CHAPTER 3
Rights and Liabilities
BREACH OF WARRANTY OR MISREPRESENTATION
Where the purchaser finds that the target company or business is not as it
anticipated, the entitlement to claim damages for breach of contract will depend on
the scope of the warranties implied or expressly given to it. The contractual remedy
for a breach will generally be damages or, rather exceptionally, rescission. Both of
these are discussed below.
As an alternative remedy, the purchaser might be able to claim rescission or damages on the grounds of misrepresentation by the vendors. The purchaser is fully
protected against fraudulent misrepresentation, but the position is more complicated
if the misrepresentation is either wholly innocent or, whilst not fraudulent, the result
of negligence by the person making it. The rights of the purchaser are governed by
the Misrepresentation Act 1967, and a detailed analysis can be found in any of the
standard books on contract law. There are, however, certain points that need to be
considered in the context of a transaction where there is a detailed legal agreement between the parties that includes specifically prepared and negotiated
warranties.
Under the Misrepresentation Act 1967, if the misrepresentation was negligent,
the purchaser, as an alternative or in addition to rescission, has a right to damages,
computed on the same basis as if the misrepresentation had been fraudulent (s.2(1)).
In the case of an innocent misrepresentation, however, damages may be awarded
in place of rescission (s.2(2)).
As the purchaser, who has the benefit of warranties in a sale agreement, is in
principle protected by the agreement, it might be thought that, in the absence of
fraud, the purchaser would not have the right to seek relief for a breach of warranty by claiming, instead, for misrepresentation. This, however, is not the case, as
the rights under the contract and under the Misrepresentation Act 1967 are cumulative and the latter may be excluded only to the extent that the exclusion satisfies the
test of reasonableness (s.3).
There are two particular implications for the vendors that arise from the concurrent rights under the contract and under the Act, being:
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(1) The measure of damages is different in the two cases.
(2) The provisions of the contract limiting the time within which claims for
breach of warranty may be brought (see para.11-02) and imposing floors and
ceilings on the claims (see paras 11-04 and 11-07) will not apply to claims
for misrepresentation unless expressly stated otherwise. If the restrictions
were extended to claims for misrepresentation, they might be rendered
invalid by s.3.
In the past, attempts have been made to exclude liability for misrepresentation
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RIGHTS AND LIABILITIES
by incorporating into the contract a clause to the effect that the contract represents
the whole agreement between the parties in relation to the subject matter of the
transaction, and that the purchaser acknowledges that it has not relied on any
representations that are not included as warranties. Such a clause is often termed
an “entire agreement clause”. The effect of such a clause was considered in Thomas
Witter Ltd v TBP Industries Ltd [1996] 2 All E.R. 573. There, it was held that an
entire agreement clause was ineffectual in excluding the right of the purchaser to
make a claim based upon misrepresentation, even though the representations in
question were included as express warranties. In particular, the clause was
considered to be unreasonable within the meaning of s.3 because it purported to
exclude claims based on misrepresentation even where there was fraud. However,
in EA Grimstead & Son Ltd v McGarrigan [1998-99] Info. T.L.R. 384, the Court
of Appeal found obiter that an entire agreement clause that did not carve out
fraudulent misrepresentation from the exclusion was reasonable in the context in
which it was used, this being in circumstances of a commercial contract between
experienced parties of equal bargaining power, where the parties had entered into
the arrangement with (most importantly) the benefit of professional advice.
