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Australia - Tax impact of warranty clauses

Australia - Tax impact of warranty clauses

Tax impacts of warranty clauses in Australia.

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Australia - Tax impact on warranty clauses

Does the seller grant warranties or indemnities to the purchaser when acquiring a company?

Yes (there may be certain exceptions to this, e.g. where vendors are private equity, but generally this is the case).

Does the tax treatment of the warranty depend on its legal classification (e.g. indemnity vs. reduction in the purchase price vs. others)?

Practically, any claim (whether it be under a specific warranty or an indemnity) is typically drafted as an adjustment of the purchase price under the SPA. This should remove ambiguity from a technical tax perspective regarding the treatment of any such payment for the vendor / purchaser.

Is classification of the contractual warranties as a price reduction clause or an indemnity clause relevant in your jurisdiction?

Not from a tax standpoint – irrespective of whether a claim is under a warranty or indemnity, any such payment is typically drafted as an adjustment of the purchase price.Nevertheless, it is a key point in Australia to include in the SPA that warranties are given on an indemnity basis. Failure to do so entails that, from a legal perspective, a claim for breach of warranty would be very difficult in practice. This is because a purchaser would have to go to court and successfully argue that there had been a breach of contract (i.e. the warranty was known to be false) and that breach directly caused the purchaser financial damage (and not financial damage to the target company). Therefore, the seller agrees to give the warranties on an indemnity basis i.e. agrees that there is $ for $ adjustment as a result of any tax loss by the target. However, warranties are still not as “strong” as an indemnity.

Are mixed clauses included in the SPA (for instance, a warranty drafted partially as a price-reduction clause for the portion corresponding to the purchase price and as an indemnity clause for the amount exceeding the purchase price)?

See above – response to question n°3.

Is the classification usually mentioned in the SPA?

No. In Australia a claim is either made under an indemnity or a specific warranty. Practically, any claim (whether it be under a warranty or an indemnity) is typically drafted as an adjustment of the purchase price under the SPA.

Are there criteria to distinguish between a price reduction clause and an indemnity clause? Could you briefly describe these criteria?

No.

What is the most common type of warranty in your jurisdiction?

It is market practice to have a price reduction clause set up in the SPA.

Is a tax warranty usually provided by way of a separate warranty agreement (different from the SPA)?

No.

Is it usual / a market practice to negotiate after-tax settlements, i.e. to reduce the price adjustment to a net payment (i.e. indemnity minus the tax effect of the deduction for the acquirer or target) or to guarantee full indemnification (i.e. gross-up payment to guarantee a net indemnity)?

Purchasers normally require a gross-up clause however, assuming the warranty/indemnity payment is structured as an adjustment of the purchase price, no gross up should be required.

Acquirer

  Corporate Income Tax
Personal Income Tax
Price reduction clause

The price adjustment has no direct impact on the taxable income of the purchaser. It is treated as a decrease in the investment value of the shares. Consequently, future capital gains will be increased.

Alternate argument: the warranty/indemnity may be considered to be an asset separate from the acquired shares. If this is the case, the acquirer will be subject to tax on the payment when received.

The price adjustment has no direct impact on the taxable income of the purchaser. It is treated as a decrease in the investment value of the shares. Consequently, future capital gains will be increased.

Alternate argument: the warranty/indemnity may be considered to be an asset separate from the acquired shares. If this is the case, the acquirer will be subject to tax on the payment when received.

Indemnification
clause

The price adjustment has no direct impact on the taxable
income of the purchaser. It is treated as a decrease in the investment value of
the shares. Consequently, future capital gains will be increased.

Alternate argument: the warranty/indemnity may be considered to be an asset separate from the acquired shares. If this is the case, the acquirer will be subject to tax on the payment when received.

The price adjustment has no direct impact on the taxable
income of the purchaser. It is treated as a decrease in the investment value of
the shares. Consequently, future capital gains will be increased.

Alternate argument: the warranty/indemnity may be considered to be an asset separate from the acquired shares. If this is the case, the acquirer will be subject to tax on the payment when received.

Vendor

  Corporate Income Tax Personal IncomeTax 
Price reduction clause

The price adjustment has no direct impact on the taxable income of the vendor. It is treated as a decrease in the investment value of the shares. Consequently, future capital gains will be decreased.

Alternate argument: the warranty/indemnity may be considered to be an asset separate from the shares being disposed of. In this case, the price adjustment should be treated as non-deductible capital loss (available to carry forward against future capital gains subject to loss integrity provisions).

The price adjustment has no direct impact on the taxable income of the vendor. It is treated as a decrease in the investment value of the shares. Consequently, future capital gains will be decreased.

Alternate argument: the warranty/indemnity may be considered to be an asset separate from the shares being disposed of. In this case, the price adjustment should be treated as non deductible capital loss (available to carry forward against future capital gains subject to loss integrity provisions).

Indemnification clause

The price adjustment has no direct impact on the taxable income of the vendor. It is treated as a decrease in the investment value of the shares. Consequently, future capital gains will be decreased.

Alternate argument: the warranty/indemnity may be considered to be an asset separate from the shares being disposed of. In this case, the price adjustment should be treated as non-deductible capital loss (available to carry forward against future capital gains subject to loss integrity provisions).

The price adjustment has no direct impact on the taxable income of the vendor. It is treated as a decrease in the investment value of the shares. Consequently, future capital gains will be decreased.

Alternate argument: the warranty/indemnity may be considered to be an asset separate from the shares being disposed of. In this case, the price adjustment should be treated as non deductible capital loss (available to carry forward against future capital gains subject to loss integrity provisions).

Target

Price reduction clause If the indemnity proceeds were paid directly to the target company, there is a risk that this could be regarded as taxable income to the target company. Instead, the purchaser could inject the cash into the target business as debt or equity.

Contact

Angus Wilson - KPMG Australia

Head of Deal Advisory Tax

Tel : + 61293358288

arwilson@kpmg.com.au

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