Meaning
A specialized financial arrangement in corporate acquisitions secures a portion of the purchase price in a third-party bank account to cover potential tax liabilities that may arise after the transaction closes. Through a tax indemnity escrow, the buyer protects itself against historical tax non-compliance or pending audits of the target company by ensuring that funds are readily available to satisfy any indemnity claims. This structure reduces the buyer’s risk of having to pursue a seller who may be difficult to locate or financially insolvent after the deal is finalized.
Contractual Protection
Establishment of this arrangement requires a tripartite agreement between the buyer, the seller, and an independent escrow agent, which is typically a commercial bank. The share purchase agreement specifies the amount to be held in escrow, which is usually determined by the tax risk identified during the due diligence process, and the duration of the escrow period. This period often aligns with the statutory limitation periods for tax audits, which in China can range from three to ten years depending on the nature of the tax issue.
The agreement must clearly define the trigger events that allow the buyer to demand a release of funds from the escrow account.
Escrow Allocation
Distribution of the escrowed funds occurs once the defined period has expired without any tax claims being made, or after a claim has been resolved and paid. If the tax bureau issues an assessment or a penalty notice against the target company for a pre-closing period, the buyer can make a claim against the escrowed funds to cover the tax liability and any associated late fees. Once the escrow agent receives a joint instruction or a final arbitration award, the required amount is transferred to the buyer or directly to the tax authority.
Any remaining funds at the end of the escrow period are then released to the seller.
Administrative Settlement
Execution of these escrow agreements in Chinese transactions encounters specific regulatory hurdles due to stringent capital controls and local bank practices. When a foreign buyer seeks to release funds from a local escrow account to pay a tax liability or return the balance to an offshore seller, the local branch of the State Administration of Foreign Exchange must review the transaction. Banks in China often demand the presentation of the official tax payment receipts and tax clearance certificates before they will process the transfer of funds out of the escrow account.
This makes it crucial for the parties to include detailed administrative procedures in the escrow agreement, ensuring that the Chinese seller is contractually obligated to cooperate with the bank and tax authorities to facilitate the timely release and transfer of the funds.