(Chadwick LJ’s reasoning in that case was that it was reasonable to assume that the
parties desired commercial certainty, that the bargaining between them would be
found in the documents they had signed and that the price to be paid reflected the
commercial risk which each party was prepared to accept. It was legitimate, and
commercially desirable, that both parties should be able to measure the risk and
agree the price on the basis of the warranties that had been given and accepted.) This
is an approach that was supported by the High Court in Zanzibar v British
Aerospace (Lancaster House) Ltd [2000] 1 W.L.R. 2333; [2000] C.L.C. 735 and the
Court of Appeal in Watford Electronics Ltd v Sanderson CFL Ltd [2001] EWCA
Civ 317; [2001] 1 All E.R. (Comm) 696. However, notwithstanding that, judicial
thinking in these cases would tend to suggest that where parties have entered into
arrangements with the benefit of professional advice, the approach in Thomas Witter would no longer be followed. In the interests of certainty, it is nonetheless common practice for the entire agreement clauses to include a carve-out for fraudulent
misrepresentation. A properly drafted and reasonable entire agreement clause that
deals with this point should operate effectively to exclude innocent or negligent
misrepresentation claims.
RESCISSION
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The circumstances in which a right to rescind the sale agreement will arise are
complex, and it is not the purpose of this discussion to provide a detailed analysis
of them. In practice, however, rescission is primarily a remedy against misrepresentation, and is generally of limited value in the context of a share sale or a business sale where the company or business is to be carried on as a going concern following its acquisition. The essential requirement is that the parties should be capable
of being restored substantially to their original position; however, this will often not
be possible once completion of the sale has taken place. In addition, the purchaser
will lose its right of rescission if, once it discovers the misrepresentation, it
nevertheless takes action that effectively affirms the contract. Ordinarily, the
purchaser will continue the running of the target company or the acquired business whilst it is considering its rights, and thus is likely to be deemed to have affirmed the contract. In practice, therefore, rescission is not a realistic option once
completion has taken place, and there is usually no harm in the purchaser’s advisers agreeing a specific provision in the sale agreement to exclude this remedy.
DAMAGES
19
Rescission is, however, a significant and practical remedy where there is an
interval between contract and completion. In that event, it is customary by the use
of interregnum provisions to restrict the method of conducting the businesses of the
target company or the business that is being acquired, so that the interests of the
vendors and the purchaser are adequately recognised during the intervening period.
An example of clauses that might be adopted in this situation are set out in Appendix 2 and, although they are drafted in the context of a share purchase, they may
be readily adapted to a purchase of assets. If, prior to completion, it is found that
the warranted circumstances do not exist, either because they never did or because
of a change that occurs in relation to the target company or the business, it is normal
for the purchaser to be given an express right to rescind in terms such as the
following:
[2A] Right to rescind prior to Completion
The Purchaser may rescind this Agreement by notice in writing to the
Vendors or the Vendors’ solicitors if prior to Completion:
[2A.1] it appears that the Warranties were not or have ceased to be accurate [in all material respects]; or
[2A.2] an act or event occurs which, had it occurred on or before today’s
date, would have had the effect that there would have been a [material] breach of the Warranties; or
[2A.3] there is a [material] breach or non-fulfilment of the Warranties
which (being capable of remedy) is not remedied prior to Completion.
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Although in practice it should be possible to achieve an effective rescission prior
to completion without too much difficulty, in some cases the vendors may prefer
to complete the sale and suffer a reduction in the sale price as a result of a warranty claim. This could be the case, for example, if the simple act of announcing
the exchange of contracts had such an unsettling effect on staff, suppliers or customers that the business could not readily be resumed under the original ownership if
the sale did not proceed. If a right of rescission is accepted, cl.2A should be
amended by the vendors by the addition of the words in square brackets, although
materiality would usually be defined by reference to financial criteria. This might
be by reference to the same financial deductibles that applied to the warranties to
be given at completion. A purchaser will often try to resist this approach, although
it is difficult to see why.
To avoid the argument that the failure by the purchaser to exercise a right of
rescission amounts to a waiver of its right to claim for damages, it is helpful to
include an express denial of waiver as in cl.3S. Sometimes, vendors may seek to
resist a provision such as that which effectively gives the purchaser a choice as to
whether to rescind or complete and claim damages, on the basis that it gives the
purchaser too much bargaining power should an event entitling this arise. In such
circumstances, the purchaser is often forced to choose whether it wishes to rescind
or complete but, in the latter case, on the basis that it waives its entitlement to make
any claim for damages, there is little logic to such a position. For a further discussion as to the circumstances in which the remedy is available and the effect of a
rescission, reference should be made to any of the leading works on contract law.
