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In one of the more comically extreme thought experiments of the Supreme Court, Lords Briggs and Sales postulated: “Suppose there is a contract for a holiday in Edinburgh which is implemented and completely exhausted at the time. If, fifteen years later, the parties want to make a contract for a different [thing] … could they agree to change the contract for a holiday in Edinburgh into a contract to build a nuclear submarine and agree that this will be by way of variation of the holiday contract…?”
The answer is no. But why?
A second scenario: suppose that instead of varying the contract to one for the construction of a nuclear sub, the parties merely sought to vary the contract to add a couple of days to the back end of the holiday. Could this be done by a variation to the contract? Probably, yes. But why is this different to the nuclear sub scenario?
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The law
It is a pillar of contract law that, when determining how a contract should be interpreted, the court should seek to give effect to the intentions of the parties (insofar as they can be objectively ascertained). So if the parties intended to vary a contract, to add in some ‘new thing’ for example, the starting point is that the court will treat it as a contractual variation (adding-in the new thing to the existing contract) rather than a new contract for that new thing. However, in Cobalt the Supreme Court sought to test the limits of that proposition, in what is likely to become a leading authority on the law relating to contractual variations at common law.
Where parties to a contract agree to make changes to their rights or obligations, they do not usually care whether the specific legal mechanism giving effect to the change is categorised as a variation (to the original contract) or categorised as a new ‘replacement’ contract (provided its terms are clear). In cases where this is of little significance to the parties (or they simply haven’t addressed their minds to it) it can be difficult for lawyers to establish whether the parties had any particular common intention as to which mechanism was used. Luckily in some cases it does not matter because the substantive outcome is the same: the parties know the terms of the contract they have agreed to perform whether it takes effect as a variation or a new contract.
However, the Supreme Court’s judgment in Cobalt illustrates why, in some cases, it matters, and why in some cases the parties do need to give it some thought. This was a case where “it matter[ed] whether the parties ha[d] chosen to bring about an alteration to their contractual relationship by the mechanism of variation or of replacement, [as] the interposition of some statutory regime in effect hung upon that outcome”.
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The facts
Consider then a third scenario: the one the Supreme Court actually had to consider (which is presented in simplified form here): a contract for the development of land contained a number of exercisable options and also a variation clause allowing the developer to unilaterally vary it in certain specified ways. The parties decided to develop the land in a way not specified any of the pre-existing contractual options clauses. They intended that this new agreed way to develop the land would take effect of as a variation of the existing contract, rather than a new ‘replacement’ contract (bearing in mind that, in either event, the new agreed development wasn’t something the original contract provide for).
Why were the contracting parties so keen to treat is as a variation? Because if they could fit it in under the old contract there were tax advantages (the availability of capital allowances under section 298 of the Capital Allowances Act 2001). That’s why HMRC was the other party to this claim: it sought to argue this capital allowance was not available. This is what the Supreme Court mean when they said that a “statutory regime in effect hung upon that outcome”.
The case was ultimately decided in favour of HMRC on the basis of the interpretation of the 2001 Act; the Supreme Court held that whether it was intended to be a variation of the old contract, or a new ‘replacement’ contract, in either event the capital allowance wasn’t available. We explain why below. However, the point of wider interest is what the Supreme Court went on to say about the ‘breaking point’ at which, even if the parties intend to vary a contract, the Courts will nevertheless find that what actually happened was creation of a new contract, and not a variation. As seen in this case, that can be an important distinction where being able to treat the change as a variation confers some kind of benefit of one or both parties (such as a tax advantage).
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The decision
So where is the line? What the Supreme Court said (albeit ‘obiter’) was:
[1] In “general terms” the law of contract “facilitates rather than frustrates the intentions of the parties, except where what they seek to do is contrary to public policy”. In particular, in the context of deciding if something is a variation or new contract: “the centrality and force of the principle of freedom of contract means that, purely in terms of the general common law, parties to an agreement have a wide margin of choice in deciding whether an alteration in their contractual relationship should be achieved by the mechanism of variation or replacement.”
This is an orthodox position: in general terms if the parties intend the change to be a variation then the courts will treat it as a variation.
