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The Law Commission |
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You are here: BAILII >> Databases >> The Law Commission >> Capital and Income in Trusts: Classification and Apportionment (Report)[2009] EWLC 315 (15 May 2009) URL: http://www.bailii.org/ew/other/EWLC/2009/315.html Cite as: [2009] EWLC 315 |
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The Law Commission
(LAW COM No 315) |
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CAPITAL AND
INCOME
IN TRUSTS: CLASSIFICATION
AND
APPORTIONMENT |
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Laid before Parliament by the
Lord Chancellor and Secretary of State for Justice pursuant to section
3(2) of the Law Commissions Act 1965 |
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Ordered by The House of
Commons to be printed 6 May 2009 |
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HC 426
London: The Stationery Office
£xx.xx |
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THE LAW
COMMISSION
The Law Commission was set up by
the Law Commissions Act 1965 for the purpose of promoting the reform of
the law.
The Law Commissioners are:
The Right Honourable Lord Justice
Etherton, Chairman Professor Elizabeth Cooke Mr David Hertzell
Professor Jeremy Horder Mr Kenneth Parker QC
The Chief Executive of the Law
Commission is Mr Mark Ormerod CB.
The Law Commission is located at
Steel House, 11 Tothill Street, London SW1H 9LJ.
The terms of this report were
agreed on 3 April 2009.
The text of this report is
available on the Internet at:
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THE LAW
COMMISSION
CAPITAL AND INCOME
IN TRUSTS: CLASSIFICATION AND
APPORTIONMENT
To the Right Honourable Jack Straw MP, Lord Chancellor and
Secretary of State for Justice
PART 1 INTRODUCTION
BACKGROUND
1.1 Trusts are
the invention of the English courts and have spread throughout the common
law world on account of their potential for flexible management of a wide
range of financial relationships. Their history goes back centuries, and
the modern world of finance and real property is pervaded by them to the
extent that many individuals are trustees, or are the beneficiaries of
trusts, without having the slightest idea that that is the
case.
1.2 The
different types of trust are myriad, ranging from the relatively simple
example of co-ownership of the family home, to pension funds, unit trusts
as investment vehicles, and the arrangements set up for the safeguarding
of property belonging to minors or to those suffering from mental
incapacity. As well as private trusts there are also thousands of
charitable trusts playing an important role in our society.
1.3 The trusts
that are most relevant to this project are of two kinds. First, there are
private trusts for interests in succession. One of the great flexibilities
that a trust can provide is the ability to share property and its income
over time; land, investments or other property can be held upon trust for
one person for his or her lifetime and then for another after that
person’s death. A gift of investments upon trust “for A for life, with
remainder to B”, for example, means that the investments will be held by
trustees in their own name, and that they will pay the income from those
investments to A until A dies, and then transfer the investments to B.
While A is alive we can say that the investments “belong”, in different
senses, to A, to B, and to the trustees. Secondly, there are charitable
trusts with a permanent endowment. A permanent endowment is a protected
fund which cannot freely be spent on the charity’s purposes, save in the
limited circumstances that statute allows (and in many cases only with the
agreement of the Charity Commission).
1.4 The common
feature of private trusts for interests in succession, and of charities
with permanent endowment, that is relevant to this project is that in both
cases trustees have to distinguish between capital and income in the way
they manage and distribute the trust property.
Capital and income
1.5 The terms
“capital” and “income” have a range of meanings in different contexts.
They represent useful ideas in the fields of personal financial
management, inheritance, investment returns, taxation, and the financial
structure of companies and of corporate distributions. Their general
significance is reasonably familiar
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and intuitive. We can say that
capital is to income as a tree is to its fruit; and it is easy (but
sometimes misleading) to regard a shareholding as capital and dividends as
income, or to see land as capital and the rent it generates as
income.
1.6 Economists’ definitions tend to be more
purposive, for example:
Income is the maximum amount the
individual can consume in a week and still expect to be as well off at the
end of the week as he
was at the beginning.1
1.7 In law,
the detailed significance of “capital” and “income” varies between
different contexts, and in different contexts capital and income may be
the subject of quite restrictive legal rules. The need for this project
arose from the interaction of some of those rules and their effect upon
the fairness and the efficient administration of trusts.
Classification and apportionment
1.8 The terms
of reference for this project encompass two sets of trust law rules – the
rules of classification and the rules of apportionment – which are
intrinsically linked to the distinction between capital and income in the
context of trusts.
1.9 The rules
of classification set out whether a particular receipt or expense
constitutes income or capital for trust law purposes. If the item in
question is classified as income then it is payable to whoever is entitled
to income (in the context of a life interest trust, the life tenant) and
if it is classified as capital it is held for the capital beneficiary (the
remainderman).
1.10 The rules
of apportionment are a response to the rules of classification, operating
in very limited circumstances defined, for the most part, in case law of
some antiquity. They require the sharing of certain returns and outgoings
between capital and income, and in some cases impose a duty to sell
certain trust property. Well-drafted trust instruments exclude these
rules; in most trusts where they have not been excluded (particularly
those that arise by implication) they are either ignored or cause
considerable inconvenience by requiring complex calculations of very small
sums of money.
Balance
1.11 At the
heart of this project are concepts of balance and of sharing value over
time. Trustees who hold an investment fund for A for life with remainder
to B have a duty to manage those investments in a way that balances the
interests of A and B. Similarly, the trustees of a charity need to bear in
mind the current and future charitable purposes - short-term and long-term
- of the charity when they invest their funds, and those with a permanent
endowment are subject to technical restrictions in this
respect.
1.12 Balance
pervades the policy issues examined in this Report. Ideally rules of
classification should, so far as possible, respect balance by producing
results
1 JR Hicks, Value
and Capital (1938) p 172 quoted in G Moffat, Trusts Law
(4th ed 2005) p 488.
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which do not disproportionately
favour either income or capital. The rules of apportionment were designed
to give effect to trustees’ duty to balance in particular circumstances.
It is therefore impossible to consider properly the rules of
classification and apportionment without examining the content and
application of the duty to balance.
Total return investment
1.13 The rules
of classification make it difficult for trustees to achieve a fair balance
between capital and income beneficiaries. Trustees with funds to invest
will choose (or instruct others to choose) a range of investments that
will provide a return that does not disproportionately favour either
income or capital. They will do so with a view to the likely form of the
return. However, as we go on to explain in Part 2, the rules of
classification do not always meet trustees’ expectations; having selected
a portfolio designed to produce balance, trustees may find that it has
generated an unbalanced return; and they have no power to adjust the
classification of investment receipts. In a private trust for interests in
succession this may mean that an investment receipt goes to the income
beneficiary when it should more appropriately go to capital, or vice
versa. In a charitable trust, a receipt may be classified as income,
and so have to be spent, when it would be more appropriate to retain it to
conserve the value of the trust fund.
1.14 The lack
of a power to go beyond the classification rules generates a further
problem, highlighted in the Parliamentary debates on the Trustee Bill in
2000: it prevents trustees from maximising their investment returns
(within acceptable parameters of risk); in other words, from investing as
profitably as they might otherwise do.
1.15 The
Trustee Act 2000 made fundamental changes to the rules of investment for
trustees. It repealed the Trustee Investment Act 1961, which had imposed
severe restrictions upon the types of investment open to trustees. By
authorising the majority of investments, the Trustee Act 2000 opened the
way to a much wider choice of investments for trustees of both private and
charitable trusts.
1.16 Concerns
were expressed in 2000 during the course of the Parliamentary debates on
the Trustee Bill about the Bill’s failure to go further in removing the
restraints upon trustees in their choice of investments. Comments were
directed at the position of trustees of charitable trusts who are
constrained by the rules that restrict their ability to deal with their
permanent endowment. The solution, it was suggested, might be the adoption
of total return investment policies. The point is equally relevant to the
trustees of private trusts for interests in succession who are required to
select investments with a view to the form of returns (in terms of capital
or income), rather than the value of returns, so as to produce a portfolio
that balances returns to the capital and income beneficiary.
1.17 Total
return investment enables the selection of investments on the basis of the
value of the returns they are expected to yield, without regard to the
expected classification of those returns as capital or income. When total
return investment is operated by trustees for interests in succession, the
global investment return is allocated by the trustees to the income and
capital beneficiaries according to what they might expect to enjoy in the
light of their respective interests in the fund. This model for trustee
investment is being operated by some charities and is facilitated by
statute in the US. In England and Wales, private trusts for
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interests in succession which
have, for tax purposes, an interest in possession are not generally
drafted so as to empower trustees to operate total return investment, for
reasons that we explain in Part 3.2
THE LAW COMMISSION
PROJECT
1.18 The Lord
Chancellor undertook during debates on the Trustee Bill in 2000 to refer
the issues outlined above to the Law Commission for consideration. The
terms of the formal reference asked us to examine:
(1) the
circumstances in which trustees may or must make apportionments between
the income and capital of the trust fund;
(2) the
rights and duties of charity trustees in relation to investment returns on
a charity’s permanent endowment;
(3) the
circumstances in which trustees must convert and re-invest trust property;
and
(4) the
rules which determine whether money or other property received by trustees
is to be treated as income or capital.
1.19 The Law
Commission commenced work on the project in 2003 following publication of
a consultation paper on another trusts project also referred by the Lord
Chancellor during the passage of the Trustee Bill.3 We
published a Consultation Paper (“the CP”) in 2004, and the Commissioner
then responsible for the project, Stuart Bridge, presented the
consultation issues at a public seminar at the Institute of Advanced Legal
Studies. The CP elicited 42 responses from a wide variety of groups and
individuals,4 all of whom gave thoughtful and detailed
responses which have influenced and assisted our thinking.
1.20
Completion of the project was deferred pending publication of our
Report on Trustee Exemption Clauses5 and then as a result of
the reference to the Commission of a project on cohabitation, which was to
be completed – at Government’s request – within the two-year period from
2005 to 2007. Work on this project re-commenced in January 2008. We then
held a number of meetings with an expert Advisory Group,6
discussions with Her Majesty’s Revenue and Customs (“HMRC”) and with HM
Treasury on the taxation aspects of the project, and meetings with
representatives of the Charity Commission and the Charity Law
Association.
1.21 We are
publishing, alongside this Report, two further documents. First, an
analysis of the responses to the 2004 consultation is available on our
website at www.lawcom.gov.uk/citcat.htm.
It provides a more detailed coverage of the
2 See paras 3.23 to 3.29
below.
3 Trustee
Exemption Clauses (2003) Law Commission Consultation Paper No 171; Trustee
Exemption Clauses (2006) Law Com No 301.
4 A list of respondents to the CP is
set out in Appendix C.
5 (2006) Law Com No 301.
6 The
names of the members of the group, and the organisations represented, are
set out in Appendix B. |
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substance of responses than is
practicable within this Report, and reflects the learning and experience
that consultees contributed to our project. Second, we have prepared a
formal Impact Assessment, again available on our website, which sets out
our proposals, and a discussion of the costs and benefits of their
implementation.
ISSUES AND RECOMENDATIONS
1.22 The CP
provisionally proposed, for private trusts, a scheme of simplified
classification rules supplemented by a new trustee power of allocation.
That power would provide the flexibility to mitigate any failings of the
classification rules and would give those trustees of private trusts who
wished to invest on a total return basis the opportunity to do so. The
current rules of apportionment had no place in the proposed scheme and
would be abolished. For charities, the CP discussed the rules surrounding
permanent endowment and discussed ways of making more widely available the
scheme for total return investment that was, by the date of the CP,
offered by the Charity Commission.
1.23 We are
not now recommending the legislative implementation of the CP's scheme for
private trusts. We have reached that conclusion in the light of the tax
consequences of that scheme for trusts, as we explain in more detail in
Part 5. Accordingly, we are not able formally to recommend to Government
the reforms that we believe would be appropriate for private trust law.