DAMAGES
The remedy that is normally sought by a purchaser where there is a breach of
warranty is compensation by the payment of damages. The measure of damages will
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RIGHTS AND LIABILITIES
be determined on the normal principles of contract law or, if the claim is based on
misrepresentation, on the rules relating to claims in tort. The standard textbooks
should be consulted for a detailed analysis of the principles involved in determining the quantum of damages in any particular case. The basic rule in contract law
is that the purchaser should be compensated for its loss of bargain; in the case of a
claim in tort, the damages will be such as will put the purchaser back in the same
position that it would have been in if the representation had not been made.
Normally, the measure of damages will be the same whether the purchase has been
effected for cash or for shares of the purchaser.
A considerable complication arises in the case of a business sale if the sale agreement adopts the normal practice of allocating the purchase consideration amongst
the various categories of assets being sold. It is often advantageous for the
purchaser’s tax position to attribute the minimum acceptable amount to the goodwill
(see the comments in para.3-20). If the breach of warranty is of such a nature that
the value of the goodwill is diminished, it is difficult as a general principle to see
how the purchaser can claim a loss greater than the amount allocated to it. The
purchaser would have to argue that the values attributed to the other assets, such
as stocks, are valid only if the company is in a sound commercial position. If the
breach of warranty has an adverse effect on the business as a whole, it might be the
case that a different valuation should have been applied to the other assets. To assist the purchaser in arguing that proposition, it could seek to include the following clause (for the purposes of which the definitions of “Goodwill” and “Assets”
in Pt 1 of Appendix 5 are used):
[2B] Purchaser’s loss on breach of Warranty
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If a Warranty does not relate to the value, or to anything affecting the value,
of the Assets other than the Goodwill, the loss suffered by the Purchaser as a
result of a breach of the Warranty shall be determined as if the value of each
of the Assets (other than the Goodwill) was not that stated in cl.[.....] but the
lesser value that they would have had if the sale of the Business had been a
forced sale and the reduction in the value of those Assets was additional
consideration given for the Goodwill. If the parties are unable to agree to the
adjustments to be made under this clause, the matter shall be referred to an
independent firm of accountants nominated by the President of the Institute
of Chartered Accountants in England and Wales for their determination as
independent experts [and not as arbitrators and the Arbitration Act 1996 shall
not apply] and, in the absence of manifest error, their determination shall be
final.
Apart from this special consideration in relation to business sales, the agreement will often provide expressly as to how damages are to be quantified in
circumstances where a specific basis of valuation has been used to value the target
company or business, and a particular basis of damages lends itself to most appropriately compensating the purchaser (recognising the basis of valuation) in the
event of any claims. However, sometimes a shrewd purchaser may seek to impose
a specific basis of damages simply to improve its own position, rather than in
circumstances where the basis sought correlates to that of its valuation. The vendors
will need to be wary of this.
An example of a specific damages clause is the following:
DAMAGES
21
[2C] Measure of damages for breaches of Warranty
Without limiting the rights of the Purchaser or its ability to claim damages
on any basis if there is a breach of Warranty or any of the Warranties is untrue
or misleading, if [the Company incurs or becomes subject to a liability or an
increase in any liability which it would not have incurred or been subject to
had the breach not occurred or] the value of any asset of the Company is less
or becomes less than the value would have been had the breach not occurred
then the Vendor[s] undertake to the Purchaser to pay to the Purchaser (as the
Purchaser elects) in cash on demand a sum equal to the [liability or increased
liability, or the] reduction in the value of the asset [(as appropriate), or the
reduction in the value of the Shares caused by the breach].
