Guarantee or indemnity - does the name matter?

The legal distinction between guarantees and indemnities can sometimes be hard to understand for a lawyer, let alone for someone without a legal background.

They share many similarities and it is not uncommon for indemnities to incorrectly be called guarantees and vice versa. However, a recent case, Dennis v HMRC [2018] heard by the First tier Tribunal (FTT), has highlighted some important distinctions between the two, as well as providing an example as to their practical consequences.

Three’s a crowd

In Dennis the FTT had to examine whether a payment had been made under a guarantee or an indemnity. Under a guarantee, as noted by the FTT, there will always be three relevant parties:

A guarantee is a promise where the guarantor undertakes to perform a certain task, or as is more common, to pay the creditor if and when another person (the debtor) fails to perform or pay the creditor under a primary contract. A guarantee is therefore conditional upon the existence of a primary obligation on the part of another party.

This can be contrasted with an indemnity, which, while it may relate to an obligation of a third party, is a direct promise by one party to another, and is not contingent upon the non-performance of a third party.

Co-extensiveness

Another distinguishing element to a guarantee is what the FTT described in Dennis as ‘the principle of co-extensiveness’. This refers to the fact that under a guarantee, the guarantor is only liable to the same extent the debtor is liable to the creditor.  The guarantor’s obligation under the guarantee will fall away if the primary obligation (between the debtor and creditor) ceases to exist.

In contrast, a party under an indemnity can remain liable even if the debtor is, for some reason, not liable under the primary obligation. This is because an indemnity is a stand-alone contract independent of the liability of another person; it is a promise from one party to another. With this in mind, indemnities are often viewed as a more robust form of protection for a creditor, especially as guarantees can be set aside where the primary obligation is varied in any meaningful way.

Subrogation

Dennis also pointed to another aspect of a guarantee which is absent from a contract of indemnity: subrogation. Once a guarantor has paid out fully under a guarantee, he is entitled to be indemnified by the principal debtor; these rights do not arise automatically under an indemnity. In Dennis, such rights were not possible, because the purported ‘debtor’ was a company which would be wound up before the guarantee could arise, which assisted the FTT in finding the relevant clause to be an indemnity.

Impact

Ultimately, due to the lack of co-extensiveness and a right of subrogation, the FTT found that the payment made in Dennis was one made under an indemnity, and not a guarantee. The practical consequence of this was that the guarantor was unable to make use of certain tax saving provisions, which were only applicable in the event of payments made under a guarantee.

This case demonstrates how the courts will frequently look towards the substance of a particular clause in determining whether it is, or is not, a guarantee or an indemnity – as Dennis shows, the consequences can be substantial!