HMRC and HM Treasury have stated that they have no policy objection to any
of the reforms that we would like to make for private trusts; rather, they
have explained the tax consequences that must follow from them. They
stress that Government policy on tax fairness is that trusts should not be
used as a means for trusts to gain a tax advantage over other individuals,
and that Government policy and decisions about changes to the tax regime
have to take this into consideration.
1.24 We
therefore set out a limited range of formal recommendations to Government
for immediate reform, while also explaining our view of how trust law
should develop in this area. We are also able to make recommendations with
respect to total return investment for charities.
1.25 The
Report discusses, in Part 2, the rules governing the classification of
investment receipts, and in Part 3 the linked issue of the facilitation of
total return investment for private trusts. We go on to outline in Part 4
the provisional proposals of the CP on these issues and the reactions of
consultees. In Part 5 we outline the recommendations we would have liked
to make to offer improved classification rules for all trustees and to
facilitate total return investment for those trusts for which total return
investment would be attractive. We explain why we are not able to
recommend those reforms. We recommend just one change to the
classification rules, in the tax-neutral context of corporate demergers,
an area generally considered to be particularly problematic.7
We recommend a limited discretion to supplement that classification
change.8 In addition, we argue that it would be possible to
devise a percentage trust model for those who wished to operate total
return investment without prejudicing tax revenue and potentially
guaranteeing a more stable and predictable return for the Exchequer. Part
5
7 Draft Bill, cl 2.
8 Draft Bill, cl 3.
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closes with a recommendation that
HMRC and HM Treasury work with the trust industry to devise a format for
total return investment that would meet the economic priorities of all
those involved.
1.26 In Part 6
we discuss the rules of apportionment, and the circumstances where
trustees are currently placed under a duty to sell certain investments. We
recommend the prospective abolition of those unpopular rules.9
These recommendations do not have tax consequences and represent a
straightforward simplification of the law of trusts.
1.27 In Part 7
we discuss the treatment of trust expenses. We describe two important
developments that have taken place since the CP: publication by HMRC of
guidance on trust management expenses and judicial consideration of the
proper treatment of trust expenses in Revenue and Customs Commissioners
v Trustees of the Peter Clay Discretionary Trust. We confirm the CP’s
provisional conclusion that the law regarding the classification of trust
expenses should remain unchanged and that it should not be placed on a
statutory footing. Consequently, we make no recommendations for reform in
this area.
1.28 Finally,
in Part 8 we discuss the issue of investment by the trustees of charitable
trusts. An important development since the CP has been the enactment of
the Charities Act 2006, which addresses and resolves a number of concerns
about the rules relating to permanent endowment. Moreover, charity
trustees have for some years now been able to operate total return
investment by following the scheme devised by the Charity Commission
pursuant to its powers under section 26 of the Charities Act 1993. We make
a recommendation that will make total return investment more easily
accessible to charity trustees.10 We also recommend that the
Charity Commission conducts a further consultation exercise about the
provisions of its total return investment scheme, in the light of concerns
expressed to us by a number of consultees about its details and the
restrictions it imposes.
HUMAN RIGHTS IMPLICATIONS
1.29 We are
confident that our recommendations have no adverse human rights
implications. Our recommendation for a change in the classification of
shares distributed to trustees on a demerger effects a change in the
entitlement to shares distributed on a demerger. No beneficiary under a
trust for interests in succession had any vested right to that
distribution; only to income and capital as defined in law. Moreover, the
change in classification will make the law reflect more accurately the
meaning of capital and income within a trust. As to the rules of
apportionment, our recommendations can have no human rights implications
since they affect only trusts created after the implementation of our
recommendations; settlors who want the rules of apportionment to operate
will make express provision to that effect. Finally, as to charities, our
recommendations extend the existing powers of the Charity Commission to
authorise total return investment and the expenditure of permanent
endowment; they have no effect upon property rights.
9 Draft Bill,
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LOOKING AHEAD
1.30 What of
the future? In the short term, we look forward to the implementation of
the draft Bill, which we regard as uncontroversial. Although limited in
scope, its provisions address serious problems with the current law –
problems which were central to the reference of this project to the Law
Commission. The Bill will facilitate investment in the charitable sector,
leading more trustees to invest without the constraints imposed by the
rules relating to permanent endowment. As to private trusts, the
provisions of the Bill will simplify the operation of private trusts by
sweeping away the outdated rules of apportionment and removing some of the
most marked and notorious anomalies arising from the classification
rules.
1.31 We look
to Government in the longer term to consider how best to implement the
recommendations we would have liked to make for the more effective and
flexible facilitation of total return investment and for the revision of
the classification rules for investment returns.
1.32 In an era
where investment returns as well as business operations are threatened by
economic downturn, it is increasingly unhelpful to have artificial
constraints upon investment, and the removal of those constraints will
have positive financial consequences for trusts and, given higher taxable
average returns, for the national economy.
1.33 To that
end, we think that the next step should be the acceptance of our
recommendation at paragraph 5.104, that HMRC and HM Treasury work with the
trust industry to devise a suitable vehicle for total return investment by
private trusts, so as to facilitate investment without prejudicing tax
revenue.
1.34 There has
been much discussion of the negative impact on trusts of the changes to
trust taxation introduced by the Finance Act 2006.Taxation is also a key
issue in this project, and adverse tax consequences have prevented us from
making a number of recommendations for trust law reform that we would
otherwise have made. The Law Commission does not make recommendations
about fiscal policy. We have held discussions with HMRC to explore the
options available within current taxation law, and to ascertain whether
there is any prospect of amendment of tax law to enable trust law reform.
HMRC has worked with us to determine what is achievable but has given a
clear message that it is not realistic to look for the changes to tax law
that would be necessary to allow the type of trust law reform we would
like to see. HMRC's position is that there will be tax advantages and
disadvantages with any investment policy, and that while Government is
happy to be advised of issues in the current system it cannot necessarily
be expected to alter pre-existing tax policy merely because a particular
type of trust does not fit particularly well within the tax
regime.
1.35 We see no
purpose in making recommendations that cannot benefit the trust industry
without changes in tax legislation which cannot be regarded as achievable.
We have therefore been able to work only within the constraints of current
trusts tax policy.
1.36 However,
while we restrict our formal recommendations to Government to those that
are currently able to operate in a tax-neutral manner, we wish to stress
the vital significance of competitive modern trust law to the individuals
and companies who are either the settlors or beneficiaries of trusts or
who provide
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trust services.11 The
importance of trusts was recognised by the then Lord Chancellor, Lord
Falconer of Thoroton, when speaking in the House of Lords in July 2006 at
the launch of the Law Commission’s Report on Trustee Exemption Clauses.
Lord Falconer said:
… the trust is one of the
greatest creations of English law and trust business is a very important
part of the UK's professional service industry. Trust law is a
multi-faceted industry dealing with varied subject matter in charitable,
pensions, commercial and family contexts. I believe that it is vital that
the UK trust industry continues to innovate, and that it retains the
flexibility that so often provides it with a competitive
advantage.12
1.37 These
sentiments are of direct relevance to this project. Lord Falconer referred
to the need for flexibility in the trust industry, flexibility which lies
at the heart of trusts themselves as the creation of the courts of equity.
We appreciate that such flexibility presents difficult challenges to those
responsible for combating the tax avoidance that can be associated with
the use of trusts. But trusts are not simply tax avoidance
vehicles.13 Government rightly wishes to ensure that trusts
bear an appropriate tax burden, but at the same time it seeks to encourage
the trust industry to innovate so as to promote efficiency and
competitiveness. We invite Government to accept and implement the
tax-neutral recommendations which we now make. We encourage Government to
accommodate, within the reasonable and proportionate constraints of fiscal
policy, our other conclusions as to how the law in this area should more
fairly and effectively develop.
ACNOWLEDGEMENTS
1.38 Law
Commission reports are always the outcome of a collaborative process, and
we have had a tremendous amount of help throughout the lifetime of this
long-running project. Special thanks are due to the members of our
Advisory Group, listed at Appendix B to this Report, with whom we have
held extremely constructive discussions. We are particularly grateful to
Rupert Allen, Murray Hallam, Simon Jennings, Christopher McCall QC, Edward
Nugee QC, Francesca Quint, Nigel Reid, Paul Saunders, Geoffrey Sultoon,
Arthur Weir and John Wood. We are also grateful for the assistance of the
Trust Law Committee throughout this project. We would like to thank those
within Government who have engaged with us, in particular James Dutton of
the Charity Commission and officials at HMRC and at HM Treasury. Finally,
we extend our warmest thanks to all who responded to the CP, listed at
Appendix C. |
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11 Trustees and trust
administrators, lawyers, accountants and investment managers. For an
analysis of the competitive importance of the trust in the UK financial
markets see The Hayton Report: Trusts and their Commercial Counterparts
in Continental Europe: a Report for The Association of Corporate Trustees
(January 2002) and the companion volume prepared by Europe Economics,
Economic and Financial Analysis of Commercial and Private Trusts in the
United Kingdom (January 2002), both available at http://www.trustees.org.uk/.
13 HM Revenue and Customs,
Research Report 25 - Research on Trusts: Experience of Setting Up and
Running Trusts (2006). |
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WORK DONE BY OTHER BODIES
1.39 We are
also indebted to the various bodies who have carried out prior work in
this area and whose thinking influenced our own. In particular there have
been a number of previous recommendations for reform in this jurisdiction
and in Scotland:
(1) The
Law Reform Committee 1982 Report on the Powers and Duties of
Trustees:14 this considered the equitable and statutory rules
of apportionment, recommending that the equitable rules should be replaced
by a general discretionary power for trustees to adjust the capital and
income accounts of the trust and that the statutory rule should be amended
so that in relation to wills and settlements income is treated as
belonging exclusively to the income beneficiary on the date when it
becomes due.
(2) The
Trust Law Committee 1999 Consultation Paper on Capital and Income of
Trusts:15 this considered both the rules for classification of
investment returns and the equitable and statutory rules of apportionment,
proposing that the existing rules of classification should remain, that
the equitable rules of apportionment should be abolished and that there
should be a discretion for the trustees to reallocate income to capital
and vice versa.16
(3) The
Scottish Law Commission 2003 Discussion Paper on the Apportionment of
Trust Receipts and Outgoings:17 this covered both issues of
classification and apportionment, proposing that the existing technical
rules of apportionment should be abolished and replaced with a general
discretionary power for trustees to decide on the allocation and
apportionment of receipts and outgoings between income and capital, and a
new power not to apportion periodical payments on a time basis when
otherwise required to do so under the Apportionment Act 1870.
1.40 As will
be seen, the conclusions of these law reform bodies and others world-wide,
most notably The National Conference of Commissioners on Uniform State
Laws in the US, provided a platform for some of the provisional proposals
in the CP and for our conclusions in Part 5 of this
Report. |
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14 The Powers and Duties of Trustees
(1982) 23rd Report of the Law Reform Committee, Cmnd
8733.
15 Capital and Income of Trusts
(1999) Trust Law Committee Consultation Paper.
16 We comment on the Trust Law
Committee’s revised position in the light of its consultation at para 5.87
and following below.
17 Apportionment of Trust Receipts
and Outgoings (2003) Scottish Law Com Discussion Paper No
124. |
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PART 2
THE CLASSIFICATION OF TRUST
RECEIPTS –
THE
CURRENT LAW AND ITS PROBLEMS
INTRODUCTION
2.1 The
project’s terms of reference require the Law Commission to examine “the
rules which determine whether money or other property received by the
trustees is to be treated as income or capital”. These rules relate to the
classification of returns from investments; those investments might be
corporate, such as shares in a company, or non-corporate, for example
land. In all cases the question arises: if the investor receives something
from the property, is that receipt to form part of the investor’s capital,
or is it income? For individual investors the issue may not be
particularly important, but for trustee investors it is crucial. If the
trust is a private trust for interests in succession, different
beneficiaries are interested in capital and income. If the trust is a
charity with permanent endowment, the trustees are subject to strict
requirements as to the expenditure of income and the retention of
capital.
