Indemnity Clean Up
Indemnity payments may not be taxable income. The IRS let a company deduct its environmental cleanup costs recently despite the fact that it was reimbursed for them under an indemnity agreement. The IRS national office said in a “field service advice” that the indemnity payments were really capital contributions to the company that had to do the cleanup.
Company A bought an oil company that owned refineries and pipelines and that had caused damage to the environment. The oil company had to spend money later on environmental cleanup. The seller of the oil company shares had given Company A an indemnity promising to reimburse it for the cleanup. An IRS agent in the field thought Company A — which, by then, was including the oil company in its consolidated tax return — should not be able to deduct the cleanup costs because it was reimbursed for them. However, the IRS national office disagreed. It said the indemnity payments were really capital contributions to the oil company, even though the seller no longer owned the oil company by the time the indemnity payments were made. It said the payments related back in time to just before the sale.
Indemnities given in connection with sale of a company should be drafted as an adjustment in purchase price or as retrospective capital contributions.