ARTICLE
21 January 2025

Variation Or Replacement Of Contract?

EL
Enyo Law

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The Supreme Court's 2024 ruling in R (Cobalt Data Centre 2 LLP v HMRC) clarified the scope of contract variations. It dismissed the taxpayers' appeal on capital allowances, emphasizing that extensive contract changes could amount to a replacement, not a variation, impacting tax relief eligibility.
United Kingdom Corporate/Commercial Law

The Supreme Court has provided guidance on what might constitute a variation of a contract, as opposed to the replacement of one, albeit in a judgment that ultimately didn't require an answer to that question.

Introduction

In a judgment handed down in late 2024 in R (on the application of Cobalt Data Centre 2 LLP and another) v HMRC [2024] UKSC 40, the Supreme Court ultimately dismissed the appellant taxpayers' appeal against HMRC's decision to reject allowances under the Capital Allowances Act 2001 ("CAA 2001") in connection with an enterprise zone scheme.

Whilst the case arose in a tax context it provides useful guidance as to contractual alterations (to use a neutral term) more broadly and may well have wider application going forward.

Background

The appeal concerned the availability of capital allowances arising from expenditure incurred in the construction of buildings in an enterprise zone under the CAA 2001. The time limit for the allowances to be permitted is stated in the CAA 2001 as being either (a) 10 years after the site in question was first included in the enterprise zone or (b) if the expenditure is incurred under a contract entered into within the 10-year period referred to in (a), 20 years after the site was first included in the enterprise zone.

In this case, the taxpayer considered that it was within the exception at (b) above, given the relevant expenditure was incurred after the initial 10-year period but before the 20-year deadline. For the purposes of the "contract entered into within the 10-year period" requirement, the taxpayer relied on what was called a "Golden Contract" entered into during the initial 10-year period. This contract provided the developer (which was succeeded in title by the appellant taxpayers) with the right to select one of a number of potential construction projects and to adjust the parameters of the chosen development (albeit with a commitment to complete one of the alternative projects). Accordingly, it claimed for tax relief on this basis.

The enterprise zone in question (in the North-East of England) was established on 19 February 1996. The original Golden Contract was entered into on 17 February 2006 – i.e. just before the 10-year period expired. The developer then purported to exercise its right to select a project and to change the scope of various projects during the 10-year period after the Golden Contract was entered into. Ultimately 3 buildings were constructed (DC1, DC2 and DC3) and this appeal related to DC2 and DC3, both of which were large data centres. The Supreme Court noted that DC2 and DC3 "differ in significant respects from the subject matter of any of the Works Options set out in the Golden Contract in its original form".

The taxpayer argued that the expenditure on DC2 and DC3 was all incurred under the original Golden Contract and so qualified for the tax relief sought. HMRC's position was that the rights purportedly exercised were, on the true construction of the golden contract, never wide enough to permit the construction of DC2 and DC3. HMRC's position was that, in reality, the ability of the developer to require the contractor to build DC2 and/or DC3 could only be contracted for by a new contract (which would, necessarily, have been entered into after the original 10-year period expired, thereby not qualifying for the tax relief).

In reply to that argument, the taxpayers advanced a case (in the alternative to their primary case) that the original golden contract had been varied (as opposed to replaced), so that the expenditure was still incurred "under" the original Golden Contract (as varied). In response to the alternative argument, HMRC's position was that the CAA 2001 does not, on its true construction, permit expenditure incurred as a result of a variation between years 10 and 20 of a contract made within the original 10-year period. Secondly, the extent of the alterations (to use a neutral phrase) to the Golden Contract that were necessary for the construction of DC2 and DC3 were such as to amount to a replacement of the Golden Contract, as opposed to an amendment to it.