2.2 Trustees
can hold a vast range of assets, each potentially giving rise to a variety
of receipts. English trust law’s classification of such receipts is
rule-based. We said in the CP that “in most circumstances, the
classification is straightforward and accords with common
sense”1 presenting the metaphor, often drawn on by the courts,
of a tree and its fruit: property which can be characterised as the “tree”
is usually classified as capital, whereas the “fruit” produced by the tree
is treated as income.
2.3 The
classification of receipts is not, however, always so
straightforward.2 In this Part we discuss the trust law rules
of classification, with particular reference to corporate receipts, by
which we mean receipts by trustee shareholders from corporate entities.
Corporate receipts cause the most acute difficulties for trustees because
their classification depends upon company law concepts of capital and
income, which are rather different from trust law concepts. This gives
rise to counter-intuitive and inconvenient results in some cases,
particularly corporate demergers, of which our terms of reference make
special mention.3
CORPORATE RECEIPTS
2.4 The
classification of corporate receipts was the primary focus of the CP. This
reflects the importance of such receipts to trustees and the extent of
perceived problems with the current law.
The rule in Bouch v Sproule
2.5 In English
law, the general rule that has developed for the classification of a
receipt by a trustee shareholder from a company is commonly referred to as
“the
1 CP, para 2.1.
2 And see
the discussion of the tree/fruit analogy by Dyson LJ in Commissioners
of Inland Revenue v John Lewis Properties plc [2002] EWCA Civ 1869,
[2003] Ch 513 at [89].
3 Eighth Programme of Law Reform
(2001) Law Com No 174, p 20.
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rule in Bouch v Sproule”.
Bouch v Sproule provides House of Lords authority,4 but
the classic exposition of the rule is found in Lord Justice Fry’s judgment
in that case in the Court of Appeal:
When a testator or settlor
directs or permits the subject of his disposition to remain as stocks or
shares in a company which has the power either of distributing its profits
as dividend, or of converting them into capital, and the company validly
exercises this power, such exercise of its power is binding on all persons
interested under him, the testator or settlor, in the shares, and
consequently what is paid by the company as dividend goes to the tenant
for life, and what is paid by the company to the shareholder as capital,
or appropriated as an increase of the capital stock in the concern, enures
to the benefit of all who are interested in
capital.5
2.6 The
fundamental principle established in Bouch v Sproule is therefore
that a receipt by a trustee shareholder from a company is classified for
trust law purposes in accordance with the company law analysis of the
payment. A corporate receipt will therefore only constitute capital for
trust purposes if it represents capital in company law terms.
2.7 A company
will normally distribute profits by way of a dividend. This will result in
a decrease in the value of the company’s assets, since cash has been paid
out; but the shareholders will instead hold cash in hand. Although the
market value of the share will fluctuate before and after payment of a
dividend, overall a healthy regular dividend return enhances the market
value of shares.6 This type of distribution is classified as
income under the rule in Bouch v Sproule.
2.8 Capital
distributions are less usual and require a little more explanation. The
concept of “capital” underpins corporate limited liability and therefore
is central to modern company law.7 The Companies Act 2006
amended the rules concerning corporate capital, and abolished the concept
of authorised capital.8 Nevertheless, English company law
retains detailed obligations and restrictions relating to capital.
Companies must provide an initial statement of capital, there are
restrictions on the reduction of capital, and public companies are subject
to
4 (1887) LR 12 App Cas
385.
5 (1885)
LR 29 Ch D 635, 653. This passage was quoted with approval by Lord
Herschell in the decision of the House of Lords (1887) 12 App Cas 385,
397-398.
6 The
price of shares rises to a “cum dividend” value before the payment is
made, and falls to an “ex dividend” value thereafter. Exceptionally, an
abnormally large dividend may involve the payment out of value
representing a large proportion of the company’s underlying assets, and
the market value of shares is likely to fall as a result of such a
distribution: see para 2.20 below.
7 For a
discussion of the emergence of the company law concept of capital and
limited liability as we now understand it, see P Ireland, “Capitalism
Without the Capital: the Joint Stock Company Share and the Emergence of
the Modern Doctrine of Separate Corporate Personality” (1996) 17
Journal of Legal History 41 and “Company Law and the Myth of
Shareholder Ownership” (1999) 62 Modern Law Review 32. See further
S Worthington, “Shares and Shareholders: Property, Power and Entitlement”
(2001) 22 Company Lawyer 258 (Part 1) and 307 (Part
2).
8 The
provisions relating to company formation are due to come into force on 1
October 2009: Companies Act 2006 (Commencement No. 8, Transitional
Provisions and Savings) Order 2008/2860, art 3.
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minimum capital requirements.
2.9 In company law terms, a
company’s capital is “the value of the assets contributed to the company
by those who subscribe for its shares”.9 This is initially the
amount subscribed by the company’s original shareholders (say, £100 for
one hundred £1 shares). A company’s legal capital is only increased if
further shares are issued. A company whose initial share capital was £100
may decide later to issue further shares, but if the value of the original
shares has risen it may do so at a premium, requiring a subscription of,
say, £5 for each £1 share; the excess over the par value of the shares is
known as share premium, and must be paid into the company’s share premium
account.10 While the share premium account is generally
regarded as part of the company’s paid-up share capital, it differs from
share capital (that is, the paid-up subscription at par value) principally
in that it can be used to pay up bonus shares.11
2.10 The
capital value of the company, in company law terms as just described, is
not the same as its market value, which comprises the company’s total
worth, taking into account all its assets – cash, land, intellectual
property, goodwill, debts and so on.
2.11 It is
open to company directors who wish to return value to shareholders in the
form of capital to do so by means of a capitalisation. This will occur
when the company’s reserves are used to issue paid-up shares to existing
shareholders. This procedure is known variously (and often confusingly) as
a “bonus”, “capitalisation”, “scrip” or “stock” issue or dividend. Value
may then be returned to shareholders by the company redeeming,
repurchasing or cancelling the shares issued by way of
capitalisation.12 Some schemes are structured so as to enable
shareholders to choose whether to receive income or
capital.13
2.12 The
company law analysis of a corporate payment is therefore dependent on the
mechanism employed by the company in making it. This is controlled by the
directors whose choice will be governed by a range of commercial
considerations. The essence of the rule in Bouch v Sproule is that
the entitlement of the life tenant or the beneficiary in remainder flows
from the decision of the company.
Restatement in Hill v Permanent Trustee Company of New
South Wales
2.13 Although
Lord Justice Fry’s statement of the rule in Bouch v Sproule appears
clear, elements of company law prevailing at the time of the case
introduced a degree of ambiguity to the rule. Argument in Bouch v
Sproule revolved around the proper classification of partly paid up
bonus shares of a value equivalent to profits that had been transferred to
reserve. The analysis was complicated by the
9 P
Davies, Gower and Davies’ Principles of Modern Company Law
(7th ed 2003), p 225. In rare circumstances a capital
contribution can be made otherwise than in return for shares: Kellar v
Williams [2000] 2 BCLC 390.
10 Companies Act 2006, s
610.
11 Companies Act 1985, s 130(2). See
now Companies Act 2006, s 610(3).
12 For example, by way of “B Share”
schemes.
13 N Adams, P Whitelock and D
Stuttaford, “Returning Cash to Shareholders” [2005] Practical Law
Company 29. |
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mechanism by which this was
achieved. The company declared a dividend and a new issue of shares,
giving the shareholders the option of taking the dividend in the form of
cash or shares. This route was taken because of the company law rule at
the time that a company might not use its own funds to pay up its shares.
Consequently, a company could only capitalise its profits by first
declaring a dividend and then using that dividend to pay up the bonus
shares. As the form of the transaction was inconclusive as to the nature
of the receipt, the court had to look to the intention of the
company.
2.14 The Court
of Appeal and the House of Lords reached different conclusions on the
facts as a result of divergent judicial interpretations of the mechanism
by which the bonus shares were distributed. The Court of Appeal considered
that this procedure did not disclose a clear intention to capitalise the
profits. Although no rational shareholder would choose to receive the
dividend in the form of cash, there was in principle an option to do so.
The House of Lords disagreed, concluding that this option was merely
illusory and that a sufficient intention to capitalise had been
manifested.
2.15 The
detailed reasoning in Bouch v Sproule was closely linked to the
facts under consideration, and in particular to the ambiguity of the
company’s actions in the light of prevailing company law. It is therefore
helpful that the principle established in Bouch v Sproule was
restated (and expanded upon) by the Privy Council in Hill v Permanent
Trustee Company of New South Wales.14 Lord Russell first
explained the basic company law principle:
A limited company not in
liquidation can make no payment by way of return of capital to its
shareholders except as a step in an authorised reduction of capital. Any
other payment made by it by means of which it parts with money to its
shareholders must and can only be made by way of dividing profits. Whether
the payment is called “dividend” or “bonus”, or by any other name, it
still must remain a payment on division of profits.
2.16 That is not the case where shares are
issued following a capitalisation:
Other considerations arise when a
limited company with power to increase its capital and possessing a fund
of undivided profits so deals with it that no part of it leaves the
possession of the company, but the whole is applied in paying up new
shares which are issued and allotted proportionately to the shareholders,
who would have been entitled to receive the fund had it been, in fact,
divided and paid away as dividend.
2.17 Lord
Russell went on to analyse the trust law consequences of both types of
corporate action. Payments made to trustee-shareholders by way of a
distribution of profits:
… prima facie belong to the
person beneficially entitled to the income of the trust estate. If such
moneys or any part thereof are to be treated as part of the corpus of the
trust estate there must be some
14 [1930] AC 720 (PC). See CP, paras 2.14 to
2.17. |
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provision in the trust deed which
brings about that result. No statement by the company or its officers that
moneys which are being paid away to shareholders out of profits are
capital, or are to be treated as capital, can have any effect upon the
rights of the beneficiaries under a trust instrument which comprises
shares in the company.
2.18 This was contrasted with the issue of
shares following a capitalisation:
The result of such a dealing is
obviously wholly different from the result of paying away the profits to
the shareholders. In the latter case the amount of cash distributed
disappears on both sides of the company’s balance sheet. It is lost to the
company. The fund of undistributed profits which has been divided ceases
to figure among the company’s liabilities; the cash necessary to provide
the dividend is raised and paid away, the company’s assets being reduced
by that amount. In the former case the assets of the company remain
undiminished, but on the liabilities’ side of the balance sheet (although
the total number remains unchanged) the item representing undivided
profits disappears, its place being taken by a corresponding increase of
liability in respect of issued share capital. In other words, moneys which
had been capable of division by the company as profits among its
shareholders have ceased for all time to be so divisible, and can never be
paid to the shareholders except upon a reduction of capital or in a
winding up. The fully paid shares representing them and received by the
trustees are therefore received by them as corpus and not as
income.15
2.19 This
authoritative restatement builds on, and clarifies, the decision in
Bouch v Sproule. It refocuses discussion away from the intention of
the company, made necessary in Bouch v Sproule by the inherent
ambiguity of the mechanics employed by the company in that case, and back
onto the proper objective analysis of the corporate action.16
The Hill approach was itself restated with approval by Lord Reid in
Rae (HM Inspector of Taxes) v Lazard Investment Co
Ltd:
There is no doubt that every
distribution of money or money’s worth by an English company must be
treated as income in the hands of the shareholders unless it is either a
distribution in a liquidation, a repayment in respect of reduction of
capital (or a payment out of a special premium account) or an issue of
bonus shares (or it may be
bonus debentures).17
2.20 The CP referred to a number of other
leading cases in this area which confirm
15 [1930] AC 720 (PC), 731 to
732.
16 See also Re Bates [1928]
Ch 682 (Eve J) in which a cash payment to shareholders was held to be
income for trust law purposes on the basis that it was made out of profits
which had not been capitalised, even though it was accompanied by a
circular explaining that the payments were made out of capital and were
“neither a dividend nor a bonus, but … a capital distribution and
therefore not liable to income tax”.
