Desert island risks

Desert island risks

The role of Warranty and Indemnity insurance in real estate transactions

When the Chancellor of the Exchequer announced the new five per cent rate of Stamp Duty Land Tax (SDLT) on non-residential properties in the 2016 Budget, many attendees at the international real estate show, MIPIM, took a break from meetings to push deals through before the midnight deadline. The higher level of SDLT is the latest factor that makes corporate/share deals (usually in offshore vehicles) the preferred route for buyers and sellers of UK real estate. 

However, recent media events such as the Panama Papers’ leak have re-awakened negative public opinion regarding offshore companies. Consequentially, scrutiny of tax efficient structures has never been so great.

Significant risk?

Offshore structures are used by investors as a tax efficient method of holding European real estate. A typical structure involves the property being registered in the name of an offshore special purpose vehicle (SPV). Jersey, Guernsey and Luxembourg SPVs are popular choices. Property held in offshore SPVs is typically transferred indirectly: the SPV remains the registered owner at land registry, with ownership indirectly transferred by the buyer acquiring the shares of the SPV. 

There are a number of tax advantages in doing a share deal for commercial properties held in offshore SPVs. No SDLT is payable on the transfer (saving up to five per cent of the price). In addition, the offshore SPV should not be liable for UK corporation tax (saving 20 per cent of any gain). 

Share deals have tax advantages but introduce significant risk for the buyer. The key risks are that the SPV is trading rather than investing and/or that it is actually a tax resident in the UK because it has not been centrally managed and controlled offshore. As a result, the SPV could be liable to UK corporation tax on any gain within the SPV.

On the featured example, this could represent a tax liability of over £20 million. The crystallisation of such a risk would impair most investments. For example, this would equate to two years’ gross rental income on a five per cent yield. 

Most buyers will need protection from the seller against potential liabilities of the SPV, including those outlined above. Traditionally, this protection has been provided by the seller in the form of warranties and a tax indemnity, allowing the buyer to make a claim against the seller in the event of a breach of the warranties or when a pre-completion tax liability arises. 

However, many sellers are unwilling to provide these protections, as it limits their ability to distribute proceeds to investors. Other sellers may be willing to provide warranties and indemnities, but have a weak financial covenant. In these situations, buyers will be concerned that the seller may be unable to meet its obligations should a claim arise. These factors often result in protracted negotiations, as buyers and sellers try to shift the risk to the other side. In some cases, this can lead to deals falling over. 

Obvious benefits

Buyers and sellers are increasingly turning to Warranty and Indemnity (W&I) insurance to avoid the issues identified above. By using W&I insurance, the seller provides a full set of warranties and a tax indemnity to the buyer, but caps its liability to a nominal £1. The buyer then obtains its protection directly from an A-rated insurer. In the event of a tax liability, the buyer claims directly from the insurer. 

In the last nine months, we have witnessed heightened tax awareness change behaviour, with buyers less willing to take a view on the seller’s financial covenant. In recent months, we have structured policies to protect specifically against residency and trading versus investment risks. This reflects buyers’ awareness that crystallisation of such a risk would ruin an investment. There is significant value in the protection of an A-rated insurer, rather than hoping the seller will be good for the money.

While W&I insurance is an ideal way of getting deals closed and ring-fencing buyers’ risk, the cover available from the insurance market varies widely. Typically, matters fairly disclosed in the due diligence reports or disclosure letter will be excluded. Due diligence reports address at length the typical risks associated with offshore structures, even if no specific issue has been identified. This creates uncertainty over which risks are covered by the policy and can be seen to erode the cover available. However, with the right advice it is now possible to obtain policies that provide affirmative cover for the key risks (including, but not limited to, residency and trading versus investment). 

Offshore structures have obvious tax benefits for real estate investors, but introduce significant risk for buyers. In the past, buyers were able to take a view on these risks, but in today’s environment of heightened tax awareness they are much less willing to do so. The need to allocate such risk between buyers and sellers often results in deal execution risk. W&I insurance is a fantastic tool for avoiding such risks by protecting the buyer, but any policy needs to be carefully structured to ensure it covers the key risks.

This article was submitted to be published by Howden UK Limited as part of their advertising agreement with Today’s Conveyancer. The views expressed in this article are those of the submitter and not those of Today’s Conveyancer.

Richard French, Director of Mergers & Acquisitions team at Howden

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