Tax indemnification: Overview, definition, and example
What is tax indemnification?
Tax indemnification refers to a contractual obligation where one party agrees to compensate another for any tax liabilities, penalties, or related costs that arise due to a specific event, transaction, or misrepresentation. This indemnity provision is commonly included in mergers, acquisitions, investment agreements, and business transactions to protect one party from unexpected tax obligations.
For example, in an acquisition, the seller may agree to indemnify the buyer for any unpaid taxes that were incurred before the sale but discovered after the transaction is completed.
Why is tax indemnification important?
Tax indemnification is important because it allocates financial responsibility for tax liabilities, ensuring that one party does not suffer unforeseen tax-related losses due to the actions or obligations of another. It provides protection in cases where tax authorities impose additional assessments, penalties, or interest on previously undisclosed or miscalculated tax obligations.
For businesses, tax indemnification clauses help mitigate risks in transactions, particularly in deals involving cross-border tax considerations, historical tax liabilities, or tax audits. Without such protection, a party could face unexpected tax burdens that significantly impact financial performance and cash flow.
Understanding tax indemnification through an example
Imagine a company acquires another business for $50 million. After the acquisition, the tax authorities audit the acquired company and discover $2 million in unpaid corporate taxes from prior years. If the purchase agreement includes a tax indemnification clause, the seller is responsible for covering this liability, ensuring that the buyer is not financially impacted.
In another example, an investor purchases a partnership interest in a real estate venture. The investor insists on a tax indemnification clause to ensure they are not held responsible for any past tax liabilities of the partnership that were incurred before they joined. This clause protects the new investor from unexpected financial obligations.
An example of a tax indemnification clause
Here’s how a tax indemnification clause might appear in a contract:
“The Seller agrees to indemnify and hold harmless the Buyer from and against any and all tax liabilities, penalties, interest, or other tax-related expenses that arise due to any period prior to the Closing Date. The indemnification obligation shall survive for a period of [Insert Timeframe] following the Closing Date.”
Conclusion
Tax indemnification ensures that tax liabilities are allocated appropriately in business transactions, protecting parties from unexpected tax assessments, penalties, and financial losses. For businesses and investors, including a well-defined tax indemnification clause in contracts helps manage risk, clarify responsibilities, and provide financial security against potential tax obligations.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.