17 [1963] 1 WLR 555,
565. |
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that where the law classifies a
distribution of profits as income, that classification applies no matter
what the source or extent of the distribution.18 In particular,
it discussed Re Sechiari19 in which a “capital profits
dividend”20 caused the market value of the shares held by the
trust, and therefore the value of the trust capital, to fall by over 75
per cent. The distribution was nevertheless held to be income for trust
law purposes.
2.21 The rule
in Bouch v Sproule is displaced by any express provision to the
contrary in the trust instrument. The CP outlined a number of judicially
recognised narrow exceptions to the rule.21 These are: when the
life tenant assented to the purchase of the original shares as a capital
investment in the knowledge that the investment was motivated by the
contemplated distribution; when a distribution is made after the
testator’s death but relates to a transaction completed before the
testator’s death; and when a company purports to accumulate profits as
capital although it has no power to increase its capital.
2.22 The CP
described a series of cases which considered the extent of judicial
discretion to apportion, and noted that the decision in Re Maclaren’s
Settlement Trusts22 appeared to support a relatively broad
power. However, subsequent case law has narrowed the extent of the
discretion, such that it is now considered available only in “special
circumstances” involving a breach of trust.23
Application of the rule to
particular forms of distribution Scrip dividends
CONVENTIONAL
2.23 A scrip
dividend is a dividend which offers shareholders the choice of being paid
in the form of cash or shares. In a conventional scrip dividend, the
shareholder is given the option to receive a cash dividend or bonus shares
of equal value to the cash dividend. Where the shareholder is a trustee,
the receipt will almost always be treated as income whichever option is
chosen.24 |
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18 It applies no matter what is
distributed: a number of American cases concern distributions of
coal.
19 [1950] 1 All ER
417.
20 It was so described by the
directors; it consisted of British Transport Commission stock, received by
the company in exchange for its road transport and haulage undertakings
which it was obliged to sell as a result of
nationalisation.
21 CP, para
2.18.
22 [1951] 2 All ER 414 (Harman
J).
23 Re Rudd’s Will Trusts
[1952] 1 All ER 254, 261 (Upjohn J, quoting Vaisey J in Re
Kleinwort’s Settlement Trusts [1951] 2 All ER
328).
24 CP, para 2.33. This treatment
appears to be widely accepted whether the option to take cash or shares is
given before or after the dividend has been declared: D Hayton,
Underhill and Hayton: Law of Trusts and Trustees (16th
ed, 2003), pp 539 to 540 and J Mowbray QC et al (eds), Lewin on Trusts
(18th ed, 2008), para 25-28. HMRC considers scrip dividends
to be received as income in trust law and are therefore within the income
tax provisions for stock dividends: s 249 of the Income and Corporation
Taxes Act 1988 and s 409 of the Income Tax (Trading and Other Income) Act
2005. |
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ENHANCED
2.24 In the
case of enhanced scrip dividends, where the bonus shares are worth more
than the cash alternative, the situation is more fluid. If the trustee
opts to take the cash dividend, the cash receipt will be classified as
income under the rule in Bouch v Sproule. However, the trustee will
usually opt to take the more valuable bonus shares. In this case, the
classification of the bonus shares will depend on whether the company
intended to capitalise its profits or intended to make a distribution. In
the majority of cases, especially where (as is common practice) the
company arranges for a third party to offer to purchase the new shares at
market value to enable shareholders to realise their cash value
immediately, the substance of the arrangement will be such that the shares
will be received as income.
2.25 However,
where the bonus shares are received as capital, it has in some cases been
held that the income beneficiary is entitled to a lien over the amount of
the cash dividend foregone; in effect, an apportionment of the receipt
between income and capital.25 HMRC’s position, set out in
Statement of Practice 4/94, is that it currently follows the trustees’
decision as to the classification of enhanced scrip dividends for tax
purposes, provided that their conclusion is supportable on the facts of
their particular case.
Demergers
2.26 As noted
in the introduction to this Part, this project’s terms of reference draw
attention to the problematic classification of demergers, making specific
mention of the case of Sinclair v Lee.
GENERAL PRINCIPLES
2.27 A
demerger involves the transfer by a company (“Company A”) of part of its
business to a new company (“Company B”), with the shareholders of the
demerged company receiving shares in the new company by way of a
declaration of dividend.
2.28 In a
“direct” demerger, the dividend is satisfied by Company A transferring the
entire share capital of Company B to its own shareholders. In an
“indirect” demerger, a further step is interposed; Company A transfers all
its shares in Company B to a separate holding company (“Company C”) and,
in consideration for this transfer, Company C satisfies Company A’s
dividend by issuing its own shares to the shareholders of Company
A.
2.29 In the
case of a direct demerger, the shares received by shareholders are
classified strictly in accordance with the rule in Bouch v Sproule.
Shares held by Company A in Company B do not form part of a Company A’s
legal capital; consequently a distribution of such shares by way of
dividend (in effect an in specie dividend) will be received as
income by a trustee-shareholder. That is the case even though the economic
value of the shares in Company A will decrease significantly as a result
of the transfer of the business to Company B, in turn reducing the capital
beneficiaries’ interest and in effect enforcing a distribution to the
income beneficiary.
25 CP, paras 2.35 to 2.36. See Rowley v
Unwin (1855) 2 K & J 138; Re Tindal (Deceased) (1892) 9 TLR 24; In Re Malam [1894] 3 Ch 578.
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SINCLAIR V LEE
2.30 This
position was revisited in relation to indirect demergers by the Chancery
Division of the High Court in Sinclair v Lee.26 In that
case, ICI plc wanted to hive off some of its business to Zeneca Ltd, which
was to be a subsidiary of the Zeneca Group plc. The demerger took the
following structure. First, Zeneca Ltd was formed as a wholly owned
subsidiary of ICI plc. ICI plc then transferred its shares in Zeneca Ltd
to Zeneca Group plc. In consideration for the transfer of Zeneca Ltd
shares, Zeneca Group plc transferred a proportionate amount of Zeneca
Group plc shares to ICI plc. ICI plc in turn declared a dividend to its
shareholders, which it satisfied by the transfer of the Zeneca Group plc
shares.
2.31 There
were two reasons why the ICI plc shareholders were to receive the Zeneca
Group plc shares. The first was to ensure that the directors of ICI plc
obtained approval for the demerger. The second was to ensure that the ICI
plc shareholders did not lose the commercial value of their current
shareholding. However, for trustee-shareholders this caused a problem as,
under the rule in Bouch v Sproule, the shares would be received as
income. The question for the court was how the rule applied in a case of
an indirect demerger.
2.32 Sir
Donald Nicholls V-C held that the shares were received as capital, saying
that this was his “instinctive reaction”, and noting that this result
would accord with the economic realities of the situation since after the
demerger the combined values of the ICI and Zeneca shares would be
approximately equal to the pre-demerger value of the ICI shares. He
said:
I venture to think that no one,
unversed in the arcane mysteries I shall be mentioning shortly, would have
any doubt over the answer to these questions. The ICI shares form part of
the capital of the fund. For the future the ICI undertaking will be
divided up, with one part belonging to ICI and the other to Zeneca Group.
To compensate for this loss of part of the ICI undertaking, the ICI
shareholders will be receiving a corresponding number of shares in Zeneca
Group. No one would imagine that the Zeneca Group shares could sensibly be
regarded as income.27
2.33 He
conceded that the line of cases developing the rule in Bouch v
Sproule28 would appear to suggest that the Zeneca shares
should be treated as income; he noted that none of them dealt with the
precise situation of an indirect demerger, and therefore felt able to
distinguish Bouch v Sproule.
2.34 However,
that helpful decision has given rise to an unprincipled distinction
between direct and indirect demergers. The formalistic ground for
distinction adopted by the Vice-Chancellor enabled him to avoid what he
considered to be an “absurd” result, but did not affect the equally absurd
result that arises from direct demergers.
26 [1993] Ch 497 (Sir Donald
Nicholls VC). In the following paragraphs we refer to Lord Nicholls of
Birkenhead using the title he held at the time of Sinclair v
Lee.
27 Above, 504.
28 Above, 505. The line of cases
referred to includes Hill v Permanent Trustee Company of New South
Wales [1930] AC 720 (PC) and Re Doughty [1947] Ch 263
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CRITICISMS OF THE CURRENT LAW
2.35 A range
of criticisms can be directed at the current law. The CP argued that the
basis of the current law is illogical and, as a result, it gives rise to
inappropriate, and unpredictable, results. Its complexity, and the need to
obtain information about the mechanics of the company’s actions, means
that it can be hard to apply in practice. Its inconsistent application to
different sorts of demergers is generally considered to be unfortunate. We
think it likely that in many cases trustees will operate in ignorance of,
or without regard to, the technical legal position.
Illogical basis of the rule
2.36 The basis
of the rule in Bouch v Sproule is the company law distinction
between capital and income. The meaning of capital and income in trust law
is different, and it is illogical to base the classification of receipts
by trustees upon the company law concept. Lord Russell commented in the
Hill case29 that whether a shareholder holds shares for
him- or herself or as a trustee is immaterial to the company; the company
directors usually will not know whether or not the shareholders are
trustees, and it is of no direct consequence to them whether payments out
constitute trust income or trust capital.30
2.37 The CP
was therefore critical of the conflation, by the rule in Bouch v
Sproule, of the concepts of share capital and trust
capital:
There is no reason why only those
profits which become share capital (following capitalisation) should be
treated as trust capital. Share capital, which cannot be returned to
shareholders except by way of an authorised reduction or during a winding
up, exists to protect creditors and other people who deal with a limited
company. Trust capital on the other hand represents the full extent of the
trust
property.31
Inappropriate results
2.38 The
potential for the current law to give rise to inappropriate results can be
demonstrated by the example of the declaration of an abnormally large
special dividend, representing a significant proportion of the market
value of the company.
2.39 Normally,
of course, the tendency of particular shares to yield a healthy dividend
will enhance their market value. But if a company makes an unexpected and
abnormal distribution of its profits in this way, the payment of such a
dividend will result in a sharp fall in the market value of the company
and so in the value of the trust’s shareholding. Yet the payment will be
received by shareholders as income and, if a shareholder is a trustee,
will be paid to the life tenant. As a result, the capital value of the
investment is eroded following the payment to the income
29 [1930] AC 720 (PC).
30 In Village Cay Marina Ltd v
Ackland [1998] 2 BCLC 327 (PC) Lord Hoffman remarked: “Shareholders
can hold their shares in trust for anyone they like; that is a matter
between them and the beneficiaries. Company law is not concerned with
trusts of shares”.
31 CP, para
2.41. |
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beneficiary. Where a trustee
initially acquired the shares after the profit arose (but before it was
distributed) the value of the reserves is likely to have been reflected in
the purchase price paid. Unless special circumstances apply, the
excessively large benefit to income represents an unexpected
windfall.
2.40 The CP,
and most commentators,32 describe this result as unfair.
“Unfairness” in this context is used to describe an outcome which, from an
economic perspective, disproportionately benefits one set of interests at
the expense of another. In the example given, the effect of the operation
of the classification rule is to diminish the real value of capital. A
classification of that receipt as income does not respect the ordinary
meaning of capital as underlying value and income as the return on that
value that can be expended without diminishing capital.33 This
is what Sir Donald Nicholls V-C was referring to in his decision in
Sinclair v Lee when he said that to classify the Zeneca Group
shares as income “would be to exalt company form over commercial substance
to an unacceptable [extent]”.34
2.41 The
consequences of the mismatch between the narrow company law view of
capital and capitalisation and the more expansive economic approach is
most obviously demonstrated by a comparison of current rules governing
trust receipts from direct and indirect demergers. A demerger, whether
direct or indirect, will include an abnormally large distribution by way
of dividend. If the demerger is direct, the rule in Bouch v Sproule
will apply and the distribution will constitute income as a result of
the application of the narrow concept of corporate capital. If the
demerger is indirect, the Sinclair v Lee approach enables the
common sense economic analysis that the receipt should be treated as
capital to prevail.