This clause effectively gives the purchaser the right to choose between the normal
measure of damages for breach of contract and the indemnity basis of damages. If
normal damages would exceed the amount paid by way of indemnity, the
purchaser’s right to the additional compensation is preserved. The vendors will usually wish for a damages basis to apply, whereas a purchaser will sometimes favour
an indemnity basis. Current convention follows a damages basis in most
circumstances. Usually, the sale agreement is silent on the measure of damages to
apply, which preserves the common law basis of damages.
In the context of a company sale, it is the measure of overall loss to the purchaser
that needs to be proven. In assessing damages, a court is likely to take account of
how the parties valued the company or business. So if the valuation had been
undertaken by reference to an EBITDA multiplier (see later commentary in Ch.13
for further discussion of this) or by reference to the level of net assets, or a combination of the two, it is likely that the court would be persuaded to adopt a similar approach in assessing the appropriate level of damages.
The clause may be used in the case of the purchase of a business although, in that
case, some of the words in square brackets will not be relevant. (The reference to
“undertake” will need to be changed to “undertakes”.)
Where the consideration for the acquisition is the allotment of shares of the
purchaser (i.e. the consideration shares), the effect of a payment of damages is
somewhat obscure. The consideration for the allotment will be the transfer of the
shares of the target company or the business of the vendor company. If, in the event
the value of the target company or the business proves to be less than the par value
of the consideration shares, then it might be thought that the purchaser will be in
the rather unfortunate position of having allotted its shares for a consideration of
less than par, which, of course, is not permitted. It is suggested that in practice this
should not give rise to a difficulty, because if the directors of the purchaser
company, acting bona fide and on the basis of a valuation of the target company or
the business, have allotted shares that they thought were for a consideration at least
equal to par, then there can be no criticism if it proves to be the case that the
consideration was less than par. A further protection in practice arises under CA
2006 s.593, which requires non-cash consideration for the issue of shares of a public
limited company to be valued before the allotment takes place.
So far as the vendors are concerned, the consideration that they receive will be
in the form of securities of the purchaser, which have a variable value. If compensation has to be paid under the warranties and, at the time that the claim is made, the
consideration shares have fallen in value, the vendors might wish to take advantage
of the provisions of CA 2006 Pt 18, which permit a company to purchase its own
shares. The vendors might suggest that, in the event of a warranty claim arising, the
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RIGHTS AND LIABILITIES
claim should be satisfied by the purchaser repurchasing an appropriate number of
the consideration shares for a nil purchase price. In this situation, the vendors will
be put in the same position as if the target company had been correctly valued in
the first instance and the number of the consideration shares reduced accordingly.
The vendors will wish the purchaser to limit its claim for damages on a breach
of warranty to the net loss it suffers, taking into account any unexpected benefits
that the target company or business enjoys. It might well seem reasonable that the
purchaser should not complain about the bad without giving credit for the good, and
a possible clause in the case of a share sale is the following:
[2D] Credit for improvements
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The liability of the Vendors under the Warranties shall be reduced by:
[2D.1] an amount equal to the value or additional value of any fixed assets (apart from the Properties and Goodwill) owned at Completion
which were not included in the Accounts or were included at less than
market value after deducting (in the case of assets acquired after the
Balance Sheet Date) their cost of acquisition [and Taxation which would
arise on their disposal at those values];
[2D.2] the amount of or by which Taxation for which the Company is accountable is extinguished or reduced as a result of the claim giving rise
to the liability;
[2D.3] the amount by which a provision for Taxation [not being a provision for deferred Taxation], bad or doubtful debts or contingent or
other liabilities contained in the Accounts proves after Completion to
have been excessive, except by reason of a reduction in Taxation rates
[or as a result of an event occurring, or action taken by the Purchaser
or the Company,] after Completion;
[2D.4] the amount of debts paid which had been previously written off
[less attributable Taxation];
[2D.5] the amount of credits, recoveries or other benefits which have been
or will be received or obtained by the Company by reason of the matters giving rise to the liability.
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Only the first of the above sub-paragraphs might be relevant in relation to a business sale, depending upon the actual terms agreed. (In such circumstances,
“Goodwill” should be a defined term. The definition of “Goodwill” in Pt 1 of Appendix 5 would be suitable for these purposes.)
