Such insurance policies, which are valid for 4-6 years, are sold outside the country by international insurance firms which have joint ventures in India. In certain cases, the premium, which can be stiff given the high risks, are shared between the buyer and seller.

Tax claims similar to Vodafone will arise in deals where the buyer and seller are both offshore entities, as well as in transactions where the buyer is a local firm but the seller is non-resident. In the Vodafone deal, where Hong Kong-based Hutchison International sold shares of Hutch Essar to Vodafone, Indian tax department claimed jurisdiction on the transaction because the company and the business that was sold was based in India, even though the transaction happened offshore between two non-residents.

The court case between Vodafone and the income-tax department has taken a course where few want to take a chance. I am aware of two cases where such insurance policies were bought, said Punit Shah, who heads financial services tax at consultancy firm KPMG . A senior official of a local insurance firm confirmed that such policies are being sold in India, but not by Indian companies, which are barred by regulations.

In markets like the US, M&A insurance has been around for a long time.

In India, where it is beginning to happen, demand for the cover may pick up. We expect increasing purchase of such insurance by large PE investors. They are professional investors who will appreciate the value of such a protection more than others, said H Jayesh, founder partner at law firm JurisCorp . Private equity funds distribute the gains from a selloff to fund investors, also known as limited partners. Such a structure makes it particularly difficult to recover money in case of a tax claim a few years later. Besides, limited partners, like mutual fund investors, may exit a fund; and new investors who enter are unlikely to share the burden of an old liability they are clueless about.

In most traditional M&A deals, the share purchase agreement has an indemnity clause that says the seller will make good the loss if the tax office comes after the buyer later for not withholding tax. But here, the buyer has to pay the tax amount and then sue the seller to recover the money. The insurance cover, which allows the money to be recovered from the insurer, is over and above the indemnity clause. Indeed, insurance firms insist on an indemnity clause for selling protection. A common practice is where the seller in an M&A transaction takes the insurance cover, pays the premium upfront and names the buyer as beneficiary, said Shefali Goradia, partner, BMR & Associates . After the Vodafone tax, this is no longer a theoretical risk. The need for greater precaution is being felt, she said.

In standard share purchase agreements, there is a disclosure schedule where all contingent liabilities and potential payment demands are listed. If there is anything outside the disclosure schedule, the buyer can go to a court of law for breach of contract. But in a private equity, it is difficult to insert an indemnity clause, as the fund distributes all its capital, said the head of an Asia-focused private equity firm that provides investors with access to special-situation investments in public and private debt. The final outcome of the feud between Vodafone and Supreme Court will influence the fate and future pricing of such insurance covers. Last month, the Supreme Court directed Vodafone to deposit Rs 2,500 crore in the court registry within three weeks and the balance Rs 8,500 crore as bank guarantee within eight weeks.

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