Tax

Amending a contract may have adverse (and sometimes unexpected) tax consequences. The impact of the amendment can depend on whether the terms of the existing contract have been varied or if the existing contract has been replaced by a new contract. A recent decision of the UK Supreme Court underscores that, in order to determine whether an alteration has varied or replaced an existing contract, the starting point should always be the parties’ common intention, objectively ascertained. Although this is not the end of the matter – common law party autonomy is subject to statutory and public policy limits – the Supreme Court’s decision illustrates the general hesitancy to interfere with the parties’ freedom to contract, except in limited circumstances.

Background

Cobalt Data Centre 2 LLP v HMRC [2024] UKSC 40 concerned the availability of enterprise zone allowances claimed in respect of the construction of two data centres. In order for the claim for allowances to succeed, the taxpayers had to show that the relevant construction expenditure was incurred under a contract entered into within 10 years after the site was first included in the enterprise zone.

The taxpayers argued that the expenditure had been incurred under a ‘golden contract’ entered into two days before the expiry of the relevant 10 year period (a ‘golden contract’, being one which sets out a range of alternative construction projects which a developer must choose, rather than stipulating or prescribing a particular contract). In response, HMRC argued that the rights under the golden contract were insufficiently wide to enable the developer to require the contractor to build the two data centres, which could only be contracted for by a new agreement (made outside of the 10 year time limit) (the “Clause 12 Issue”).

The taxpayers also contended (in the alternative) that, even if the expenditure had been incurred under a ‘new agreement’, it was still incurred under the golden contract, as varied. To this, HMRC responded as follows: (i) first, the relevant legislation did not treat as qualifying any expenditure required or allowed pursuant to a variation which was made outside of the 10 year limit in respect of a contract made within the 10 year period (the “Section 298 Issue”); and (ii) the alterations necessary to the golden contract to provide for the construction of the two data centres amounted to a replacement of the golden contract rather than a variation of it, so that the expenditure could not be said to have been incurred under a contract made within the 10 year period (the “Variation Issue”).

Decision

The Supreme Court dismissed the taxpayers’ appeal, finding in favour of HMRC in respect of both the Clause 12 Issue and the Section 298 Issue. While it was not necessary to consider the Variation Issue, the court thought it was of sufficient public importance to address it in any event.

In considering the Variation Issue, the Supreme Court emphasised the centrality and force of the principle of freedom of contract, which affords the parties to an agreement a wide margin of choice in deciding whether an alteration should be achieved by way of variation or replacement. The court rejected HMRC’s suggestion that there was a rule of law to the effect that if there was a fundamental difference between the original contract and the later contract, the later contract had to be taken to “rescind” the original contract. The fact that the agreed alterations were fundamental was relevant to ascertaining the parties’ common intention (i.e. whether to rescind the original contract rather than to vary it), but that did not operate as a separate rule of law, regardless of intention. The parties were free to choose the mechanism for alteration; the outcome was by no means determined purely by the content of the alterations themselves.

The Supreme Court found that the parties to the golden contract clearly intended to make the alterations by way of variation rather than replacement. This was evident from the express label of “variation” which they gave to the amendments and could also be inferred from the ‘tax context’ in which the arrangements were entered into. Claiming the enterprise zone allowances was a “very important part of the factual background” for making the golden contract and the later amendments, with the parties having a “shared goal” of claiming the relevant tax advantage.

The common law doctrine of party autonomy is indeed wide-ranging. However, the Supreme Court did not agree with the taxpayers that the only limit to this is the sham doctrine, which disregards the false appearance of a particular legal relationship the parties have sought to present in order to give effect to the true intention of the parties. The court commented, obiter, that at some point it would bring the law into disrepute and damage its legitimacy in the eyes of the public if the parties could specify that some change in their contractual relations should take effect as a variation rather than a replacement, even though that was utterly absurd. It is a question of fact whether that line is crossed in any given case, but the Supreme Court considered it may not be too difficult to discern the probably rare cases in which the chosen label (variation or replacement) does not match the alteration mechanics actually deployed.

Comment

The Supreme Court’s comments in Cobalt place greater emphasis on respecting the freedom to contract and indicate a greater hesitation of the courts to interfere with the common intention of the parties than in previous cases. Previous authorities focused on the content and fundamentality of the contractual amendments to ascertain the parties’ common intention and, consequently, whether the contract had been varied or replaced. For example, in:

• Associated British Maltsters Ltd v Inland Revenue Commissioners [1972] 3 All ER 192, the Chancery Division considered that the alteration of two trust deeds constituting unsecured loan stock by conversion into secured debenture stocks was essentially a replacement (rather than a variation) of the original trust deeds, and constituted an issue of loan capital assessable to stamp duty. In reaching its decision, the court had regard to the fact that: (i) the new trust deeds were an “entirely complete and totally exhaustive definition of the rights and obligations of the taxpayer company”, without need for any reference to the original trust deeds; (ii) the nature of the investment had been “fundamentally altered”; and (iii) the covenants had changed (converting from unsecured to secured loan stock); and
• Triodos Bank NV v Dobbs [2005] All ER 364 (a non-tax case), the Court of Appeal found that a rescheduling of existing debt would be allowed as a variation. However, changes which involved: (i) finance for a different purpose; (ii) finance for a much larger sum; or (iii) a rescheduling which was substantially different to the original terms, would be replacements and not variations. The Court of Appeal said that it was not easy to draw a hard and fast line between permissible and impermissible variations, but concluded that to the extent the alterations were ‘in the purview’ of the original arrangements, this would indicate that there is a variation. By contrast, if the changes were substantial, the court indicated that this would tend towards a replacement.

Moreover, it is noteworthy that the Supreme Court’s decision indicates the parties’ common intention could be inferred from the ‘tax context’ in which they altered the contract. In varying (rather than replacing) the golden contract, the parties were clearly acting with a “shared goal” of claiming the enterprise zone allowances (albeit this was based on a mistaken interpretation of the relevant legislation). The Supreme Court acknowledged that the tax context in which an agreement or series of agreements is made can be part of the relevant background for assessing the intention of the parties. This fact alone, it seems, would not go so far as to “bring the law into disrepute” and therefore engage the limits on the common law doctrine of party autonomy.

The Supreme Court implicitly acknowledged that parties can, and often will, have regard to tax considerations in deciding whether to effect an amendment by way of variation or replacement. But acting with a view to securing a tax advantage should not be determinative of whether the amendment is construed as a variation or replacement. The Supreme Court’s comments are perhaps an interesting juxtaposition with the recent line of decisions of the Court of Appeal in the unallowable purpose cases, albeit they were made obiter and in a very different context to the legislative framework underpinning the unallowable purpose decisions.    

In this case, the impact of an amendment of a contract was relevant to whether expenditure was incurred by reference to a particular time period following entry into a contract. It is also relevant in other scenarios; for example, in applying certain grandfathering provisions and considering whether a new “provision” arises for transfer pricing purposes. Guidance published by HMRC in the context of amending loan instruments (in particular the impact of market changes to the interest benchmark) (available here), illustrates that the intention of the parties, and how this is reflected in the legal documents, will be of paramount importance in determining whether a variation constitutes an amendment or replacement of the existing contract.