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The Meaning of Words in Tax Contracts

The United Kingdom High Court recently considered the contractual words "subject to taxation in the hands of the receiving party" in the course of litigation concerning the interpretation of a gross-up clause in a share sale and purchase agreement. 

In AXA SA v. Genworth Finance International Holdings LLC and others, AXA (as the share purchaser and litigation claimant) was entitled to receive certain compensatory payments from Genworth (the share seller and litigation defendant). Under the share sale and purchase agreement, if payments under the agreement were “subject to taxation” in a recipient’s hands, the payer was to make an additional payment to the recipient (known as a “gross-up” payment). AXA argued that the words “subject to taxation” fed into its own tax calculations, regardless of whether the relevant payments actually resulted in any tax being paid. In this context, amounts would be “subject to taxation” even when such amounts benefited from a tax exemption being available to AXA in respect of the payments being made.

By contrast, Genworth argued that the contractual expression “subject to tax” required the amount to be actually taxed in AXA’s hands. Genworth argued an amount would be payable under the gross-up clause only if and when the recipient was under an enforceable obligation to pay tax on the payments being made.

The High Court held for the defendant, Genworth, finding that the purpose of the gross-up clause in the contract was to ensure that the purchaser, AXA, was “made whole” against any taxation arising on the sums AXA received. AXA was not to be left out of pocket, but neither was AXA intended to receive a windfall as a result of the gross-up clause operating. Interpreting the gross-up clause as being referable to the actual tax burden on the recipient was therefore congruent with the commercial objective of the gross-up clause. By contrast, treating the gross-up clause as generating a payment based on a hypothetical tax liability, which AXA admitted in the High Court was unlikely to equal the actual tax burden AXA would incur, had not been the apparent intention of the parties when the gross-up clause in the share purchase agreement had been drafted.

The High Court’s decision was therefore grounded in an interpretation of the gross-up clause that accorded with the ordinary and natural meaning of the words of the contract. Furthermore, the construction of the contract by Genworth was a “business-like construction of a clause in a commercial contract that makes perfect commercial sense.” There was no evidence in the contract that the parties had intended the gross-up clause to operate to pay AXA a gross-up amount that amounted to a “windfall” (with no mechanism for repayment) and that was divorced from the reality of any tax actually payable. 

The High Court noted that the interpretation of the gross-up clause needed to be undertaken in accordance with the commercial context in which the contract had been created. Where differing contractual constructions were possible, the construction that was more consistent with business common sense was to be preferred. Such an approach was precisely on all fours with English contract law, and a long jurisprudence of decided cases in the commercial courts dealing with contractual interpretation. 

In this regard, the High Court’s construction of the contractual gross-up clause was very similar to a leading decision of the Supreme Court (or the House of Lords, as it then was) on the construction of taxing statutes. In Barclays Mercantile Business Finance Limited v. Mawson (2005), the House of Lords stated, in the context of construing taxation legislation, that “[t]he ultimate question is whether the relevant statutory provisions, construed purposively, were intended to apply to the transaction, viewed realistically.” In this regard, statutory and contractual construction might be considered to be aligned in a process of discerning both the purpose of the drafting and a realistic view of the contractual words used.

How does that impact the drafting of legal documents, and, in particular, legal documents that deal with taxation? According to the High Court in the AXA case, one starts with what the ordinary and natural meaning of the words of the contract say, and construes those words alongside the objective common intention of the parties in contracting together. With a clause aiming to gross-up a recipient party, or “make whole” a recipient party for a payment that is “subject to tax,” it was unsurprising that the High Court focused on a contractual construction that was compatible with payments being made to compensate for actual tax imposed, and not hypothetical tax calculated.

However, other situations might not be as clear-cut. Published guidance by HMRC was cited in the AXA case that states that an amount can be “subject to tax,” in the sense of being not exempt from tax and remaining within the scope of taxation, even if little or no tax is actually paid. Examples of income being “subject to tax” could potentially include where a non-domiciliary’s taxation is based on whether payments are being remitted to the UK, or where taxable income is covered by tax reliefs or allowances. 

The commercial context of the gross-up clause in the AXA case was the intention to make the recipient whole against actual tax liabilities. The interpretation of the words “subject to taxation” might be different in other contexts. For example, in a representation by an asset manager or service provider that the management of a client’s affairs would not result in that client being “subject to taxation” in the United Kingdom, a court might come to a different answer on how the words “subject to taxation” should be interpreted. A clause providing an indemnity for losses incurred by a counterparty’s default might carry a different construction of the words “subject to taxation,” compared to a covenant to pay a specific actual amount of tax (such as the gross-up clause in the AXA case).

Drafting tax documentation to achieve the desired result between contracting parties is therefore a process of using clear words, and also conveying in those words the commercial understanding between the parties. Yet such words also exist in the context of the precise circumstances for which they are being used. The AXA case is illustrative that the Courts will settle disputes about contractual construction according to which interpretation of the contract is more consistent with business common sense. In doing so, the AXA case shows that Courts will view the contractual words in the context of the precise circumstances those words are dealing with. 

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