Contractual terms regarding variations

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Authored by: KK Cheung

In Cobalt Data Centre 2 LLP and Cobalt Data Centre 3 LLP v The Commissioners for His Majesty’s Revenue and Customs (HMRC), England’s Court of Appeal had to consider how to interpret a contractual term regarding variations. It held that the clause in question in a JCT contract, was not wide enough to allow a change because such change amounted to a completely new project. Consequently, the Claimants were not entitled to allowances in relation to the construction of two data centres.

Background

At the relevant time, Parliament encouraged investment in the construction of industrial buildings in disadvantaged areas (enterprise zones) by permitting generous allowances against tax on construction expenses, known as enterprise zone allowances (EZAs).  The issue before the Court of Appeal was whether the two taxpayers (LLPs) were entitled to EZAs on the whole or part of sums paid by them in order to obtain rights under contracts relating to the construction of certain buildings. The buildings that were eventually constructed were two data centres (DC2 and DC3).

Upper Tribunal Ruling and appeal

The Upper Tribunal had held that that the LLPs were entitled to EZAs on some, but not all of their expenditure.  HMRC now appealed to the Court of Appeal, on the basis that the LLPs were not entitled to the EZAs.  The LLPs cross-appealed on the basis that they were entitled to EZAs on the whole of their expenditure.

Legal Framework

EZAs were a sub-set of industrial building allowances (IBAs).  The relevant legislation (Capital Allowances Act) provided that capital expenditure incurred in the construction of certain types of buildings qualified for IBAs.  Under s.298 of that Act, EZAs were only allowable if the expenditure was incurred within a 10 year time frame, namely 10 years after the site was first included in the zone.

The Contracts

On 17 February 2006, the Contractor and Developer executed a contract (referred to as the Golden Contract) which incorporated the JCT Standard Form of Building Contract with Contractor’s Design 1998 Edition (JCT Contract), with modifications.  This was one day before the enterprise zone at the site expired and formed part of the arrangements that both the Developer and Contractor hoped would ensure that EZAs could still be claimed on future construction on the site.  One significant amendment to the JCT Contract embodied in the Golden Contract was that, while the JCT Contract envisaged that the Contractor would be obliged to perform and the Employer be obliged to pay for, a single building project, the Golden Contract contained a number of different works options, each linked with a specific part of the overall site.  The LLPs were two limited liability partnerships, who in 2011, acquired an assignment of rights under the Golden Contract.   

Clause 12 of the JCT Contract, as modified by the Golden Contract, permitted the Employer to make “Changes” in the “Employer’s Requirements”.  The LLPs’ case was that the Developer had exercised its rights under Clause 12.  On 1 April 2011, the Developer’s agent issued “Change Order 2”, which required the Contractor to add to the Employer’s Requirements for Works Option 1 so as to provide the shell and core for a data centred (DC2).  The LLPs argued that this legitimately altered the scope of Works Option 1, so that instead of involving the construction of a semiconductor manufacturing facility, it would involve the construction of a data centre.  The Developer then served a Notice to Proceed, also on 1 April 2011, and the Contractor ultimately built DC2.  

On 4 April 2011, the Developer’s agent issued Change Order 3, which the LLPs again argued invoked Clause 12, altering the scope of Works Option 1 yet again, so that it involved construction of a further data centre.  The Developer then served a Notice to Proceed and the Contractor ultimately built DC3.  

Issues before the court

One of the issues before the court was whether the changes made to the contract by the two Change Orders issued by the Developer’s agent were such that they amounted in law to a new contract, which was made outside the 10 year period, meaning that any expenditure was not incurred under a contract made within the 10 year period.  HMRC argued that the effect of the Change Orders was so radical as not to amount to a variation of the Golden Contract, but rather took effect as the rescission of that contract and its substitution by a new contract as at the date of the Change Orders. Accordingly, the expenditure was not incurred under the original contract, but under a new and different contract made outside the 10 year period.  Also, they argued, the data centres constructed as a result of the Change Orders, were not any of the original Works Options.  The LLPs argued that by virtue of Clause 12, the Employer in effect had unlimited power to change its requirements.

Court’s decision

The court said that the underlying question was whether the contract under which the expenditure incurred by the Developer on the construction of a building was the same contract as that made within the 10 year period and whether that was characterised as a rescission of the old contract and its replacement by the new one, or was simply a new contract, did not matter.  The court pointed out that not only was each Work Option defined by reference to a particular type of building, but it was also site-specific.  It said that it would be extraordinary if a contract to build an industrial unit could be unilaterally changed by the employer to require the contractor to design and build a nuclear power station; still more extraordinary, if instead of requiring the industrial unit to be built in one location, the employer could require the nuclear power station to be built in another location.  There must, the court said, be some limits to the power to instruct changes under Clause 12 and the extent of a contractual power of variation must be a question of interpretation of the contract in question.

The court agreed with the editors of Hudson’s Building and Engineering Contracts (14^th Edition), paragraph 5-030, that “Whether additional or omitted work which has been ordered is of the character contemplated by the contract, and so within the conditions of the contract relating to the power to order variations, or whether on the other hand it is outside the contract, will depend in each case on the nature of the work and the terms of the contract”.  Even a widely drawn variation clause has its limits.

The court agreed with the Upper Tribunal that the Employer’s Requirements were requirements about how the particular Works Options were to be achieved.  The Golden Contract recited that that the Employer wished to obtain the design, construction and commissioning of one of the Works Options, each of which was described in detail.  Each Works Option was both building and site specific.  In addition, the Golden Contract required the Contractor to provide the design for each of the Works Options, and it was entered into on the basis that the Contractor’s proposals met the Employer’s Requirements for each of the Works Options.  It could not have been the meaning of Clause 12, the court said,  that the Employer was entitled to require a complete design which had the effect of substituting a different project.   The Court of Appeal unanimously concluded that the expenditure on the construction of DC2 and DC3 was not under the Golden Contract and accordingly, there was no entitlement to the EZAs.

Comments

The definition of variation is usually very wide in construction contracts.  A challenge by the contractor that a change order is too wide is seldom heard of.  However, as Hudson’s says, even a widely drawn variation clause has its limits.  In this case, the changes of the type of the building and its site were considered to be substituting a different project, rather than a variation authorised by the contract.

Key Contacts

Kwok Kit (KK) Cheung

Partner | Litigation and Dispute Resolution

Email or call +852 2825 9427