Warranty and indemnity (W&I) insurance provides protection for investors against unknown risks associated with M&A transactions, while tax insurance usually protects investors against known tax risks that could be detected during the due diligence of an M&A transaction, in the normal course of business, or in a tax audit. These risks are typically excluded from W&I insurance coverage.
Despite W&I insurance and tax insurance solutions having been available on the market for many years (with the US and UK markets being the most mature), there has been an exponential growth in their use in Portugal over the past few years.
The framework of the Portuguese market has facilitated this growth, and this trend is expected to persist in the years to come.
The rise in M&A transactions involving a substantial number of international and sophisticated players – which are accustomed to adopting W&I insurance and tax insurance solutions – has led Portuguese players to develop these products and instilled confidence in them.
The Portuguese tax landscape’s complexity has grown due to various changes introduced in recent years, including a significant rise in taxes to be paid, causing investors to seek greater protection.
Investors’ demand for greater protection is also attributable to the Portuguese tax authorities becoming more sophisticated, as they now have access to big data, engage in greater cross-border exchange of information, and are under pressure to issue additional tax assessments.
New and emerging risks in the Portuguese market
Alongside the traditional risks in the Portuguese market and tax landscape, new and emerging risks are also being widely discussed and insured against. Moreover, the number of policies being taken out and the number of risk types have been increasing.
One common risk discussed in Portugal is the VAT risk related to the VAT framework applied to lease agreements. Over the past few years, the Portuguese tax authorities have issued several rulings on the VAT exemption’s scope of application, giving rise to some inconsistencies.
In recent binding rulings, the Portuguese tax authorities have distinguished between the mere lease of properties (VAT exempt) and other situations where the lease, based on the corresponding conditions, confers a particular added value on the lessee (subject to VAT). Also, according to the Portuguese tax authorities, the mere lease of properties, even if preceded by construction works to adapt the property to the lessee’s needs, should still be considered VAT exempt.
The transfer of a going concern (TOGC) recharacterisation for VAT and stamp duty purposes is another frequently discussed risk in Portugal and is typically covered by tax insurance policies.
From a VAT perspective, this risk derives from the potential for the transfer of assets and rights to be recharacterised as a mere transfer of assets subject to VAT, rather than a TOGC that is not subject to VAT.
Regarding stamp duty, the risk arises from the possibility of there being no transfer of a branch of activity, which could jeopardise the stamp duty exemption provided for in Portuguese tax rules.
Also, like many other jurisdictions, Portugal imposes certain limitations on the application of the participation exemption to “land-rich companies”. This has raised several questions regarding what constitutes a land-rich company.
The uncertainty surrounding this issue, coupled with the booming Portuguese real estate market, has led to an increase in tax insurance policies addressing this risk. This is because the participation exemption regime is naturally considered when determining whether to invest in Portugal, and real estate investors seek a degree of certainty when making their business plans, including on exit and disinvestment.
This issue is also relevant for transfer tax purposes, and an increase in activity within the tax insurance market is expected for this topic. This is due to the rule changes introduced in fiscal year 2021, combined with a lack of clear guidance on the Portuguese tax authorities’ stance on certain matters.
The Portuguese State Budget Law for 2021 raised the municipal property tax rate to 7.5% and the transfer tax rate to 10% on the ownership of Portuguese real estate assets by entities directly or indirectly controlled or dominated by entities residing in blacklisted jurisdictions. The Portuguese blacklisted jurisdictions list comprises approximately 80 jurisdictions.
There are several ongoing discussions in the market regarding the definition of control or domination, as well as the compatibility of this rule with EU freedoms; namely, the free movement of capital. Given the boom in the Portuguese real estate market, this topic is also being discussed in the context of tax insurance policies.
Portugal has one of the most complex and formal withholding tax regimes among EU member states, and the Portuguese tax authorities are becoming increasingly forceful in their application of the Danish cases doctrine, having already issued several additional tax assessments on this matter.
The uncertainties surrounding the final approval of the Third Anti-Tax Avoidance Directive, along with the Portuguese tax authorities’ lack of guidance on substance requirements, have resulted in an uptick in the number of tax insurance policies addressing this risk.
Increased W&I insurance and tax insurance use set to continue
The complexity of the Portuguese tax landscape, the various interpretation uncertainties regarding new tax rules, and the Portuguese tax authorities’ vigilance, as well as the substantial impact of tax issues on M&A transactions, have all played a role in the growing demand for W&I insurance and tax insurance policies.
Indeed, these products represent a fresh approach in the M&A context and are increasingly viewed as cost-effective solutions for tax issues, as they:
Enable transactions to proceed;
Facilitate deal negotiations; and
Mitigate the effects of a tax risk.
These products are increasingly being used as a viable alternative to traditional mechanisms that have been in place for years, such as price adjustments, escrow accounts, indemnities, and even tax rulings.
Given the present economic and tax environment, it appears that the trend of heightened demand for W&I insurance and tax insurance policies is likely to persist. In the near future, the authors expect further growth in activity within these markets, along with the emergence of new issues and an increased awareness among market players.
