Indemnity payments under a share purchase agreement are taxable in the hands of the purchaser, irrespective of their accounting treatment. This is what the Italian Supreme Court held in its decision no. 17011 of 13 August 2020, highlighting the importance of tax gross-up clauses.

What happened?

Seller sold 100% of the shares in Target to an SPV set up by Purchaser. Target and SPV then merged. The SPA included a standard tax indemnity, subject to an agreed threshold. If that threshold was exceeded, Seller would be liable only for the amount above the threshold.

Years after the acquisition, Purchaser settled a tax claim that was covered by the tax indemnity and Seller paid out under the indemnity. Purchaser accounted only for the net amount that it effectively bore, i.e. the threshold amount (rather than accounting for the full indemnity payment as a windfall profit and the full tax payment as a cost).

Nonetheless, Purchaser included the full indemnity payment in its taxable profits, while the full tax payment was – obviously – non-deductible. Purchaser then requested a refund of the tax paid on the indemnity payment. In its view, the indemnity payment simply restored the value of Target and was purely financial in nature. Moreover, since it was intrinsically connected to a non-deductible tax payment, it should not have been taxable.

The Italian tax office denied the refund and Purchaser appealed. Two lower Courts agreed with Purchaser and ordered the tax office to grant the requested tax refund. The Supreme Court reversed the decision and confirmed that the indemnity payment was taxable in full in Purchaser’s hands.

The Supreme Court’s decision

The SC based its decision on its interpretation of the tax indemnity. In its view, the tax indemnity is not a price adjustment mechanism, but a warranty by Seller as to the net asset value of Target. That value was diminished by the undisclosed pre-closing tax liability, and the indemnity was intended to restore the agreed value.

The accounting treatment chosen by Purchaser was irrelevant.

The SC rejected the taxpayer’s objection (which it nonetheless found attractive: “suggestiva”) that the tax treatment of connected profits and costs, such as the tax indemnity received and the tax payment made, should be symmetrical. Purchaser argued that, if a cost is not tax deductible, the connected profit should not be taxable either.

The SC, however, held that the payment of the undisclosed tax liability was merely the triggering event of the generic obligation to restore the net asset value of Target. The “connection” between the two items was not close enough to require symmetrical tax treatment.

Important take-aways

The judgment is a clear reminder of the importance of negotiating a tax gross-up for indemnity payments under an SPA. 

Simply labelling the indemnity in the SPA a price adjustment is unlikely to be sufficient to ensure that indemnity payments are not taxable in the purchaser’s hands. The SC seems to consider that only clauses which provide for a change in the price based on the target’s post-closing economic performance, such as earn-outs, would constitute price adjustments.

From a seller’s perspective, if the purchaser includes the indemnity received in its taxable profits, there is an argument that the seller should be entitled to take a matching tax deduction. The item is the same and there is no reason to exclude a symmetrical tax treatment. If the seller would be prevented from taking a tax deduction there would be economic double taxation. However, the SC did not rule on this.