Unpredictable results
2.42 Aside
from the unacceptability of inappropriate classification, the fact that
the current law can give rise to unanticipated returns (in particular,
large income returns) presents particular problems for those selecting
trustee investments.
2.43 As Part 3
explains, trustees are currently only able to balance the interests of
beneficiaries interested in income and capital by means of the careful
selection of investments. It would not be unreasonable, in normal markets,
for a trustee to invest in an established company with a history of
declaring market-average dividends with a view to securing a reasonable
rate of income return and a degree of capital growth. If, however, the
company in question decides to declare an abnormal special dividend – and
so unexpectedly yields a large return which the law treats as income
rather than capital - the intended function of the investment within the
overall portfolio will not have been fulfilled, and the trustee can do
nothing about this. |
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32 Including many of our consultees:
see para 4.62 and following below.
33 For a classic exposition of the
different meanings of capital from an economic perspective, see Adam
Smith’s An Inquiry into the Nature and Causes of the Wealth of Nations
(in particular, chapter 1 of book 2; “Of the Division of Stock”). On
the difficulty of the meaning of capital in the context of corporate
receipts, see Smith v Dana (1905) 77 Conn 543; 60 Atlantic Reporter
117, 121.
34 [1993] Ch 497,
514. |
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Applying the rule in practice
Complexity
2.44 The
complexity of the law makes it difficult for trustees to comprehend and to
apply. Lay trustees inevitably struggle with technical distinctions
between capitalisation and distribution. Even professional trustees, and
their advisers, may be unsure of the correct answers to difficult
questions of company (rather than trust) law.
Availability of information
2.45 The
application of the law in practice is complicated by the fact that it
requires trustees to ascertain precisely what a company has done when
making a particular payment.
2.46 For most
shareholders, the technical company law distinction between capital and
income is of little practical relevance. Consequently, companies may not
supply sufficient information about a distribution to enable trustee
shareholders to assess its true nature. For example, the labelling of a
distribution as a “bonus issue”, “bonus dividend”, “scrip dividend”,
“stock issue” or a “special issue” does not inform the shareholder whether
the company is capitalising profits or distributing profits. The company
may be more concerned with presenting itself in a positive light in
describing the benefits it is offering to its shareholders than with
providing a technical description of the substance of the
receipt.
2.47 In some
cases, the company itself may not be entirely clear about what it is doing
and may give misleading statements. For example, in Bouch v Sproule
the directors of the company first resolved to make a “bonus dividend”
but later resolved merely to issue a “bonus”. This caused confusion as to
whether the transaction was a distribution of accumulated profits as a
special dividend or a capitalisation of the accumulated profits, with the
dividend being used to pay up the issue of new bonus shares.
2.48 In most
cases, the trustees can ascertain the technical nature of the receipt by
careful study of the accompanying documentation supplemented, where
necessary, by enquiries of the company. However, this process may be
time-consuming and, especially where professional assistance is required,
expensive.
Uncertainty in application to novel
arrangements
2.49 We have
seen how the law has been forced to create special rules for certain sorts
of distribution, such as enhanced scrip dividends and indirect demergers.
As companies continue to develop innovative new ways of distributing value
to shareholders, perhaps in response to commercial or taxation changes,
the difficulty of applying the rule in Bouch v Sproule may
increase.
Ignorance or disregard of the rule
2.50 Anecdotal
evidence suggests that, in practice, many trustees do not allocate
corporate receipts in accordance with the strict rule in Bouch v
Sproule. This is especially likely to be the case where trustees are
not legally advised. |
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Corporate receipts: conclusion
2.51 The
policy argument as to the proper classification of corporate receipts can
be presented as a direct clash between the positions adopted by Lord
Justice Fry and Sir Donald Nicholls VC.
2.52 The
former argued that a trust law classification rule based entirely on the
perspective of the company rather than that of the trust should accord
with the expectations of trustees investing in shares as, by and large,
distributions (classified as income), and the proceeds of capitalisation
or a distribution on liquidation or winding up (classified as capital) are
all that a shareholder is entitled to expect. As the House of Lords said
in Bouch v Sproule:
The division of the enjoyment of
property between a tenant for life and a remainderman is itself
artificial, and if any artificial rule has been established regulating
such enjoyment, every settlor or testator may well be presumed to have
intended that the objects of his bounty should share its benefits
according to this rule.35
2.53 The
alternative position holds that this is an unrealistic analysis which has
an innate capacity to produce an inappropriate result. The price at which
a trustee purchases a share will rarely bear any meaningful relation to
the value of the company’s share capital as the share’s market value is
affected by a myriad of other factors. Enquiry should be focused on the
impact on the capital and income beneficiaries under the trust rather than
on the effect on the legal capital of the company. From the trust’s
perspective, the capital expenditure on the share is likely significantly
to exceed the company’s legal capital and even its net asset value. This
mismatch can lead to payments which in company law terms constitute
income, but which lead to an erosion of the market value of the company
and holdings in it.
2.54 In Part 4
of this Report we explain the CP’s proposals for the improvement of the
rules for the classification of corporate receipts.
NON-CORPORATE RECEIPTS
2.55 We have
already noted that the CP concentrated on the classification of corporate
receipts. The current law governing the classification of non-corporate
receipts was discussed in much less detail. The category “non-corporate
receipts” is very wide, comprising all those receipts that do not arise
from a trustee’s shareholding in a company. It includes receipts from
leaseholds, loans, mortgages, mines and quarries, timber and intellectual
property.
2.56 The
following paragraphs summarise the current law governing the
classification of traditionally some of the most common types of
non-corporate receipts. This is an area where we make no recommendations,
and so we go on to outline the CP’s provisional proposals for reform of
the classification of non-corporate receipts and consultees’ reaction to
those proposals, and then set out our conclusions. |
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35 Bouch v Sproule (1887) 12 App Cas 385,
392 (Lord Herschell). |
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The current law
General
2.57 The
guiding principle for the allocation of all non-corporate receipts between
income and capital is settlor intention. In the absence of express
provision in the terms of the trust, case law provides default principles
for inferring or presuming a settlor’s intentions as to whether the life
tenant or remainderman should benefit from the receipt. These default
principles historically depended on inferences from the settlor’s own use
of the trust property prior to the creation of the trust: if the settlor
used the trust property to produce receipts for his or her enjoyment it
would usually be inferred that the settlor intended those receipts to be
enjoyed by
the life tenant.36
Rents, leaseholds, loans and
mortgages
2.58 The CP
explained that rental receipts and receipts from loans now fall within the
“straightforward” category of returns which follow the fruit/tree analogy;
rents received from the letting of trust property37 and
interest received on loans of trust property should be classified as
income and the return of the principal of a loan of trust property as
capital.38 Likewise with receipts from leasehold property and
mortgages; the income beneficiary is entitled to the rent from the lease
or the interest paid accruing on the mortgage during his
term.39 However, if the leasehold is sold, then the proceeds
should be invested in an annuity that has as many years to run as did the
leasehold.40 The result is intended to mirror what the income
and capital beneficiaries would have received had the leasehold been
retained and can be understood as giving effect to the presumed intentions
of the
settlor.41
Open-mine doctrine
2.59 Receipts
from mines42 are not generally susceptible to the fruit/tree
analogy. As Lord Blackburn explained in Campbell v
Wardlaw:43
Where there is “produce”, such as
minerals, which, when once taken away, is never replaced, it is in a very
different position from, I may |
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36 37 38 39 40
41 |
See Simpson (Davidson’s
Trustees) v Ogilvie (1910) 1 SLT 45, 48 (Clerk LJ).
Sinclair v Lee [1993] Ch 497, 506 (Sir
Donald Nicholls VC).
Re Atkinson [1904] 2 Ch 160, 165 (Vaughan Williams LJ).
In re Hubbuck [1896] 1 Ch 754; Re
Lewis [1907] 2 Ch 296.
The proceeds of the sale thereby
being exhausted on the date that the leasehold would have ended (Askew
v Woodhead (1880) LR 14 Ch D 27).
Note also Pagliaro v Thomas
[2008] WTLR 1417, which concerned interest payments receivable upon
compensation paid by instalments to the trust fund by former trustees,
pursuant to a settlement deed compromising litigation concerning alleged
breach of trust and fiduciary duty. It was held, on somewhat unusual facts
and as a matter of construction of the deed, that the interest payments
were a mixture of capital and income and should be classified accordingly.
That classification reflected the purpose of the compromise, which was to
compensate the capital and income beneficiaries for what they would have
received in the absence of any breach of trust.
On the meaning of “mines and
minerals” see Earl of Lonsdale v Attorney General [1982] 3 All ER
579.
(1883) 8 App Cas 641. |
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42 43 |
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say, apples or fruits of that kind, which are annually reaped
and which
replace themselves.44
2.60 Case law
has, however, made distinction between receipts from “open mines” and
“unopened mines”. Receipts from “open mines” are classified as income
while receipts from “unopened mines” are capital.45 Generally,
a mine is “open” if it was being worked at the time that the trust was
established, whereas mines are unopened if they are only opened after the
date of the settlement.46
Timber and trees
2.61
Generally, receipts from the sale of “timber” are classified as
capital and receipts from the sale of other wood are income.47
The reason is that the income beneficiary is not usually entitled to cut
timber. However, where the timber is cultivated to produce saleable timber
as part of a timber estate and timber is cut periodically, the periodical
cuttings can be viewed as “part … of the annual fruits
of the land”.48
Intellectual property
2.62
Intellectual property rights include copyright, patents, designs and
trade marks. Receipts from intellectual property will be classified in
accordance with the presumed intentions of the settlor. Usually receipts
such as royalties and profits arising from copyrights, patents, designs
and trade marks owned by the settlor or testator before his death will be
allocated to the income beneficiary, while receipts from the sale of
intellectual property rights will be allocated to the capital
beneficiary.
2.63 Where the
trustees obtain intellectual property rights after the creation of the
trust in works created by the settlor or testator before the creation of
the trust, royalties and profits should be treated as capital. For
example, Simpson (Davidson’s Trustees) v Ogilvie49
concerned royalties, profits and sums in respect of book sales, the
copyright to which was held by trustees. It was held that receipts from
works that had been published by the testator himself should be treated
as
44 (1883) 8 App Cas 641, 644. The
principle underlying this is the duty to balance; the life tenant must not
destroy the trust property as “the substance of the estate is to be
preserved and not destroyed” (1883) 8 App Cas 641, 656 (Lord
FitzGerald).
45 Section 47 of the Settled Land
Act 1925 makes special provision for the classification and apportionment
of receipts from mining leases.
46 Further considerations apply
where, for example, the mine has been worked by the settlor or has been
dormant for a period of time. Halsbury’s Laws of England comments
that “whether a mine is open or not is no longer a question of much (if
any) practical importance”: Volume 31, Mines, Minerals and Quarries
(2003), para 7.
47 See Honywood v Honywood
(1874) LR 18 Eq 306. Section 66 of the Settled Land Act 1925 provides
special classification and apportionment rules in relation to the cutting
of timber by tenant for life under a settlement.
48 Honywood v Honywood (1874)
LR 18 Eq 306, 310. This case also establishes the meaning of “timber”: a
tree will be “timber” where it is oak, ash or elm; it is at least 20 years
old; and it is “not so old as not to have a reasonable quantity of useable
wood (Honywood v Honywood (1874) LR 18 Eq 306, 309 (Jessel MR).
Trees that do not fall within this definition may nevertheless be
classified as timber according to the local custom of the
county.
49 (1910) 1 SLT
45. |
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income. By contrast, receipts
from works written by the testator but published by the trustees after the
testator’s death should be treated as capital.
Provisional proposal and consultation
responses
2.64 The CP
considered that the criticisms of the rules governing corporate
distributions do not apply to the rules governing the classification of
non-corporate receipts. It concluded that, even though some of the rules
are not entirely straightforward, they do not appear to give rise to any
significant problems in practice.50 The CP therefore
provisionally rejected the introduction of comprehensive statutory
classification rules for non-corporate receipts and provisionally proposed
that the existing rules for the classification of non-corporate trust
receipts should be retained. Consultees were asked if they agreed and
invited to give their views on whether the rules should be placed on a
statutory footing.