Key points for determination

The Supreme Court distilled the issues before it into three key questions:

  1. Was the relevant expenditure triggered by the exercise of the Developer's unilateral rights to select and to change conferred by the Golden Contract in its original form ("the Clause 12 Issue")?
  2. If not, does section 298 of the CAA 2001 on its true construction enable expenditure, incurred by reason of a variation during the second period of a contact originally made in the first period, to be treated as expenditure incurred under the original contract ("the Section 298 Issue")?
  3. If the answer to (2) above is "yes", was the Relevant Expenditure triggered by a variation or by a replacement of the Golden Contract ("the Variation Issue")

HMRC accepted that if the answer to the Clause 12 Issue was yes, then the appeal should be allowed. If the answer to both the Clause 12 Issue and the Section 298 Issue was no, then the appeal must fail, with the Variation Issue then becoming largely academic. The Variation Issue was said by the parties to raise an important issue of common law – namely, whether and to what extent the characterisation of a contractual alteration to a contractual relationship (either as a variation or replacement) of the original contract depends upon the common intention of the parties to that original contract, objectively ascertained.

Decisions below

The taxpayer originally appealed against HMRC's denial of the tax relief sought. In addition, the taxpayers also issued a claim for Judicial Review. Their tax appeal and judicial review claim were transferred to the Upper Tribunal to be heard together.

The Upper Tribunal ultimately allowed the taxpayers' appeal, holding that expenditure on DC2 and DC3 was incurred "under" the original Golden Contract, which had been entered into within the original 10-year period, which the Upper Tribunal considered to have been amended (as the taxpayer contended) as opposed to having been rescinded and replaced (as HMRC contended).

HMRC appealed to the Court of Appeal and, in summary, was successful. The Court of Appeal rejected the taxpayers' arguments that the orders relating to DC2 and DC3 were validly given under the original Golden Contract. There was a divergence between the Court of Appeal's reasoning (albeit it was unanimous in rejecting the taxpayers' appeal). One view was that the original contract only gave the developer the right to proceed with one project, and that right was "used up" by the first change order. It was considered that the Upper Tribunal erred in equating the desire of the developer and the contractor to preserve the tax relief with an intention, on an objective assessment, to do so, and to treat the change order 2 as a variation of the original contract. The intention was, in fact, that the second change order would be the basis for the construction of DC2, so the expenditure was therefore not incurred under the Golden Contract. Questions, therefore, of whether that contract had been replaced, fell away. A second view was that change order 2 represented a "major departure" from what had been originally agreed and did not constitute a variation of the original agreement. The Court of Appeal therefore considered the change order 2 to be a fresh contractual arrangement, which didn't involve variation or replacement of the Golden Contract, but which was necessarily outside of the qualifying initial 10-year period.

The Supreme Court's decision

The Supreme Court considered that the expenditure was not incurred "under" the original Golden Contract. As a result, it did not need to decide whether the changes in question constituted a variation or a replacement of the original contract.

The Supreme Court considered that the terms of the Golden Contract, which permitted the developer to change the scope of the work, did not extend to any change in the work, of any character or breadth. The Court of Appeal had previously given various illustrations as to why it considered this must be the correct interpretation – one being a shipbuilding contract providing a right to alter or modify aspects of the design of (say) an aircraft carrier. If the purchaser changed its mind and decided it, in fact, wanted a nuclear submarine, that cannot be considered an alteration or modification of the contract. Instead, it would involve the complete abandonment and replacement of the entire specification. Here, the Supreme Court considered that changing the building and its site, to be "outwith the confines" of the original Golden Contract.

The Supreme Court accepted that parties would ordinarily be able to state that they were varying and not replacing a contract and that common law freedom of contract principles would permit them to do so. However, the Supreme Court felt that answering the question in the abstract was of limited use, and the choice of mechanism (i.e. variation or replacement) in the circumstances of a particular case could be significant. Here, to allow the parties complete freedom to state a contract was being varied risked undermining the tax regime and "make tax legislation too uncertain in its effect, and would improperly elevate taxpayer choice as to how it should operate above implementation of the policy purpose behind the 10 year limit".

Conclusion

The decision provides a useful reminder of the breadth of the principles of party autonomy when negotiating a contract (and variations to / replacement of that contract), and the circumstances in which other factors also warrant consideration. In this case, the applicable tax regime was such a factor, but one can imagine other situations where intervention by the court may be necessary, whether on behalf of public bodies (here, HMRC) or other third parties where the distinction as to whether a contact has been varied or replaced is important.

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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