The concept of this clause is not particularly fair if the purchase price for the
shares has been calculated otherwise than on the basis of the asset value of the target
company. Very rarely, however, is this the only basis. Even in that event, it is difficult to see how the reduction can be quantified in any but the simplest case. This
in itself is not an adequate reason to reject it, as an arbitration procedure (e.g.
permitting the target company’s auditors to certify the adjustment) can be included.
Most purchasers will be reluctant to accept provisions such as these without further
definition and care over the precise terms. The vendors might reasonably argue that
clauses such as this are no more than a contractual recognition of the need to prove
overall loss in the context of a company acquisition where no specific basis of damages has been agreed. If the purchaser accepts the clause, it should add the words
in square brackets to make a rather crude adjustment for the tax implications and
to avoid the vendors benefiting from reductions in taxation liability that were not
attributable to circumstances existing before completion. In relation to this last
point, the vendors would not normally be entitled to savings that result from a
SECURITY IN RELATION TO THE WARRANTIES
23
retrospective reduction in the corporation tax rate or the carry-back by the target
company of subsequent losses. Similarly, the adequacy of a provision for deferred
taxation will depend on later events and should not affect the liability of the vendors
whether it proves to be excessive or inadequate. It would be unusual to see a clause
such as this in practice. To the extent that the purchaser is willing to agree to the
vendors having contractual rights to the benefit of any “upside” arising in connection with breaches of the warranties, these will usually be included in the warranty
limitation provisions. See Ch.11 for details and a discussion of some of the standard
warranty limitation provisions that the vendors might seek to include in the sale
agreement.
SECURITY IN RELATION TO THE WARRANTIES
The vendors will have a potential liability to the purchaser for perhaps the whole
amount of the consideration that they receive, and this liability might remain a
contingent risk for a number of years. This is particularly so in the case of the
obligations under the tax covenant, which customarily continue for at least six years,
and more usually seven. The purchaser should review the ability of the vendors in
the case of a share sale, or the vendor in the case of a business sale, to meet claims
that might be quantified only after a considerable period of time. This is of particular
concern where some or all of the vendors may be looking to retire abroad. Where
the transaction involves the sale of a business, the ability of the vendor company
to meet warranty claims needs particular attention, as the liabilities retained by the
vendor will invariably, and often drastically, reduce the net assets that it has
available.
The purchaser might wish to consider whether it should require security for these
liabilities. In relation to the tax covenant, it is impossible in practice for the
purchaser to require the covenantors to provide any significant amount of security
for the whole of the six or seven-year period unless perhaps a significant potential
tax liability has been identified, in which circumstances it may be appropriate to
provide for a proportion of the sale proceeds to be retained in an escrow or retention account. There is, however, a possibility that the vendors will agree to provide
security for the duration of the warranties if the period in respect of which they apply is sufficiently short. In these circumstances, it is not unusual in the case of a
share sale, but less likely in a business sale, for part of the purchase price to be
retained in an escrow or retention account for some period to enable the purchaser
to determine whether warranty claims are in fact likely to arise. Typically, this might
be for one or two years. This is usually appropriate where there is a risk that the
sale proceeds are likely to be difficult to trace.
If the consideration is in the form of shares of the purchaser, the most suitable
security is a charge on those shares. This, however, cannot be given in favour of
the purchaser if it is a public limited company (CA 2006 s.670). Historically, in the
case of private companies, it has been common for the articles to amend reg.11 in
Table A of the Companies (Table A to F) Regulations 1985 (SI 1985/805) so that
the company has a lien on the shares held by a member in respect of all sums that
he owes to the company. There is no equivalent provision in the model articles
under CA 2006, as they have been drafted on the assumption that shares in private
companies are issued fully paid, as is most often the case. To take advantage of the
same principle for securing warranty claims, it would be possible for the purchaser
to sub-sell the shares and assign the warranties to a subsidiary, which would take a
charge or lien to secure potential claims. This solution is not free from difficulties
and reference should be made to para.2-12.