[2] But there is a “limit…to the ability of the parties to specify that a change in their contractual relations should take effect by way of variation rather than replacement of an original contract.” It is “subject to limits … at the margins”
Okay, so where is this limit “at the margins”?
[3] “At some point it would bring the law into disrepute if the parties specified that some change in their contractual relations should take effect as a variation rather than a replacement even though that was utterly absurd, yet the law still gave effect to that specification in some way which had effects in the real world. We do not think that the general law would give effect to the intentions of the parties to the extent that it brought [the law] into disrepute and damaged its legitimacy in the eyes of the public.”
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Some analysis
There’s quite a lot to unpack there, but to simplify:
- where the parties intend something to be a variation because “that specification in some way …[has] effects in the real world” (i.e. whether it is a variation or new contract has real world consequences such as whether there is a tax benefit or not),
- but treating it as a variation would be “utterly absurd” to that point that it “brought [the law] into disrepute and damaged its legitimacy in the eyes of the public” – to use the court’s own ‘absurd’ example: varying a package holiday agreement as a contractual vehicle to construct a nuclear submarine,
- then the Court will not give effect to the intention of the parties and will instead look at whether the true nature of what has happened is that a new contract has been created.
That all makes sense: the intentions of the parties are very important, but the parties should not be able to cite them as justification for doing something so “utterly absurd” that it would damage the legitimacy of the rule of law! But is it the basis for a workable test? Outside of the hypothetical world of parties using holiday contracts to build nuclear submarines, where is the line?
The Supreme Court expressly acknowledged this problem: “It has to be acknowledged that these are vague standards which, as purely abstract statements, are not very informative about where precisely the limits lie of the ability of the parties to specify that a change to a contract is a variation rather than a replacement and by doing so to bring about some substantive legal result.” However, the Court did not go on to say more about where the line might be drawn, save to say that it hoped it would not “be too difficult to discern the probably rare cases where the chosen label simply does not match the mechanics actually deployed. We do not think we can usefully say more”. Adding (with apparently no irony): “This court deals with practical legal questions and does not seek to provide exhaustive abstract statements of the law.”
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Application to the facts
Onwards, therefore, to the practical legal question of whether the contract in this case was a variation or a new ‘replacement’ contract. Which was it? The parties clearly intended it to be a variation of the original contract, and this was reinforced not just by the language they used (they called it a variation) but by the objective they hoped to achieve (a tax advantage only available if this new development work could fit under the old contract via a variation).
The Supreme Court rationalised that seeking to achieve that tax advantage via a (really very substantive) variation (not provided for in the original contract) evidently wasn’t so “utterly absurd” as to draw the law into disrepute. The Court said it was inclined to treat it as a variation: “In view of the degree of respect afforded by the common law to party autonomy and the relevance of the tax context, we would incline to the view that such alterations would in such circumstances have been assessed to be by way of variation rather than replacement”.
In reaching this conclusion, the Supreme Court also poured cold water on a previously mooted theory: that one of the reasons this change must have taken effect as a new contract was because (so argued HMRC:) “there was a rule … 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 Court rejected this entirely (“we do not accept this”).
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Conclusions
What we are left with therefore is, in one sense, a reassuring confirmation: the intentions of the parties really are king…unless (and this is the new bit) the parties' intentions seek to achieve something so “utterly absurd” as to draw the law into disrepute. Then the court will instead seek to give effect to what it understands to be the ‘correct’ legal mechanism.
And finally, as for whether the parties could exploit the specific tax advantage they sought to achieve by treating the change as a variation: they couldn’t, but not because of any issue with their intentions. The reasons are slightly complicated but the crux is this. The relevant tax law provided that, to obtain the tax advantage, expenditure on the construction of a building on a site in an enterprise zone had to occur either: (a) the first 10 years after the site was first included in the zone or (b) ‘if the expenditure is incurred under a contract entered into within those 10 years, 20 years after the site was first included in the zone’ (emphasis added). The relevant contract had been entered into during the first 10-year period, but it was not until after this that the parties agreed the change (which was either a variation or a new contract). Therefore in either event, said the Supreme Court, the new work was not “under a contract entered into within those 10 years”.
We do not think that the general law would give effect to the intentions of the parties to the extent that it brought [the law] into disrepute and damaged its legitimacy in the eyes of the public.”
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