2.65 The vast
majority of the consultees who answered this question agreed that the
existing rules for the classification of trust receipts other than
distributions from corporate entities should be retained. They considered
the current rules to be sufficiently clear and valued their flexibility.
The Association of District Judges, for example, said that “there is
little or no need for change [to] the existing classification, the law
being in the main clear”. One consultee agreed “subject to there being a
fair allocation system”.51
2.66 Some
consultees felt that the existing rules for the classification of trust
receipts other than distributions from corporate entities should be given
a statutory basis. One argued that “trustees are more likely to take
account of statutory provisions than rules of equity buried in case law
that they have never heard of”.
2.67 However,
most of the consultees who answered this question did not think that the
rules should be placed on a statutory footing. Consultees pointed to the
difficulty of drafting provisions that would embrace the vast range of
non-corporate receipts and the rigidity of a statute-based
classification.
Conclusions
2.68 We
conclude that the current law relating to the classification of
non-corporate receipts should be retained. This was overwhelmingly
supported in consultation. We have sympathy with the view that it would be
desirable to place the current rules on a statutory footing,52
but we do not consider that the case has been made for codification,
bearing in mind the following points.
2.69 First, a
comprehensive statement of trust law classification of receipts would be a
monumental (if not impossible) undertaking. Trustees can invest in
anything if the terms of the trust authorise them to do so, and in almost
anything as a result of the statutory powers of investment given by the
Trustee Act 2000. The general
50 CP, para
5.13.
51 Wills and Equity Committee of the
Law Society.
52 And we note the steps that have
been taken in this regard in those US states that have implemented the
Uniform Principal and Income Act: see Uniform Principal and Income Act, ss
405 (rental income), 410 (liquidating assets), 411 (minerals, water and
natural resources) and 412 (timber). |
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power of investment in section
3(1) of the Trustee Act 2000 allows trustees to make “any kind of
investment that he could make if he were absolutely entitled to the assets
of the trust”.53 Trustees therefore have power to invest in
company shares, futures, derivatives, hedge funds, debentures, bonds,
freehold and leasehold property, mortgages, art, life assurance, timber,
minerals, intellectual property rights and so on. Although rules of
classification would not have to list each and every possible investment,
it would be necessary to consider the proper treatment of the various
classes of investment before setting such rules.
2.70 Aside
from the breadth of current investment possibilities - and we have not
listed them all - it is also inevitable that the types of investment
trustees make will change. In the event that Parliament were minded to
enact our recommendations for classification we could not expect further
consideration of the issues in the foreseeable future and a code might
become out of date quite quickly.
2.71 We are
not convinced that the lack of a statutory code in this very specialised
field is causing sufficient practical difficulties to warrant legislation.
We agree with consultees that equity has to date provided generally
acceptable classification rules, and that a statutory codification may
stifle judicial development of those rules as new types of investment (and
so of receipt) emerge.54 It should be noted that the rules
relating to the classification of non-corporate receipts are far more
flexible in their operation than the rule in Bouch v Sproule. It
is, of course, open to settlors who intend to settle property liable to
give rise to receipts of this sort to include express classification
provisions in the terms of the trust.
2.72 We
therefore make no recommendation for the reform of the law relating to the
classification of non-corporate receipts; the current law should be
retained and should not be codified in statute. |
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53 |
Trustee Act 2000, s 3(3) makes
clear that land is not included in the general power of investment with
the exception of loans secured on land. However, s 8 provides a special
power for trustees to invest in freehold and leasehold
property.
Mr Justice Lloyd noted in
consultation that “to lay down a rule in statute would incur the risk that
some situation which is not foreseen might be dealt with in an
inappropriate way” and that it would be “more desirable that the position
… should continue to be laid down by judicial
decision”. |
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54 |
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PART 3
TOTAL RETURN
INVESTMENT
CLASSIFICATION AND THE SELECTION OF
INVESTMENTS
3.1 We
explained in Part 2 that the classification of corporate receipts as
income or capital is governed by relatively inflexible rules, and that the
rules may produce unexpected or irrational results. This causes
difficulties when an investment fund is held on trust for successive
interests; sometimes a return that amounts to capital for the trust has to
be treated as income, and vice versa, with the result that it goes
to the “wrong” beneficiary. We have also noted the more fundamental
problem relating to trustees’ selection of
investments.1
3.2 The
Trustee Act 1925 authorised trustees to invest only in a limited range of
investments. The policy underlying trust investment was generally to
conserve capital and obtain a reasonable fixed income during the life of
the trust. Changing economic circumstances and an increasing variety of
financial instruments meant that over time the restriction to authorised
investments became problematic. The Trustee Investment Act 1961 went some
way to resolving this by allowing trustees to invest up to 75 per cent of
the trust fund in equities. However, broad investment powers had long been
expressly included by numerous settlors in trust instruments, and the
Trustee Investment Act 1961 was considered by many
to be inadequate.2
3.3 The
Trustee Act 2000, implementing the Law Commission’s 1999 Report on
Trustees’ Powers and Duties,3 went significantly further in
widening trustees’ investment powers. The Explanatory Notes to section 4
of the Trustee Act 2000 state that it “provides that in exercising a power
of investment … a trustee must have regard to the suitability to the trust
of the investment and, secondly, to the extent that it is appropriate in
the circumstances, to the need for diversification of
the trust's investments”.4
3.4 However,
trustees of trusts with successive interests continue to be constrained in
their investment decisions. They are restricted by the combination of the
rules that classify trust receipts as income or capital and the
overarching duty to balance the interests of the life tenant and
remainderman. Trustees must maintain the value of the trust capital while
providing a proportionate income; they cannot invest wholly for capital
growth, obviously, nor wholly for income return. Because they are bound by
the form of the investment receipt, that balance between the successive
interests must be achieved by investing with a view to the likely form –
capital or income – that returns from particular investments will take.
This inevitably skews investment decisions; instead of investing for
optimum return, trustees who have no power to override the form of the
receipt are forced to invest to obtain the best possible balanced return
which may be significantly lower than that which they could have obtained
if investing
1 See
para 1.13 and following above.
2 See HM
Treasury, Investment Powers of Trustees (1996).
3 Law Com
No 260.
4 Trustee
Act 2000 Explanatory Notes, para 23.
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freely.
TOTAL RETURN INVESTMENT
3.5 Investment
by trustees without those constraints is known as total return investment,
which focuses on all the returns generated from a portfolio of assets
regardless of whether they take the form of income or capital. The total
return approach to investment potentially delivers a higher rate of return
than one that isolates income returns from capital returns, because it
facilitates the spreading of investments and removes restrictions from
trustees’ choices.
3.6 The effect
of removing these restrictions is that trustees would be free to construct
the investment portfolios which they and their relevant advisers consider
appropriate. Section 4(3) of the Trustee Act 2000 sets out standard
investment criteria to which trustees are to have regard when exercising
any power of investment and from time to time:
(a) the suitability to the
trust of investments of the same kind as any particular investment
proposed to be made or retained and of that particular investment as an
investment of that kind, and
(b) the need for
diversification of investments of the trust, in so far as is appropriate
to the circumstances of the trust.
3.7 The
Explanatory Notes to that section explain that the “definition of the
standard investment criteria in section 4(3) is closely modelled on
section 6(1) of the Trustee Investments Act 1961 and accords with modern
portfolio theory”.5 Modern portfolio theory puts forward an
analysis of risk and return in accordance with a statistical
model6 and has been a popular investment theory for some
decades. However, the underlying assumptions of modern portfolio theory,
as well as the reliability of its associated mathematical models for
financial decision-making, have been called into question.7 The
Trustee Act 2000 enables but does not require trustees to follow modern
portfolio theory, and the same is true of total return investment.
Investing on a total return basis would not oblige trustees to follow any
particular investment theory; but it would free them from artificial
restraints in constructing a portfolio. It would also enable them to make
investment choices to compensate for unexpected or unbalanced investment
returns.
3.8 We have
appended to our analysis of consultation responses an explanation of the
effects of total return submitted as part of the consultation response of
the UK Society of Trust and Estate Practitioners Technical Committee
(“STEP”). It sets out two contrasting portfolios, one constructed with an
eye to achieving a particular level of income within the overall return,
and the other constructed
5 Trustee Act 2000 Explanatory Notes,
para 25.
6 See H
Markowitz, “Portfolio Selection” (1952) 7(1) Journal of Finance 77;
J Hirschleifer, “Efficient Allocation of Capital in an Uncertain World”
(1964) 54(3) American Economic Review 77; E Ford, “Trustee
Investment and Modern Portfolio Theory” (1996) 10(4) Trust Law
International 102; I Legair, “Modern Portfolio Theory: a Primer”
(2000) 14(2) Trust Law International 75.
7 See eg
B Mandelbrot, The (Mis)Behaviour of Markets (2008), in particular
chapters 4 and 5.
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without that objective. The
latter portfolio is therefore able to include a higher proportion of
investments that are known to generate significant capital growth; and
accordingly the overall return is enhanced without loss of stability. We
note this as an example of investment practice, and of the limitations of
choice and potential effect upon returns where investment decisions are
constrained by the classification of returns.
3.9 Clearly, as we write this
Report the global financial markets are in crisis. A portfolio selected on
the basis of total return is not immune from this because the risks that
affect the entire investment market cannot be diversified away. But the
principles of total return investment, and the importance of active
portfolio management, remain constant; trustees of charities with
permanent endowment, and of trusts for interests in succession who are
unable to operate total return investment, may therefore be more
vulnerable in the current climate than they need be. This is particularly
pertinent for those who depend on returns to provide a relatively stable
pattern of income.
Total return investment in the US
3.10 Moves
towards total return investment have taken place in a number of other
jurisdictions. The CP referred to reports from Canadian law reform bodies
which have argued that “the formalistic distinction between capital and
income is inimical to the movement away from a list-based approach to
authorised investments.8 The CP also noted that jurisdictions
in Australia and the Bahamas have advocated the adoption of total return
investment. But the most significant developments have taken place in the
US, where there has been detailed academic discussion over a number of
years9 and the enactment by many states of the Uniform
Principal and Income Act 1997 (“UPIA”).10
The power of adjustment model: Uniform Principal and
Income Act 1997
3.11 The UPIA
detached trustees’ investment strategies from their traditional impact on
classification, allowing trustees to invest on a total return basis. To
achieve this, the UPIA created a simple set of default classification
rules and introduced a new power of adjustment11 for use in
relation to corporate receipts and certain other apportionable receipts.
Section 104 of the UPIA provides a new power for trustees to adjust
between capital and income, which is available when the following three
conditions are met: (1) when the trustee invests as a prudent
8 See CP, paras 5.33 to
5.40.
9 See, for
example, RB Wolf, “Defeating the Duty to Disappoint Equally – the Total
Return Trust” (1997) 32 Real Property, Probate and Trust Journal 45
and “Estate Planning with Total Return Trusts: Meeting Human Needs and
Investment Goals through Modern Trust Design” (2001) 36 Real Property,
Probate and Trust Journal 169. Other recent works include AA DiRusso
and KM Sablone, “Statutory Techniques for Balancing the Financial
Interests of Trust Beneficiaries” (2005) 39 University of San Francisco
Law Review 261 and RW Nenno, “The Power to Adjust and Total-Return
Unitrust Statutes: State Developments and Tax Considerations” (2008) 42
Real Property, Probate and Trust Journal 657.
10 As amended in 2000 and 2008. The
UPIA should not be confused with the Uniform Prudent Investor Act 1994:
see n 12 below. The relevant provisions of the UPIA are set out in
Appendix D.
11 Note that the term that we have
used for this kind of power is “power of allocation”; see para 4.3 and
following below. |
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investor;12 (2) the
terms of the trust require or allow a certain amount to be distributed to
income; and (3) the trustee is unable to comply with section
103(b).