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RIGHTS AND LIABILITIES
While it is obvious that the purchaser has a risk in respect of these unsecured liabilities, it is often overlooked that the vendors are also at risk in respect of the
obligations of the purchaser under the warranties and the tax covenant. This point
arises, particularly, under the tax covenant where it is not unusual for a tax liability to arise because of a decision of a lower court, only to find that this is
reversed on appeal to a higher court. In those circumstances, the payments under
the tax covenant may pass backwards and forwards between the vendors and the
purchaser during the currency of the tax covenant.
JOINT AND SEVERAL LIABILITY
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In the absence of express provisions to the contrary, where two or more parties
undertake the same obligation, they are considered to have assumed liability jointly
with each other (White v Tyndall (1888) 13 App. Cas. 263). This presumption can
be rebutted by an express statement in the sale agreement and, in the case of the
sale of shares, it is almost invariable for the purchaser to request that the warranties and the tax covenant are given on a joint and several basis by the vendors and,
if different, the covenantors.
The broad effect of this is well known. The purchaser, having the benefit of the
warranty or indemnity, can recover against any one of the vendors or covenantors,
leaving him to exercise his right to obtain a contribution from the other vendors or
covenantors. This right of contribution is given under the Civil Liability (Contribution) Act 1978 and entitles the court to determine a just and equitable basis for allocating the liability amongst the vendors and the covenantors. More commonly,
the liability is shared between the vendors or covenantors by a specific deed of
contribution drawn up by their advisers and reflecting what has been agreed as just
and equitable between them. Purchasers, or their advisers, commonly set great store
by the apparent advantage of joint and several liability, since it offers the purchaser
the flexibility to sue all or some of the vendors or covenantors for the full amount.
In the usual case, however, the ultimate effect is to shift from the purchaser to the
vendors the risk that, if a claim is made, a vendor may not be traceable or may not
be able to meet his share of the liability.
If, as is commonly the position, the vendors and covenantors are one and the
same and the consideration is paid to them pro rata to their shareholdings, the statutory concept of liability sharing will give rise to no difficulty. The following are
some examples of situations whereby complications may arise:
(1) If some of the vendors are not required to give the warranties and indemnities, or different maximum claim levels apply, as frequently happens in the
case of trustee vendors (see para.2-06): Whilst in that event, it may normally
be the case that the liability will be apportioned amongst those vendors who
do give the warranties, or who are not able to take advantage of a reduced
maximum claim level, in proportion to the consideration that they receive,
this may be unfair. If, for example, the target company is owned by two
families and one of the families holds a large number of their shares through
a trust, then the family for whose benefit the trust exists should accept
responsibility for liability that would have fallen upon the trustees if they
had given the warranties.
(2) If the share capital of the target company consists of preference shares and
ordinary shares: It would normally be appropriate for liability under the
warranties to be borne only by the vendors holding ordinary shares. Preference shares usually have a fixed value and, beyond their fixed value, do not
ordinarily participate in the overall equity value.
TAXATION TREATMENT OF PAYMENTS (SHARE PURCHASES)
25
(3) If the claim under the warranty results from benefits received by one of the
vendors, such as a distribution from the target company: In that event, it
would normally be appropriate for the liability under the warranty to be
borne by the vendor who has received the corresponding advantage.
Accordingly, where the sale is not a straightforward case of all the vendors giving the warranties and indemnities, the vendors should come to an agreement
amongst themselves determining how liability should be apportioned. Whilst the
contribution agreement may be included in the sale agreement so as to bind the
purchaser, it is almost always in a separate document as the purchaser will not wish
to be a party to the arrangements, for the reasons noted at para.2-21. A clause that
partly deals with this is suggested in that paragraph, and this may suffice where the
position is not particularly complicated. If, however, there are significant differences in the interests of the parties or, for example, one vendor is willing to accept
liability under the warranties in respect of both his or her own holding and those
of other members of his family or his trustees, then the clause will have to be
altered.
