Mutual mistake and rectification: lessons to be learned from MV Promotions v TMG

A number of important points emerge from the recent decision in MV Promotions Limited and Micheal Vaughan v Telegraph Media Group Limited and HMRC [2020] EWHC 1537 (Ch) (the "MV decision"):

• Although parties can agree to rectify a bilateral contract to correct a mutual mistake by an amending deed (and are bound by the amendment for the entire period), such an amendment may not have retrospective effect for tax purposes beyond the beginning of the tax year in which the amendment is made.
• A court order is required to achieve full retrospectivity, but the existence of a mutual mistake is not sufficient to secure an order in rectificiation: the remedy is discretionary and may be withheld by the Court. In particular, the Court will not labour in vain, so if the parties have already entered into a deed to correct the error that may be a barrier to the Court exercising its discretion to issue an order to rectify. As such, it seems better to make an application once an error is discovered rather than to rectify by a deed.
• Preserving records of intention when preparing contracts will be vital if rectification is ever required.

The MV decision is a very recent decision and there may be an appeal.

Facts and Decision

The case arose out of a bilateral contract (the "2011 Contract") made in 2011 between Telegraph Media Group Limited ("TMG") on the one hand and (on the face of it) an individual, Michael Vaughan ("Mr Vaughan"), on the other.  The contract was for the provision of Mr Vaughan's services to TMG.

Based on Mr Vaughan rather than MVP being a party to the 2011 Contract, HMRC claimed tax from Mr Vaughan and issued a closure notice for the tax that they said was due. On 8 March 2018 Mr Vaughan, MVP and TMG entered into a deed (the "2018 Deed") which purported to confirm that the 2011 Contract (properly construed) constituted an agreement as between TMG and MVP (rather than Mr Vaughan).  All three parties (Mr Vaughan, MVP and TMG) confirmed that their intention had been that TMG was to contract with MVP  (see the MV decision at [58]).

In the MV Decision, HHJ Hodge QC explained the legal effect of the 2018 Deed as follows (at [58]):

"As between [Mr Vaughan, MVP and TMG, the 2018 rectification [deed] is effective to achieve the objective [of clarifying and confirming] the true intention and effect of the 2011 contract; and it makes it clear that [the 2011 contract] operates as a contract between TMG and MVP to the exclusion of Mr Vaughan."

It is of course the legal position that is relevant to Mr Vaughan's income tax liability.  The Judge added:

"…the 2018 Deed … cannot act retrospectively or bind third parties."

(It may be observed in passing that if Mr Vaughan had for some reason relied on the terms of the 2011 Contract as originally written to claim that he, rather than MVP, was entitled to fees under the 2011 Contract, such a claim would be barred by the 2018 Deed, whether the claim was for fees falling due before or after the date of the 2018 Deed (because the deed could have retrospective effect as between the parties to it).)

Mr Vaughan started court proceedings against MVP, TMG and HMRC to establish that MVP, not he, was entitled to the fees under the 2011 Contract on the alternative bases that:

1. that was what the 2011 Contract on its true construction meant, or
2. he was entitled to the remedy of rectification, so that the 2011 Contract would, following rectification, provide for the fees to be paid to MVP (and not to him).

The first basis of claim (point 1 above) was rejected for reasons which depended on the particular facts of the case (see the MV decision at [16] – [33]).  The rectification claim (point 2 above) raises issues of general interest and importance, and is further discussed below. TMG did not take any active part in the proceedings but would be bound by the Court's order.

The Judge was satisfied that there was in 2011 a common intention as between Mr Vaughan, MVP and TMG that MVP (not Mr Vaughan) should be a party to the 2011 Contact, and that that intention had not been recorded in the written document (see the MV decision at [54] – [56]).  However, the Judge held that proof of the appropriate common intention was only a necessary, and not a sufficient, condition for the grant of the remedy of rectification.   In this instance the only dispute (following the 2018 Deed) was about tax, and was a dispute between Mr Vaughan and HMRC - not a dispute between the parties to the transaction. (The position would have been different if the transaction resulting in the 2011 Contract had been motivated by a desire (as between the parties to it) to secure a specific tax benefit but, because of the way the contract had been written, the benefit was not secured (see the MV decision at [61]).)

Overall, Mr Vaughan's claim failed and the terms of the 2011 Contract stood.

General points about rectification and their application in the MV decision

Rectification does not allow the Court to alter the bargain that the parties have made.  It simply permits the Court to remedy an error which the parties may have made in recording the bargain in writing. Proof of what the bargain was is therefore essential to success.  On the facts of the present case, the necessary proof was available (see the MV decision at [56]).

The remedy of rectification is a discretionary one, and the Court will not exercise its discretion in vain: therefore it is also essential to demonstrate that the grant of the remedy will achieve some significant result (as between the parties) that cannot be achieved by other means. Where a claim for rectification is motivated by tax considerations of one party, and there is no commercial purpose (as between the parties) sought to be achieved by rectification, the remedy will be withheld.  However, where the error made in the document sought to be rectified has caused HMRC to deny the claimant a specific tax benefit (intended by the parties from the outset), rectification may it seems be granted (because there will then be a dispute capable of being contested as between the parties: see the MV decision at [61]). The judge in the MV decision commented (at [60]) that:

"I am satisfied the [case-law] authorities warrant a distinction between the putting in place of a specifically intended tax-efficient structure and the creation of such a structure in circumstances where none was intended at the date of the relevant document."

