Court upholds appeal on notice of tax covenant claim

28 May 2021

The Court of Appeal has reversed a decision by the High Court that a notice of claim under a tax covenant was invalid because it did not state in reasonable detail the matter giving rise to the claim.

What happened?

Dodika Ltd v United Luck Group Holdings Ltd [2021] EWCA Civ 638 concerned the sale of shares in a company whose business was the development of mobile game applications.

The sale was governed by a sale and purchase agreement (SPA). The SPA included a tax covenant given by some of the sellers in favour of the buyer, under which the sellers promised to reimburse the buyer for any tax liabilities of the target group relating to events that occurred before the sale.

The SPA stated that the buyer could bring a claim under the tax covenant only if it “gave written notice … stating in reasonable detail that matter which gave rise to such Claim, the nature of such Claim and (so far as reasonably practical) the amount claimed” before a specified deadline.

Shortly before the deadline, the buyer sent the sellers notice of a claim under the tax covenant relating to an investigation by the Slovene tax authority into the group’s transfer pricing policies.

The notice cited the relevant provisions of the SPA, including the tax covenant. It also confirmed that the claim under the tax covenant related to an investigation by the Slovene tax authority and set out a brief chronology of events concerning that investigation. However, as the investigation was ongoing, it was not possible at the time to include the amount the buyer was claiming.

The sellers rejected the notice on the basis that it did not state the amount of the claim and had not provided reasonable details of the “matter which gave rise” to the claim.

The High Court held that the notice was not invalid by virtue of failing to state amount of the claim. However, it said that the mere reference to “an investigation by the Slovene Tax Authority … into the [subsidiary’s] transfer pricing activities” did not provide the sellers with sufficient information to identify the matter giving rise to the claim. Instead, the notice should have explained “the reasons why a tax liability might accrue”, which, in this case, meant setting out details of the relevant transactions.

You can read more about the High Court’s decision in our previous Corporate Law Update.

The buyer appealed to the Court of Appeal.

What did the court say?

The Court of Appeal said that the notice had been valid.

The judges agreed that the matter giving rise to the claim was indeed the target group’s transfer-pricing practice, rather than the mere fact of a tax investigation. However, they felt that the notice had provided reasonable details of the issues arising out of that practice for the purposes of the SPA.

The court gave various reasons for this:

  • The sellers had already been aware of the detail of the tax authority’s investigation. The judges agreed that a notice which did not comply with the SPA would be invalid, even if the sellers already knew about the matter in question. But they also felt that information conveyed by a notice was informed by the background context, including any knowledge which the sellers in fact had.
  • There was very little specific detail available to the buyer. Although the notice contained very limited information on the investigation, any further detail available would have described the transfer pricing practice at only a high level. The tax authority had not at that point identified any specific transactions that it was challenging.
  • The notice had to be read in the context of the commercial purpose of the requirements in the SPA. This was to enable the sellers to make enquiries into the factual circumstances of the claim so as (so far as possible) to assess its merits. It served no commercial purpose to set out further “limited and generic detail” or to recite facts which the sellers already knew. This would have reduced the notice requirements to “empty formalism”.

What does this mean for me?

The court’s decision is interesting. There is a long-standing principle that, where a contract requires a notice to contain prescribed information, it must do so. If it fails to, it will be invalid. The court must judge this based on what a “reasonable recipient” would understand by the notice, rather than by what the actual recipient may or may not have understood.

However, the court clearly felt that it was able to take the sellers’ actual background knowledge into account, framing the question as one of what a “reasonable recipient with the (assumed) knowledge of both parties” would understand. As a result, the brevity of the notice in this case did not render it invalid, whereas, in another set of circumstances, it might well have.

It is always important to view these decisions in context. In this case, the sellers had been informed throughout the course of the investigation and had even been represented in proceedings with the tax authority. This will not be true in every case.

There is always a degree of tension between, on the one hand, ensuring that a seller is not blindsided by a vague claim with very little information to understand what is being claimed and, on the other hand, requiring a lengthy and formulaic recitation of facts known to both sides. Often the court will take a pragmatic approach, but there are certain steps a buyer can take to shore up their position.

  • Observe the notice requirements in the SPA. These can vary from case to case, and failure to comply with any specific requirement can nullify a notice. In this case, the SPA required “reasonable detail” of the claim. However, in another case on which we recently reported, a notice was invalid because it did not set out “full particulars” of the claim, as required by the SPA.
  • Provide as much detail of the claim as is reasonably possible. This entails striking a balance between providing enough detail to ensure the seller understands the claim and not stating the buyer’s case so exhaustively that the notice effectively rules out other avenues of claim.
  • Consider whether there are any other breaches of the SPA. If there are, set them out separately. The more lines of attack a buyer pursues, the more success it is likely to have.