It will also be necessary in a complicated case to determine how any provisions
relating to a floor for claims should apply (see para.11-04). In the absence of a
special arrangement, it would seem that the floor for claims would operate for the
benefit of the parties who are liable in relation to the first claim that happens to be
made. A fairer arrangement would be for the vendors to agree amongst themselves
that the benefit of any floor should apply pro rata to the liabilities that they incur.
Even this may not be wholly satisfactory in cases where, for example, a warranty
liability arises specifically because of a benefit that has been received by one vendor,
and where the other vendors have had nothing to do with it.
If the vendors are successful in making inroads into the basic concept of joint and
several liability, there are two approaches that they might adopt. The more extreme
is to provide that each vendor is liable only for an appropriate proportion of any
claim—normally being the proportion that he receives of the total purchase price.
A more modest alternative would be to provide that the total liability of each vendor
has a ceiling, which would usually be the amount of the sale proceeds that he actually receives. It is a matter for negotiation to determine whether one of these approaches and, if so, which, should apply.
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TAXATION TREATMENT OF PAYMENTS UNDER
WARRANTIES AND INDEMNITIES IN CONNECTION WITH
SHARE PURCHASES
In general, the vendors will hold the shares of the target company as a capital asset and the proceeds of sale will be brought into account in a capital gains tax
computation. A partial recognition of the taxation implications is contained in
TCGA 1992 s.49. This provides that, in the first instance, no account is taken of any
contingent liability in respect of a warranty or representation made on a sale of
property other than land. If and when a liability materialises, a retrospective adjustment is made.
Accordingly, a payment under a warranty operates retrospectively to effect a
reduction in the purchase consideration. The vendors’ chargeable receipt is
decreased and a corresponding reduction is made to the purchaser’s base cost with,
on an eventual sale of the shares, a related increase in its chargeable gain at that
time. This is clear enough if the consideration is cash, but the position is more
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RIGHTS AND LIABILITIES
obscure if the disposal is wholly or partly by way of exchange for shares or other
securities of the purchaser. In such circumstances, it is suggested, and understood
to be the view of HMRC, that:
(1) Where the vendors receive wholly securities of the purchaser, the warranty
payment is treated as additional consideration given for those securities
under TCGA 1992 s.128(1), being the section giving a roll-over on a capital
reorganisation.
(2) Where the vendors receive a mixture of securities and cash, the payment
will be apportioned pro rata and dealt with partly under s.128(1) and partly
under s.49.
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It is considered that in the rather unusual case of the shares of the target company
being held by the vendors as trading stock, a warranty payment will be treated as a
revenue expense.
Different principles would apply to payments under the tax covenant in
circumstances where it was structured such that the benefit of it was in favour of
the target company rather than the purchaser. (It would be very unusual to have a
tax covenant structured in this way these days.) The legal position, which derives
from the decision in Zim Properties Ltd v Procter (Inspector of Taxes) [1985] S.T.C.
90; 58 T.C. 371, has been recognised by HMRC as giving rise to some unintended
results. In that case, it was held that a right to compensation arising from the
negligence of a solicitor constituted an asset. The receipt of the compensation
resulted in a disposal of the asset for the amount received. By analogy, it would
seem that the contingent right to receive an indemnity payment is an asset of the
target company of which disposal is made when the payment is received.
As the right would have been acquired for no consideration and without a corresponding disposal, no allowable expenditure can be brought into account to
reduce the chargeable gain (TCGA 1992 s.17). The whole payment is thus taxable.
On 19 December 1988, the Inland Revenue (as it then was) published a concession (ESC D33) to the effect that payments made by the vendor, whether under a
warranty or an indemnity, to the purchaser (or, at its direction, to the target
company) will be dealt with under TCGA 1992 s.49. However, ESC D33 does not
deal specifically with payments to the target company in its own right and therefore
such payments may be treated as giving rise to a gain on the disposal of the right
that is not exempt from capital gains tax. HMRC have since amended ESC D33,
although this does not affect the position on share sales. They have also consulted
on legislation formally to enact ESC D33, but no detailed wording or proposed
implementation date has yet been given.
