The Middle Ground

A GUIDE TO DEAL TERMS IN PLAIN ENGLISH


+ Introduction

+ Purchase and Sale

+ Closing

+ Representations & Warranties - Seller

+ Representations & Warranties - Buyer

+ Covenants

+ Conditions to Closing

+ Indemnification

+ Termination

+ Miscellaneous

Tax Clearance Certificates


Classification: Under the Radar
Section: Covenants
Negotiation Time: Minimal
Transaction Costs: Insignificant
Major Impact: Risk Management


What is This? When a company is registered to conduct business in a particular state, the state keeps records of state-level taxes owed by the company. A tax clearance certificate is a document provided by the state indicating that the Business does not have any overdue taxes or, if taxes are owed, indicating the amount that the Business is required to pay.

The Middle Ground: This covenant requires the Seller to notify the taxing authorities (in jurisdictions that impose taxes on the Seller) of the transaction and to request tax clearance certificates from those taxing authorities where available. If the taxing authority indicates that the Seller is liable for unpaid taxes, the Seller must promptly pay those taxes and provide evidence of the payment to the Buyer.

Purpose: The goal of this provision is to prevent the Buyer from becoming liable for the Seller’s delinquent tax obligations. It plays a small role in risk allocation, but its importance is limited by the fact that the Buyer is indemnified for any such tax obligations. Thus, the covenant is most useful for the Buyer in situations where the Caps or Baskets on indemnification would preclude the Buyer from making a claim. With that said, indemnification can be tricky to negotiate and can involve a long claims process, so this covenant also serves to provide some peace of mind that state-level taxes will not cause problems for the Buyer.

Buyer Preference: The Buyer wants to include this covenant, especially if time is not an issue and including it would not place an undue burden on the Seller. The Buyer may even prefer to obtain the certificates itself rather than putting that task on the Seller’s plate. However, most buyers will not object to omitting it, especially if they can exclude tax-related claims from the limitations on indemnification.

Seller Preference: The Seller wants to exclude this covenant on the grounds that it unnecessarily adds more work to an already lengthy and exhaustive process. The Seller can point to the Buyer’s indemnification rights to show that the Buyer’s risk from delinquent taxes is already addressed elsewhere in the Agreement.

Differences in a Stock Sale Transaction Structure: This covenant is not included in stock sales. In the asset sale context, the covenant only requires the Seller to make notifications and requests of the relevant taxing authorities if the failure to do so would result in the Seller’s tax liability being transferred to the Buyer. Since that transfer is automatic in a stock sale, the Buyer relies on its indemnification rights to shield it from becoming responsible for the Seller’s unpaid taxes.


DISCUSSION

We want The Middle Ground to be an ongoing dialogue for and resource to the lower middle market M&A community. The outline above is generally applicable, but there is always specific case law and nuance around certain industries that can be useful in helping buyers and sellers come together. If you are a lawyer or deal professional, we encourage you to add your perspective below.