As I’m currently working on an interesting transaction for the sale of a well-established business, the question of tax liabilities and how these will be allocated between the Parties came up.

With this article, I aim to outline and explain one of the key provisions in agreements for the sale of a business and similar transactions, often essential in protecting a buyer from pre-closing tax exposure.

What is a Tax Covenant?

A tax covenant is a clause commonly found in Share Sale and Purchase Agreements that aims to allocate responsibility for any tax liability that arises from a period prior to the closing of the proposed transaction.

This often requires the seller to indemnify the buyer against any such liability.

This clause is essential as there is often a delay by the Tax Department in assessing tax declarations submitted by Companies and a new shareholder (or the new owner of an existing business) may be faced with an unexpected tax bill for a period prior to taking over the business.

This is unlike transactions involving real estate in Cyprus where the transaction is assessed on a case-by-case basis by the Tax Department prior to completion and transfer of legal title.

Key Components of a Tax Covenant

Tax Covenants often include:

• Scope of Covered Liabilities: Defines the specific tax liabilities covered, including those related to income tax, VAT, corporation tax, and other obligations, typically up until the date of completion.
• Indemnification for Pre-Completion Tax Obligations: The covenant ensures that the seller indemnifies the buyer for any tax liabilities tied to the seller’s period of ownership.
• Limitation Period for Claims: To balance the seller’s ongoing exposure with the buyer’s need for protection, tax covenants include a time limit for claims.
• Notification Requirements and Enforcement Procedure

Tax Covenants v Tax Warranties

Tax Covenant: A contractual commitment by the seller to cover specific tax liabilities allowing the buyer to claim indemnification upon the emergence of such liabilities.

Tax Warranty: A statement from the seller affirming that no tax liabilities are due, with the buyer entitled to claim damages only if the relevant warranty proves to be inaccurate.

It is quite often the case that an agreement for the sale of an operating business will include both Tax Covenants and Tax Warranties. It is important to be familiar with the distinction and how these are often drafted and negotiated.

In conclusion, tax covenants are an important tool and negotiation point in transactions involving the sale of an operating business as they help allocate tax risk and costs between parties.

Should you wish to find out more, contact us at info@paraschou.com.cy.