3.12 Section
103(b) states that the exercise of the power to adjust is underpinned by
the duty of impartiality “based on what is fair and reasonable to all of
the beneficiaries, except to the extent that the terms of the trust or the
will clearly manifest an intention that the fiduciary shall or may favour
one or more of the beneficiaries”. A determination in accordance with the
Act is presumed to be fair and reasonable to all of the beneficiaries.
Section 105 of the Act provides that a court may not change a decision to
exercise or not exercise the power to adjust unless it determines that the
trustee’s decision was an abuse of discretion.13
3.13 The notes
accompanying the UPIA provide guidance on the conditions for the exercise
of the power to adjust, the factors to consider in exercising the power
and the limitations on the power. The notes also provide a number of
examples to illustrate the application of the power to
adjust.
3.14 Detailed
guidance is given on what amounts to an abuse of the power to adjust. This
provides an insight into how trustees are expected to exercise the power
in accordance with the duty of impartiality: “Because [the duty of
impartiality] involves the exercise of judgment in circumstances rarely
capable of perfect resolution, trustees are not expected to achieve
perfection; they are, however, required to make conscious decisions in
good faith and with proper motives”. The guidance makes it clear that the
key element in this process is to determine “the appropriate level or
range of income for the income beneficiary, and that will continue to be
the key element in deciding whether and to what extent to exercise the
discretionary power conferred by section 104(a)”.
3.15 The
guidance goes on to state that trustees have a broad latitude in choosing
the methods and criteria to use in deciding whether, and to what extent,
to exercise the power, and that the adjustment may be made either
prospectively at the beginning of an accounting period (based on projected
returns) or retrospectively.
3.16 Professor
Edward C Halbach Jr, University of California at Berkeley, is the Reporter
for the American Law Institute's Restatement of Trusts project. In January
2008 he indicated in correspondence with us that total return investment
is now prevalent in the US, especially as a result of widespread adoption
of the 1994 Uniform Prudent Investor Act (the equivalent of Trustee Act
2000). It readily became apparent that total return investment practices
of trustees rendered traditional US principal and income accounting
principles obsolete, leading to the Uniform Law Commission's 1997
promulgation of the now widely adopted UPIA. Whilst Professor Halbach has
not been able to provide us with statistical data on the frequency of use
of the UPIA’s power of adjustment, he has stated that in California (one
of the first states to adopt the Act) “use by trustees (even the initially
reluctant) is widespread”. Professor Halbach further notes that, in other
states, despite a certain lack of familiarity and comfort regarding the
power:
12 The “prudent investor” is the
standard of care adopted in the US in the Uniform Prudent Investor Act
1994.
13 This amounts to a codification of
the normal US rules governing the reviewability of fiduciaries’
discretions. |
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There is nevertheless a growing
interest in and actual use of investment programs that will depend on
application of adjustment/unitrust solutions to the impartiality issues
that are inherent in such trust investment programs whenever the
distribution rights of any beneficiary would be determined by
trust-accounting income.
Percentage trusts
3.17 Not
surprisingly there is more than one way to facilitate total return
investment. Although the CP concentrated on the power of allocation, it
also discussed percentage trusts. This is a model familiar in the US
(where it is also known as the “unitrust”) but not used, so far as we are
aware, in England and Wales. The idea is that investment is carried out on
a total return basis and at the end of each year a percentage of the net
market value of the trust fund (the “unitrust rate”) is allocated to
income and paid to the income beneficiary.
3.18 In the
US, the most significant unitrust statutes are those of Pennsylvania,
Delaware, Illinois, Texas and Ohio. The Pennsylvania statute has served as
the model statute for a number of states. It adopts a fixed four per cent
unitrust rate and a three-year “smoothing rule”; this means that the
trustees are directed to apply the unitrust rate to the net fair market
value of the trust’s assets averaged over a three-year period. This
creates a more consistent stream of distributions.
3.19 Delaware
was the first state to enact a unitrust statute. Its distinguishing
feature is the trustee’s ability to choose a rate for distribution to the
income beneficiary within the range of three per cent to five per cent.
Other states which have implemented unitrust statutes provide a lower
limit to the unitrust rate, but without setting an upper limit (Missouri
has three per cent).
3.20 Texas has
provided a model based on the definition of income; a unitrust is defined
as a trust whose terms require the distribution of a unitrust amount,
defined as “a distribution mandated by the terms of a trust in an amount
equal to a fixed percentage of not less than three or more than five per
cent per year of the net fair market value of the trust’s assets, valued
at least annually”, which may be done with or without a smoothing rule.
Importantly, the distribution of the unitrust amount is then deemed to be
“a distribution of all of the income of the unitrust” and a reasonable
apportionment of the total return of the unitrust.
3.21 The Ohio
model is slightly different in that it combines features of the power to
adjust and the unitrust. It provides trustees with a “safe harbour” power
to adjust whereby they can adjust trust accounting income upwards not to
exceed four per cent of the trust’s fair market value. Where they do this
the propriety of the adjustment is conclusively presumed.
3.22 There are
of course further possible variations. The percentage trust model of total
return investment is only appropriate where there is a range of
investments. It would be wholly unsuitable for a trust with a handful of
investments, still less for one with a single asset, for example a farm or
a shareholding in a family company. Nor would it be suitable where the
trust’s assets were difficult to value. |
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Total return investment in the UK
Charitable trusts
3.23 Total
return investment requires an ability to retain or distribute investment
yields without regard to the form in which they were received.
Accordingly, the starting point for charities with permanent endowment is
that they are prevented from operating total return investment because
they are not able to spend capital receipts without the consent of the
Charity Commission. It was concern about this issue that led to the
reference of this project to the Law Commission.14 We noted in
Part 1 that total return investment has been made possible for charitable
trusts with permanent endowment by the procedure published in Operational
Guidance by the Charity Commission, which enables trustees to free capital
from restriction for this purpose.15 As we explain in Part 8,
we received a number of consultation responses about the details of the
Charity Commission’s scheme, and we consider there the arguments for
further reform. However, it is clear that in the charitable sector
trustees are already investing profitably on a total return
basis.
Private trusts
3.24 Private
trusts for interests in succession can only operate total return
investment if the terms of the trust enable them to distribute investment
returns without regard to their form. If they do have such a power, then
they are free to invest for maximum return (subject only to the need to
balance risk and return), and can attribute receipts and expenses to
income or to capital in proportions that maintain an appropriate balance
between the capital value of the fund and its income yield. In choosing
investments they therefore need not concern themselves with the likely
form taken by returns, and can instead focus on maximising the growth of
the trust fund as a whole.
3.25 Trusts
for interests in succession may incorporate a power of advancement. This
enables trustees to advance capital to the income beneficiary. It also
enables a limited form of total return investment. The trustees are free
to invest in funds that maximise capital growth, and can advance capital
to the income beneficiary at their discretion. They may operate a form of
percentage trust, distributing a percentage of investment return each year
to the income beneficiary. But a power of advancement will not permit true
total return investment. In particular, it does not enable an income
return to be treated as capital; nor does it give total freedom across the
range of possible investments.
3.26 Trustees
for interests in succession can only operate true total return strategies
if they have a power of allocation16 enabling them to allocate
investment returns to the income beneficiary or to capital, or if they are
set up as percentage trusts.
3.27 There is
nothing in the current law to prevent the establishment of power of
allocation trusts by express provision in the terms of the trust
instrument.17 All that is required is a power to allocate
capital receipts to income and vice versa in order to establish a
balance. An example of such a power can be found in the
14 See para 1.16
above.
15 See para 1.28 above. See Part 8
below for details of the scheme.
16 See n 11
above. |
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Encyclopaedia of Forms and Precedents:
The [Trustees] may if they in
their absolute discretion think fit from time to time and at any time
decide whether any property received by them as such trustees shall be
treated as income or as capital for the purposes of any one or more of the
trusts powers and other provisions contained in or conferred by this
settlement.18
3.28 However,
we have been unable to find evidence of private power of allocation trusts
being set up in this jurisdiction. To some extent that is a matter of
culture; settlors and their advisers may be unwilling to venture into an
unfamiliar model, of which there is little experience. However, the
critical factor is that, as things stand, a power of allocation trust will
not be drafted in the trust instrument for interest in possession
trusts,19 because of the perceived risk that a power of
allocation would lead to the loss of that status.20 The
Encyclopaedia of Forms and Precedents states that the tax
implications of such a power are “uncertain”;21 that is a risk
that the vast majority of settlors would not be willing to
take.
3.29 For
similar reasons, the percentage trust has not been adopted in England and
Wales. In particular, there is no specialised mechanism for taxing
receipts and distributions by percentage trusts, with the result that they
would attract disadvantageous tax treatment. In addition, because they
inevitably attribute to capital some part of income in some years,
percentage trusts falls foul of the rule against excessive accumulations.
The latter problem, however, would disappear with the enactment of the Law
Commission’s recommendations on excessive
accumulations.22
CONCLUSION
3.30 In this
Part we have looked at the arguments for total return investment for
trustees. Moves have been made in other jurisdictions to facilitate total
return investment, through a power of allocation and through percentage
trusts. Similar steps have been taken in this jurisdiction for charities,
but not for private trusts. We revert to charities in Part 8; in Part 4 we
explain the CP’s provisional proposals to improve the rules for the
classification of investment receipts, and to enable total return
investment for trustees. In Part 5 we go on to explain our final
recommendations. |
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17 Provided their terms do not
offend the rule against excessive accumulations.
18 Trusts and Settlements Vol
40(1) (2007), Form 178 [4741].
19 See Part 5, n 4 for our use of
the term “interest in possession”.
20 See para 5.67 and following below
for discussion of the taxation implications of a power of
allocation.
21 Trusts and Settlements Vol
40(1) (2007), para 146 [1380].
22 A Perpetuities and Accumulations
Bill was introduced in the House of Lords on 1 April
2009. |
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PART 4
THE CP PROPOSALS AND
CONSULTATION
RESPONSES
INTRODUCTION
4.1 We
explained in Part 2 of this Report the difficulties arising from the
current classification rules for corporate receipts, and in Part 3 we
discussed total return investment and outlined the difficulties faced by
trustees wishing to invest on a total return basis. In this Part we set
out the CP’s approach to those problems.
4.2 At the
heart of the CP’s provisional proposals for reform was the suggestion of a
power of allocation. This was presented as a means of resolving the
problems of trust classification and of enabling total return investment
for trusts.1 The following discussion focuses first on the CP’s
proposals for the power of allocation itself and concludes by outlining
the CP’s suggested reform of the classification rules in the light of the
potential availability of a power of allocation. We also explain why the
CP had also to consider a further fundamental issue -the trust law duty to
balance. We discuss the CP’s position on the percentage trust as an
alternative total return investment vehicle to the power of allocation. We
provide an overview of consultees’ responses to all the CP’s provisional
proposals on these points.2
THE POWER OF ALLOCATION
4.3 The CP’s
provisional proposals for a flexible power of allocation built on the
approach recommended by the Law Reform Committee in 1982, the Trust Law
Committee in 1999 and the Scottish Law Commission in 2003. But its
proposal of an allocation power, in parallel with revised classification
rules, also drew on the approach adopted in many US states whereby a
similar power not only allows flexible classification but also enables
total return investment by trusts.3
Nature of the proposed power
4.4 The CP’s
proposed statutory power of allocation would enable trustees to allocate
receipts and expenses to income or to capital in proportions that
maintained an appropriate balance between the capital value of the fund
and its income yield. Although the allocation power would in theory enable
the allocation of each individual receipt (and we envisaged that such
allocation could be in whole or in part), the trustees’ objective would be
to ensure that, over a period, a proportionate level of return was
attributed to the classes of beneficiaries entitled to capital and to
income. To achieve this result, trustees might need only to allocate one
or two receipts, irrespective of how any imbalance had been
caused.
1 The
power of allocation also underpinned the CP’s proposals for the
classification of expenses (discussed in Part 7 of this Report); and it
was relevant, although less important, in the CP’s discussion of the rules
of apportionment (discussed in Part 6 below).
