Indemnification

What does indemnification mean?

Indemnification (in German Freistellung) describes the contractual obligation of one party to hold the other party or the company sold harmless from certain liabilities, costs and losses. Equivalent terms are indemnity and, in German, Haftungsfreistellung and Schadloshaltung; the provision in the contract is called an indemnification clause (Freistellungsklausel). If a risk described in the contract materialises, the obligor pays or reimburses the amount. Unlike liability under a warranty, indemnification does not require that a representation was incorrect. Similarly, when a let flat is sold, the seller sometimes bears the costs of a legal dispute with a tenant that is already under way, even if the judgment is delivered only after handover.

Indemnifications appear in the company purchase agreement alongside the warranty catalogue, that is, the seller's assurances about the condition of the company. They concern risks that the buyer does not want to assume and that cannot be reliably reflected in the purchase price because occurrence or amount is uncertain. Typical are taxes for periods before the effective date, pending legal disputes, claw-backs of public funding or additional claims for social security contributions. They mostly go back to findings of the due diligence, the buyer's review of the company before signing. In the US market, indemnification also denotes the general claim for compensation when warranties are breached; in German contracts, indemnification as a rule means the separate assumption of individual risks (specific indemnity).

Indemnification and warranty liability

Both instruments allocate risks between seller and buyer but follow different rules:

• Trigger: The warranty describes a condition on an effective date. The indemnification is tied to an event, such as a tax assessment or a judgment, irrespective of whether a warranty is breached.
• Knowledge: The buyer's knowledge is irrelevant. Indemnifications are agreed precisely for risks that have been disclosed and are known.
• Scope: The amount of the liability is reimbursed, as a rule including reasonable defence costs, euro for euro. A calculation of damages under Sections 249 et seq. of the German Civil Code (Bürgerliches Gesetzbuch, BGB) does not apply.
• Liability limits: The de minimis threshold (minimum amount per claim) and the basket (threshold for the sum of all claims) generally do not apply to indemnifications. The liability cap is regulated separately and is often set at the purchase price or at a risk-related amount.
• Limitation period: The period depends on the risk, for taxes for example on the finality of the assessments, and usually runs longer than for the business-related warranties.

Typical indemnification events

Tax indemnity

The tax indemnity is a regular component of a share purchase agreement. The seller indemnifies buyer and company against taxes attributable to periods up to the economic effective date, including ancillary tax payments such as interest and late-payment surcharges. In a locked box, in which the purchase price is fixed on the basis of an existing balance sheet, this is that balance sheet's date. Otherwise it is usually the day of closing, on which the shares pass. Excluded are taxes for which provisions were formed in the effective-date accounts or which were deducted as debt in the purchase price. Provisions are amounts booked in the balance sheet as a precaution for uncertain liabilities.

Negotiation concerns mainly three points. The first is the offsetting of later tax benefits, for example when a tax audit shifts expense into later years (timing difference). The other two are the seller's participation rights in tax audits for periods before the effective date and the allocation of tax refunds. If the company employs staff abroad, the question whether a permanent establishment and thereby a tax liability arose there belongs in the tax due diligence and, where relevant, in the indemnification.

Legal disputes and regulatory proceedings

For pending or threatened proceedings with an open outcome, the indemnification often covers the judgment sum, the settlement amount and the costs of proceedings. Since the seller bears the result economically, it demands influence over the conduct of the proceedings. The buyer, by contrast, must take account of customers, suppliers and authorities with which the company continues to work. A common middle way: the company conducts the proceedings, informs the seller on a running basis and concludes settlements or admissions only with its consent.

Further risks from due diligence

Typical triggers are freelancers who might have to be classified as employees, because social security contributions for several years can then be claimed retroactively. Further triggers are funding award notices that provide for repayment on a change of control or on breach of conditions, legacy contamination on used land, and known proceedings over possible breaches of data protection or competition law.

Course of an indemnification case

1. Notice: The buyer informs the seller of the third-party claim or the assessment within an agreed period. According to a common design, late notice excludes the indemnification only to the extent that the seller's position has deteriorated as a result.
2. Defence: The seller receives access to the documents and an opportunity to comment. Admissions and settlements require its consent.
3. Mitigation: The buyer must take reasonable measures to keep the amount low; Section 254 BGB applies in addition.
4. Payment: The indemnification often falls due a few days before the company itself has to pay, so that it does not have to pay in advance.

