When the tax tribunal can intervene to fix your mistakes

The case, which provides wider learning points for others, involved an appeal by Jonathan Cooke against a decision by HM Revenue and Customs (HMRC) to deny him entrepreneurs’ relief on the basis that he did not technically meet the shareholding threshold for eligibility for that relief. Both Cooke and HMRC agreed that Cooke would have been entitled to the relief if he held at least 5% of the ordinary share capital in the company, ISC Holdings – he met all the other conditions for entrepreneurs’ relief. The only question was whether he met the 5% test.

Cooke also accepted that, as a matter of fact, he only held 4.99998% of the ordinary shares because he held one share fewer than he needed to meet the 5%. However, he pursued an appeal to the FTT arguing that, even though he was technically under the 5% threshold, he should still be granted relief on the basis of rectification.

What is rectification?

Rectification is an equitable remedy through which a document can be amended or rectified so that it accords with the intention of the parties at the time that it was made. A claim for rectification does not alter the terms agreed between the parties, but rather alters the document so that it reflects what was agreed.

Rectification is usually pursued through an application to the High Court and a series of principles have been established through these court proceedings. The core principles were set out by the Court of Appeal in the case of Swainland Builders Ltd v Freehold Properties Ltd in 2002. Under these principles, the party seeking rectification must show four things:

• the parties had a common and continuing intention in respect of a particular matter in the instrument, in this case, a contract, to be rectified, whether or not that intention amounts to an agreement;
• there was an outward expression of accord, i.e. something that the parties can point to exhibiting that common intention;
• the common intention continued at the time the contract was executed; and
• the contract did not reflect the common intention, by mistake.

Some additional principles have also been established in other cases, including that the standard of proof is on the balance of probabilities. There has also been some discussion of whether rectification can be sought if the only effect of the order for rectification will be to secure a fiscal or tax benefit. In the Racal Group Services case, the conclusion was reached that rectification will not be ordered if the parties’ rights will be unaffected and the only effect is a fiscal benefit.

Can the tax tribunal consider rectification?

This question was addressed by the Upper Tribunal (UT) in the case of Lobler v HMRC in 2015. The UT found that although the FTT does not have the power to order rectification, it can make a determination that a court would have granted rectification and make its decision on the tax consequences as if such rectification had been granted. The FTT can effectively deem rectification to have happened for the purposes of deciding a person’s tax appeal.

What did the tribunal decide?

The FTT followed Lobler in concluding that it did have jurisdiction to consider rectification, but also noted that it had to have a high degree of certainty about what the High Court would do.

The FTT found as a matter of fact that the parties had a clear common intention for Cooke to acquire and hold at least 5% of the ordinary share capital and that this had an outward expression in the form of the heads of terms agreement between the parties. The FTT was satisfied based on the evidence given by witnesses, in the documentation and email correspondence between the parties at the time, that all the parties intended Cooke to meet the 5% condition. They were all very much aware of the entrepreneurs’ relief consequences, including by the provision of an anti-dilution clause ensuring that his shareholding did not reduce below 5%. It was also clear that the failure to achieve the 5% arose because of rounding in a spreadsheet – the spreadsheet had rounded 4.99998% to 5% because it was set to round to two decimal places.

HMRC tried to persuade the FTT that this was not the case, arguing that the parties only ever intended that Cooke would receive “about 5%” because it wasn’t clear exactly how the transfer of shares to Cooke would have transpired if the spreadsheet had been correct. Cooke had bought his shares from two existing shareholders, so there would have to have been an additional share bought from one of those two individuals, but there was no indication of who the additional share would have been bought from. The FTT rejected these arguments in the face of overwhelming evidence of the intention of the parties.

The FTT was also satisfied that the intention of the parties continued up to the signing of the documents, and beyond, because all parties were surprised that he did not have 5% when he later sold the shares.

The FTT was therefore satisfied that the core principles for a rectification order had been met. However, it went on to consider whether there would be “only” a fiscal benefit.

Notwithstanding that there have been other cases where the tribunals have deemed rectification where that appeared to be the case, this FTT panel considered that they could not be sure that the High Court would order rectification if the only consequence was a fiscal one. However, in this case, the FTT was satisfied that other rights would also be affected by the rectification because in addition to the tax relief, Cooke would also have received slightly more consideration on the disposal of the shares and other shareholders would have received slightly less. It also considered that there had been no delay in seeking the rectification or acquiescence to the mistake and that rectification would not put another person in an unjust position.

The FTT therefore decided that the High Court would have ordered rectification. The consequence of this was that Cooke was treated as if he in fact held 5% of the ordinary share capital and was therefore entitled to entrepreneurs’ relief on the disposal.

Should clients pursue rectification separately, or rely on FTT powers?

Where a taxpayer finds themselves in a position such as Cooke, where the tax treatment of a transaction, income or gain is not as expected as a result of a mistake in an instrument, the question arises whether they should pursue a claim for rectification in the High Court or could instead rely upon the FTT using its power to consider what the High Court would have done.

It may be appealing to taxpayers to try to consolidate the question into a single tax appeal, particularly if there are other elements of the tax dispute, not least because the costs of pursuing two pieces of litigation are inevitably higher. However, taxpayers would require overwhelming evidence of the intentions to not pursue a High Court claim for rectification first.

As pointed out by the FTT, the bar for the FTT to grant this deemed rectification is arguably higher than an actual High Court claim, because the FTT has to be satisfied that the High Court would have granted it. It may also be the case that obtaining rectification in fact resolves the tax dispute without a further hearing in the tribunal.

Health warning for investors

The best outcome for a taxpayer is to avoid such a problem in the first place. Investors and their advisers should therefore be alive to the spreadsheet rounding error that gave rise to the mistake in this case. Where a proportion of shareholding is important to accessing a tax relief or giving persons certain rights in the company, advisers should be checking that the percentage is met when looking at whole shares without rounding.