Although this concession removes a potential liability arising from payments to
the purchaser made under indemnities, payments to the target company are not of
themselves within the concession and will generally be subject to corporation tax
on the full amount of the payment without any deduction for the cost of acquiring
the right to the payments. Furthermore, the covenantors will receive no tax relief
for the indemnity payments made to the target company.
It is therefore generally in the interests of all the parties, so far as tax is concerned,
that a claim should be made by the purchaser under the warranties or indemnities
and not by the target company. In most cases this will not be an issue, as indemnities are rarely given in favour of the target company for these reasons and, in the
vast majority of transactions, the tax covenant is an integral part of the sale agreement, with any payments required pursuant to it being made to the purchaser.
TAXATION TREATMENT OF PAYMENTS (BUSINESS SALES)
27
TAXATION TREATMENT OF PAYMENTS UNDER
WARRANTIES IN CONNECTION WITH BUSINESS SALES
A major difference between share and business purchases is that whilst the former
involves the acquisition of a single category of assets, the latter relates to a mixture
of assets with widely differing commercial and tax characteristics. Certainly for tax
purposes, and probably also for balance sheet reasons, both the vendors and the
purchaser will have to allocate the price amongst the assets that are sold. Although
it is not essential that they should adopt the same allocation, the agreement of
HMRC will be more readily forthcoming if the purchase price is attributed to the
different assets by the sale agreement. HMRC will not normally dispute the allocation in the sale agreement unless it is manifestly unreasonable and is excessively
motivated by tax considerations.
For the purchaser, it will usually be advantageous to minimise the part of the
price paid for goodwill and to maximise the part of the consideration that is apportioned to stocks, as this will reduce the taxable profits on the eventual sale of
the stocks. The vendor has a more difficult tax analysis, as much will depend upon
the base cost for the purpose of chargeable gains of the goodwill sold by it. If the
base cost is high, the vendor may prefer the purchase price to be attributed to the
goodwill, as this could result in a lower tax bill than if the price is dealt with as a
profit on the sale of trading stock.
Where a payment has to be made in respect of a warranty claim, it will not always
be obvious which of the purchased assets is affected. A number of warranties—
such as those relating to trading relationships and employees—clearly affect the
value of the goodwill, and it is likely that this is true of most of the warranties that
do not specifically concern particular assets. The impact of this on the amount of
damages that can be claimed on a breach of warranty is discussed in para.3-06.
If the warranty payment relates to a capital asset, the taxation implications will
arise under the legislation in respect of corporation tax on chargeable gains and will
be similar to those applicable to share sales, as discussed in the preceding section.
There is a difficulty, however, if the warranty payment exceeds the amount of the
purchase price allocated to the asset involved. This will often arise if the claim affects the value of the goodwill of the business and the common practice of allocating a nominal value to the goodwill has been adopted. In that case, no relief will
be obtained by the vendor for the excess of the amount of the claim over the allocated price.
Where the claim concerns trading assets such as stock, the tax liability will be
determined in accordance with the normal rules for corporation tax purposes. The
taxable profits will initially be determined on the basis of the allocation of the
purchase consideration set out in the sale agreement, unless it is clearly unrealistic,
and no deduction will be made at that stage for contingent liabilities under the warranties unless the likelihood of a claim being made is so great that normal accountancy practice would require the making of a provision. If by the time the claim
is made and settled the vendor has ceased to trade, the warranty payment will be
made otherwise than for the purposes of a trade and accordingly will not carry tax
relief.
The above tax analysis is an additional reason for the vendor to seek a very short
warranty period where there is the sale of a business (see also the discussion in
para.11-02). If the claim can be quantified before the accounts for the period in
which the sale takes place are adopted, it may be possible to adjust the accounts to
provide for the claim.
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3-21
3-22