This is not the easiest distinction to apply in practice.  It is well known that it can be more advantageous from an income tax point of view for an individual to derive income from his activities indirectly through a company than directly.  Yet absent proof that that was what was in the minds of Mr Vaughan, MVP and TMG at the time of entry into the 2011 Contract, that advantage could not found a claim for rectification.  Further, in the present case, the 2018 Deed meant that there was no longer any dispute between Mr Vaughan, TMG and MWP.

Comment

As a matter of tax law, could the 2018 Deed operate retrospectively?

It would appear that the relevant tax liability of Mr Vaughan was on trading or professional income (as a cricket correspondent). The person liable for income tax in respect of such income is "the person receiving or entitled to the profits" (Income Tax (Trading and Other Income) Act 2005, s.6).

The Court accepted in the MV decision that the 2018 Deed did have retrospective effect as between Mr Vaughan, MVP and TMG (see above).  It might thus appear arguable that (even in the absence of successful rectification) Mr Vaughan did not "receive" nor was "entitled to receive" the relevant profits.

However, some case-law suggests that contracts and alterations to contracts cannot take effect for tax purposes earlier than 6 April in the year that the contract or alteration is made, because income tax is imposed for each tax year individually (Dodworth v Dale (1936) 20 TC 285, KBD;  Boston Deep Sea Fishing and Ice Co Limited v Farnham [1957] 3 AER 204 (Ch D)).  Therefore, on the basis of this case law, the retrospection provided for by the 2018 Deed could not have affected Mr Vaughan's liability for 2016-2017 or earlier years.

Are third parties bound?

The Judge in the MV decision somewhat sweepingly observed that the 2018 Deed could not bind third parties. This was an apposite observation in relation to the facts of the case before it.  However there may be circumstances where a third party is subject to an equitable right of rectification, particularly where the third party is not "equity's darling", i.e. a purchaser for value without knowledge of the right.  In this connection it is to be observed that there seems to be no reported case where HMRC have claimed that a right to rectification must be disregarded for tax purposes because HMRC are to be regarded as such a purchaser. It seems that any such claim would be unfounded: far from being a purchaser HMRC are likely to be regarded as a "volunteer" because it gives no consideration for the tax that it levies.

Unilateral instruments

The MV decision was concerned with a bilateral instrument: the 2011 Contract. It appears from the case of Joost Lobler [2015] UKUT 152 (TCC) that different considerations apply where it is sought to rectify unilateral instruments such as surrenders of life policies.  In the case of such unilateral instruments it is necessary to show that the executing party intended some tax (or other) result other than that which the instrument produced; was labouring under a mistake when the instrument was executed; and the mistake was a serious one – i.e. the mistake related to some matter of fact or law fundamental to the relevant transaction.

Contracts made by fiduciaries

In the MWP case the 2011 Contract had been made on behalf of Mr Vaughan/MVP by an agent (Mr Fairbrother). There was no finding as to whether Mr Fairbrother was a fiduciary.  In similar agency cases where the agent is a fiduciary and the agent has made a contract with a third party in breach of his duty, it may be that the contract is voidable (i.e. can be set aside if an interested party so requires: Pitt v Holt [2013] STC 1148, Supreme Court).  Such setting aside will be retroactive (see Pitt v Holt per Lord Walker at [130]: "the court is in effect deciding that a transaction of the specified description is not to be treated as having occurred"). The setting aside will not be done if to do so would prejudice the rights of third party purchasers for value without knowledge of the right to set aside, but on the facts neither MVP nor HMRC would be such purchasers (MVP because it would be constructively aware of the right, and HMRC because it is not a purchaser: see above). The setting aside would not, on the facts, deprive MVP of any of its fees, because of the 2018 Deed. The same issue about tax liability for 2017/18 and earlier years would have arisen (see above).

Some possible lessons

When a tax issue arises about the interpretation of a contract or similar instrument:

• the greatest caution needs to be exercised before embarking on a remedial transaction.  As the MV decision illustrates, such a transaction may be only partially successful (in that it will remedy the position as between the parties to the transaction prospectively) but that partial success may jeopardise the achievement of a retrospective correction though a Court order; and
• it is important to collect and preserve all possible documentary and witness evidence about the instrument and the factual background to its execution, in case it is necessary to establish the intentions of the parties to the instrument or the facts surrounding its execution.  (While it is true that the subjective intentions of the parties are not normally relevant to the interpretation of an instrument, those intentions may be relevant to mistake, such as where it is alleged that one party knew that another party was mistaken but did not correct the mistake, or where the subjective intentions point to objective occurrences which assist in such interpretation.)

Where a claim is made for rectification of an instrument on the ground that a mistake was made in its drafting, an explanation of how the mistake came to be made will be required and in the absence of such an explanation the Court may be inclined not to grant relief (see the MV decision at [49]).

The seeking of a particular tax treatment can sometimes allow the Court to grant rectification in a case where the remedy would otherwise be withheld, and for this reason care will need to be taken at the evidence-gathering stage to assemble explanations of any tax advantage sought and indications of whether the advantage may have been frustrated by the way that documents have been drafted. It should however be borne in mind that it may be necessary to inform HMRC of rectification proceeding and to offer them a chance to participate, so that they will be bound by the Court's decision.