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Case study

Director remuneration: When is a deductible expense non-deductible?

In this case study, we explore how Marsh supported a client after the buyer’s due diligence flagged a tax authority could challenge the tax deductibility of remuneration payments.

30/03/2022 · 2 minute read

A target company in Spain had made remuneration payments to it directors over the course of several years. Strictly speaking, the payments should have been authorised by way of shareholder resolution and by the full board of directors. However, the payments were all in line with employment contracts and were perfectly proper. The buyer’s due diligence flagged that the Spanish Tax Authority could seek to challenge the tax deductibility of such payments.

A. Background

Over several years, the company had made ordinary course remuneration payments to its directors for their services as directors (the ‘payments’). The payments were made pursuant to their employment contracts and in line with the company’s articles.

With one exception, the shareholders of the company did not expressly approve the directors’ remuneration each year. The Spanish tax code provides that director remuneration is deductible, but separately it provides that illegal payments are non-deductible.

The fact that the director payments may not have been fully compliant with all legal formalities was flagged during the due-diligence process by a potential buyer of the company.  

B. The risk

The Spanish Tax Authority could argue that in failing to obtain the requisite shareholder approvals, the payments were illegal and thus non-deductible for tax purposes. Tax advisors thought that the law that states director expenses are tax deductible ought to prevail but could not be certain what approach the Tax Authority and/or courts might take.

C. The motivation

The seller wanted a clean break from the transaction so did not want to indemnify the buyer. Understandably, the buyer did not want to bear the risk of a legacy tax risk. The buyer had discussed possible price reductions or escrow solutions, but these were not palatable to the seller. Insurance provided an elegant solution that facilitated the transaction.

D. The solution

An insurance policy with a limit of €1.5 million was placed to protect the buyer against the risk of the target becoming liable to pay additional tax, interest, or penalties as a result of a challenge to the deductibility of the payments.

The premium was €40,000 plus insurance premium taxes, underwriting fees, and placement fees. This solution helped unlock an otherwise problematic risk allocation between the buyer and seller.

Investment teams and risk managers often only think of specific tax risk insurance where the exposure is tens or hundreds of millions of euros and as an M&A risk advisory community, we usually highlight only the largest placements or the biggest transactions. However, this example shows that specific tax risk insurance can also be an appropriate risk management solution where the quantum of the risk is comparatively modest (typically over €1 million).

If you would like more information on this topic, please contact your Marsh representative.

 

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