Securing the indemnification

An indemnification is worth only as much as the seller's ability to pay at the time of the claim. Buyers therefore often require security, for example a retention in an escrow account, a bank guarantee or the right to set off against purchase price parts still outstanding, such as an earn-out. Warranty insurance generally does not help here, because W&I insurance excludes known risks. For individual known tax risks, separate insurance is partly offered.

Worked example: tax indemnity after a tax audit

A GmbH (German limited liability company) is sold with an economic effective date of 31 December. The purchase agreement contains a tax indemnity for all periods up to the effective date. Tax provisions in the effective-date accounts and later tax benefits from the same matter are credited. Two years after closing, a tax audit for the three years before the effective date produces the following result:

• Additional corporation tax, solidarity surcharge and trade tax: EUR 210,000
• Interest on back payments: EUR 18,000
• Credit for the tax provision in the effective-date accounts for the same years: EUR 60,000
• Credit for the tax benefit in later years through higher depreciation: EUR 30,000
• Indemnification amount: 210,000 plus 18,000 minus 60,000 minus 30,000 = EUR 138,000

The seller pays EUR 138,000 without a de minimis threshold or basket applying. By comparison, if the same matter were covered only by a tax warranty with a basket of EUR 100,000 as a deductible, only the excess part would be reimbursed. The buyer would then receive, without further claims, only 138,000 minus 100,000 = EUR 38,000. The credit for the provision at the same time prevents the seller from bearing the same tax twice, once through the purchase price deduction and once through the indemnification.

Distinction: indemnification, warranty, purchase price reduction and provision

• Warranty: liability for the correctness of certain facts on the effective date; usually excluded for disclosed circumstances.
• Purchase price reduction: prices a risk in immediately and finally. It fits where occurrence and amount are sufficiently certain; for uncertain risks it shifts the dispute into the valuation.
• Provision: reflects a risk in the company's balance sheet and can reduce the purchase price as a debt-like item. The indemnification then applies only to the amount beyond that.
• Indemnification of officers: With an indemnification agreement or indemnification letter, a company undertakes towards its managing directors or advisory board members to hold them harmless from third-party claims arising from their activity, usually in addition to D&O insurance.

Common mistakes

• Unclear definition of tax. If the definition covers only taxes in the narrow sense, interest, late-payment surcharges or liability notices for third-party taxes may remain outside.
• Double counting. Without crediting of provisions and purchase price deductions, the seller bears the same risk twice.
• No regulation of the conduct of proceedings. If information and consent rights are missing, a settlement may be reached that the seller must pay without having influenced it.
• Indemnification as a catch-all. If an indemnification is tied generally to any breach of warranty, it undermines the de minimis threshold, basket and cap, unless it expressly is subject to the same limits.
• Missing security. If the proceeds have already been distributed or tied up long term by the seller, the buyer is left with an unsecured claim.

Frequently asked questions

How does an indemnification differ from a warranty?

The warranty assures a condition, the indemnification assumes a specific risk. A warranty protects the buyer above all against unknown circumstances, an indemnification precisely against known ones. De minimis threshold and basket usually do not apply to indemnifications.

What does a typical indemnification clause look like?

In simplified form: “The seller indemnifies the buyer and the company against all taxes attributable to periods up to the effective date, to the extent that no provision was formed for them in the effective-date accounts.” In addition, the contract regulates notice, conduct of proceedings, due date, cap and limitation. The buyer's knowledge does no harm, because the clause covers a known risk precisely.

How long does a tax indemnity apply?

As a rule until the taxes for the periods concerned can no longer be changed, plus a period of often six months. What usually matters is the finality of the assessments after a tax audit, so that the indemnification can have effect for several years beyond closing.

How are payments under an indemnification treated for tax purposes?

Purchase agreements usually classify them as a reduction of the purchase price. If the payment flows directly to the company instead of to the buyer, the tax treatment may differ; the question therefore belongs in the tax review of the draft contract.

Are there indemnifications in funding rounds too?

Yes, but less often than in company purchases. In the participation agreement, warranties are in the foreground. Indemnifications occur mainly where the investors' due diligence has uncovered a specific risk. If the company itself is to indemnify, the same limits of capital maintenance apply as for warranty payments to shareholders.

The Roemer Capital view

In sell-side mandates, indemnifications generally arise from individual findings of the due diligence. We assign each finding early to a treatment: remedy before signing, disclosure, purchase price reduction or indemnification. For the remaining indemnifications, we estimate with the client's management and tax advisers ranges for occurrence and amount, so that sellers know which risk they retain after closing.

The law firm drafts the wording. In the negotiation we make sure that trigger, crediting of provisions, procedural rights and security fit together and that the indemnification does not become a general catch-all for warranty claims.