Most Read Contributor in Australia, September 2016
M and S were business partners, indeed successful business
partners. One day they decided to sell their business. This raised
millions of dollars, which were paid into several jointly owned
entities, including one company which received
A few years latter, M and S chose to go their separate ways.
Agreements were drawn up to effect the separation. The way it
worked was that one business partner (S) was to sell his interests,
including in the company, to the other business partner (M). The
agreement provided two relevant indemnities.
First and under clause 5, M and S agreed that
they "they will each be liable for one half of the
taxation liability assessed as payable by the Australian Taxation
Office for the Joint Entities." The Joint Entities
included the company.
Secondly under clause 8, S agreed to
"indemnity [M] for up to one half of any fines or
penalties that may be imposed on any of the Joint Entities arising
out of any ATO audit conducted in respect of the activities of the
Subsequent to the agreement (and how could it be any other
way?), the ATO conducted an audit of the company for a tax year
covered by the agreement. The ATO issued an amended assessment
which significantly increased the tax payable by the company and
included a large penalty. M, now being the sole director and
shareholder of the company, arranged to pay the tax debt, but he
did so through another entity - a trustee company of a family
Litigation on the construction of the indemnity
M demanded that S pay half of the tax debt and half of the
penalty. S refused and the matter came before the Supreme Court of
New South Wales in McLeary v Swift  NSWSC 1403.
S defended the litigation on the basis that all payments had
been made by the trustee company, and since the trustee company was
not a party to the agreement, the indemnities were ineffectual. M
countered that the reference to 'M' in the agreement was to
be construed as being a reference to M and M's interest in
various entities including the trustee company, and alternatively
that specific performance of S's compliance with clause 5
should be ordered, which would require S to make a payment to the
In respect of clause 8 of the agreement and the
payment of the tax debt, the Court disagreed with M – the
words of the agreement were clear. Clause 8 specified that S was to
indemnify M, and the liability would only arise where M made a
payment. There was simply no basis to extend the reading of
'M' to include other entities. The indemnity did not
An escape under clause 5
The situation was different under clause 5.
This clause was not drafted in terms of S indemnifying M, but
instead that M and S agreed to be liable for one half of any tax
liability of a Joint Entity, which included the company. Based upon
this different wording, M asserted that S's argument on the
construction of clause 8 did not apply - the relevant issue was not
the scope of the word 'M', but whether there was a tax
liability for a Joint Entity, which plainly there was.
M asserted that in this case the Court should order specific
performance to mandate that S pay the company half of the tax
liability (which was construed to include the penalty portion of
the liability). This submission was made on the basis that a Court
can compel a promisor to perform their promise by paying money to a
third party, particularly where the damages suffered by the
plaintiff are inadequate to meet the justice of the case. In this
case, the damages were inadequate since M had not paid anything
himself, and suffered no loss.
The Court agreed with M's argument and S was ordered to pay
50% of the tax liability to the company to give effect to the
indemnity in clause 5.
While this case isn't ground breaking – it doesn't
have to be – it is an important reminder that indemnities
need to be prepared with some precision. Attention needs to be
given to matters such as:
Who is likely (or may potentially become likely) to incur a
liability which is meant to be covered by the indemnity?
Does the indemnity actually provide that entity in need of
indemnification will be able to obtain it?
Is the indemnity sufficiently clear? While M ultimately
received indemnification (of sorts) it took litigation to reach
that outcome. Ideally, the indemnity provision should be clear
enough to deliver the result without resort to a court.
If it is likely that a third party will be in need of
indemnification, consideration needs to be given to how the
indemnity will extend to the third party. Options include the
wording used in the clause (compare clauses 5 and 8 above), having
the indemnifying party execute a deed poll, or having the
indemnified party hold the indemnity on trust for the non-party
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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We discuss whether certain clauses commonly found in ordinary commercial contracts could be considered to be penalties.
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