2 Further
detail on the results of consultation is available in our analysis of
responses: available at http://www.lawcom.gov.uk/citcat.htm.
3 See para
3.11 and following above for the relevant provisions of the US Uniform
Principal and Income Act 1997, in particular its power to adjust. The CP
also referred to Canadian recommendations for “discretionary allocation
trusts” (see CP, para 5.33 and following).
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Alternatively, they might take a
more global approach, not unlike a percentage trust, allocating an
appropriate proportion of the entire investment return to income and
capital respectively. The exercise of the power of allocation would be
underpinned by the trustees’ overarching duty to balance the interests of
the different beneficiaries; the proposed power would only be capable of
exercise in so far as necessary to discharge the duty to balance and for
no other purpose.4
4.5 The CP
envisaged that trustees would be given a specified time limit in which to
exercise the power of allocation, after which the default classification
provided by the classification rules5 would become conclusive.
The CP argued that the new power of allocation would be “strictly
‘administrative’, in the sense that it was intended to facilitate the
internal administration of the trust”:
… it will be available to
trustees for one reason only; to enable them to discharge their overriding
duty to balance the interests of the income and capital beneficiaries. It
must be clearly distinguished from a “dispositive” power whereby trustees,
having considered the various claims of beneficiaries, are entitled to
make distributions out of the trust fund to particular beneficiaries at
the expense of the others.6
4.6 The CP
asked whether consultees agreed with its provisional proposal for a
statutory power of allocation, and put forward a number of questions about
the practical and accounting implications of the
power.7
4.7 The CP
debated whether the new power of allocation should be included in all new
trusts by default (or by implication) or whether it should only be
available where expressly included by the settlor. It invited consultees’
views on whether the power of allocation should operate on an opt-in or
opt-out basis. The CP also anticipated that the trustees of some existing
trusts might wish to take advantage of the power of allocation. It invited
the views of consultees on whether such trustees should be able, either
unilaterally or with the sanction of the court, to opt into its proposed
statutory power.
Advantages of the
power
4.8 The power
of allocation would enable trustees to overcome inappropriate
classifications. It would ensure that neither income nor capital
beneficiaries gained or lost disproportionately when investments made with
a view to income return or capital protection had not performed as
expected.
4.9 The power
would also enable trustees to ignore the likely form of receipt when
making investment choices and so invest on a total return basis. As the CP
put it:
A power of allocation would give trustees much greater freedom
to
4 For a
discussion of the duty of balance, see para 4.10 and following
below.
5 See para
4.57 and following below.
6 CP, para
5.56.
7
Including the time limit from the date of a receipt or expense within
which the power should be available, the basis of judicial review of the
power, the consequences for trustees of failure to exercise the power and
the procedure for dealing with disputes. See CP, para 5.41 and following
for a detailed discussion.
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select investments, as they would
no longer need to concern themselves with the likely form taken by
returns, and they could instead focus on maximising the growth of the
trust fund as a whole. The duty to balance could be satisfied by exercise
of the power of allocation. In consequence, trustees would be able to
postpone the balancing process from the time when investment policy is
being formulated until after investment returns are received. This, we
believe, would result in less speculative, better informed and
more
effective trusteeship.8
THE DUTY TO BALANCE
4.10 The power
of allocation was not proposed in isolation; it was to be underpinned by
the trustees’ duty to hold a balance between those entitled to income and
those interested in remainder. It is a fundamental principle of equity
that trustees must not favour one beneficiary or class of beneficiaries
over another in exercising their powers and fulfilling their duties. The
duty that flows from this principle is known variously as the duty of
even-handedness, the duty of impartiality, the duty to keep a fair balance
and the duty to keep an equitable balance between the potentially
competing interests of the income and capital beneficiaries.
4.11 While the
duty to balance provides a general principle, it can be understood in both
a positive and negative sense. In its negative sense, the duty requires
trustees to act impartially between beneficiaries without favouring one
class of beneficiary over the other. This expression of the duty is the
focus of the current law, in particular in the context of trustees
exercising their powers of investment.
The current law
4.12 Lord Justice Cotton set out the basis
of the duty to balance in Learoyd v Whitely:
[Trustees] must take such care in
conducting the business of the trust as a reasonably cautious man would
use, having regard, not only to the interests of those who are entitled to
the income, but to the interests of those who will take in
future.9
4.13 The
meaning of balance was more recently considered by Sir Robert Megarry VC
in Cowan v Scargill where he concluded that “the starting point is
the duty of trustees to exercise their powers in the best interests of the
present and future beneficiaries of the trust, holding the scales
impartially between different classes
of beneficiaries”.10
4.14 However, in Nestle v National
Westminster Bank plc11
Mr Justice Hoffmann, as
8 CP, para 5.42.
9 (1886)
LR 33 Ch D 347, 350. Cotton LJ continued “... That is to say, it is not
like a man simply investing his own money where his object may be a larger
present income than he can get from a safer security; but trustees are
bound to preserve the money for those entitled to the corpus in
remainder, and they are bound to invest it in such a way as will produce a
reasonable income for those enjoying the income for the
present”.
10 [1985] Ch 270, 286 to
287.
11 (29 June 1988), reported in
(1996) 10(4) Trust Law International 112.
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he then was, preferred the
formulation that trustees “must act fairly in making investment decisions
which may have different consequences for different classes of
beneficiaries” to the image of holding scales equally between income and
capital.12 He rejected a mechanistic approach to discharging
investment duties, holding that in reality trustees have “a wide
discretion” in making their investment decisions. In the Court of Appeal
Lord Justice Staughton reiterated that “the obligation of a trustee is to
administer the trust fund impartially, or fairly … , having regard to the
different interests of beneficiaries” but, like Mr Justice Hoffmann, noted
that “at times it will not be easy to decide what is an
equitable
balance”.13
4.15 The duty
to balance was also embedded in the Trustee Act 2000. Section 4 requires
trustees to have regard to the standard investment criteria in exercising
their general power of investment under section 3. The standard investment
criteria are “the suitability to the trust of investments of the same kind
as any particular investment proposed to be made or retained and of that
particular investment as an investment of that kind” as well as “the need
for diversification of investments of the trust, in so far as is
appropriate to the circumstances of the trust”. The Explanatory Notes
explain that “suitability” includes “considerations as to the size and
risk of the investment and the need to produce an appropriate balance
between income and capital growth to meet the needs of the
trust”.14
4.16 Under
section 4(2) of the 2000 Act, trustees are required to review their
investments in the light of the standard investment criteria, which the
Explanatory Notes explain is a codification of the common law duty as
stated in Nestle.15 The Explanatory Notes also state
that the general power of investment is not entirely unfettered as
trustees remain subject to their fundamental duties, including “the duty
to act in the best interests of the present and future
beneficiaries”.16
The CP’s provisional proposals on balance
4.17 The duty
to balance underpinned the power of allocation proposed by the CP. The
power would allow trustees to overcome inappropriate classifications that
caused an imbalance, to restore a balance where investments made with a
view to a particular form of return had not performed as expected, and to
allocate the global receipts from an investment portfolio selected on a
total return basis. The duty to balance would place an active duty on
trustees to consider whether or not to exercise the power of allocation.
The CP’s proposals amounted to a new positive manifestation of the duty to
balance.
4.18 The proposed extension of the duty to
balance into the post-investment stage of
12 (29 June 1988), reported in
(1996) 10(4) Trust Law International 112, 115. See also the
statement of Chadwick LJ in Edge v Pensions Ombudsman that in
constructing an investment policy “the essential requirement is that the
trustees address themselves to the question what is fair and equitable in
all the circumstances” ([2000] Ch 602, 627).
13 [1993] 1 WLR 1260,
1279.
14 Trustee Act 2000 Explanatory
Notes, para 23.
15 Trustee Act 2000 Explanatory
Notes, para 24. See Nestle v National Westminster Bank plc [1993] 1 WLR 1260, 1282G (Leggatt LJ).
16 Trustee Act 2000 Explanatory
Notes, para 21. |
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trust administration was a novel
concept.17 Under current law, there is no general duty on
trustees to effect a balance between income and capital beneficiaries on
receipt of investment returns as there is no power to allocate investment
returns; the availability of the power of allocation would allow balance
to be considered later than is currently the case:
In consequence [of the
availability of the power of allocation], trustees would be able to
postpone the balancing process from the time when investment policy is
being formulated until after investment returns
are received.18
4.19 The CP
made a number of provisional proposals about the duty to balance. It
considered that the duty to balance should remain a central component of
all trusts, unless excluded or modified by the settlor (either expressly
or by necessary implication).19 It concluded that the duty
should not be excluded by implication merely on the basis that the subject
matter of the trust constitutes an unauthorised investment or a specific
gift, nor merely because there is a power to postpone conversion of the
original trust assets.20 The CP invited consultees’ views on
whether the duty to balance should be placed on a statutory
footing.
4.20 The CP
did not consider there to be any need to provide further statutory
guidance to trustees as to the meaning of balance. In particular, the CP
considered, but rejected the possibility of providing a non-exhaustive
statutory list of relevant factors to help trustees determine whether or
not a balance has been maintained between competing
beneficiaries.21
The relevance of personal circumstances to
balance
4.21 In
Nestle v National Westminster Bank plc, Mr Justice Hoffmann and
Lord Justice Staughton took the view that the personal circumstances of
beneficiaries are a relevant factor in discharging the trustee’s duty to
balance when selecting investments.22 The CP considered the
issue of whether trustees should take into account the personal
circumstances of beneficiaries in discharging their duty to balance in the
context of its discussions of a proposed new power of
allocation.23
4.22 In line
with its view of the nature of the power of allocation, the CP considered
it “essential that the personal circumstances of beneficiaries should not
be a relevant consideration in the exercise of the statutory power of
allocation”.24 The CP considered that to require or permit
trustees to consider personal circumstances would blur the distinction
between an administrative and a dispositive power. To do so would
potentially have an adverse tax impact on
17 Except to the extent that the
rules of apportionment can be understood as restoring a
balance.
18 CP, para
5.42.
19 CP, para
5.29.
20 CP, para
5.31.
21 CP, paras 5.67 to
5.77.
22 See paras 4.11 and 5.27; consider
further discussion in CP, paras 5.67 to 5.76.
23 See CP, paras 5.56 to
5.76.
24 CP, para
5.57. |
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trusts benefiting from the new
power; it would provoke legal uncertainty, increasing the risk of
litigation against trustees; and it would depart from the express
intentions of the settlor.25
4.23 This
conclusion was at odds with the understanding of the pre-investment duty
to balance established by Nestle. The CP therefore considered
whether or not personal circumstances ought to remain a relevant
consideration in contexts other than the exercise of the power of
allocation; in particular, when formulating an investment
policy.26 The CP noted the difficulty in justifying a position
where personal circumstances were relevant to some aspects of the exercise
of the duty but not to others, and invited consultees’ views on the
relevance of personal circumstances in exercising the power of
investment.
PERCENTAGE TRUSTS AS AN
ALTERNATIVE VEHICLE FOR TOTAL RETURN INVESTMENT
4.24 We have
outlined how the CP’s proposed power of allocation would have enabled
trustees to invest on a total return basis. As explained in Part 3, the
power to allocate is not the only way to achieve total return investment.
Percentage trusts - known in the US as unitrusts – are another tried and
tested method. The CP outlined their operation, noting that English law
does not prohibit a settlor from constituting a percentage trust. However,
it explained the “significant obstacles to the widespread adoption of
percentage trusts in England and Wales”.27 In addition to a
number of practical issues,28 the CP noted two major technical
impediments to the current adoption of the percentage trust
model.
4.25 The first
was tax. The current tax system for trusts is based exclusively on the
traditional income/capital dichotomy. Percentage trusts are based on the
entitlement of different beneficiaries (or classes of beneficiaries) to a
percentage of the value of the trust fund rather than on the traditional
income/capital divide. From a tax perspective therefore, their structure
does not map onto the current system, and so it has been unclear how they
would be treated for taxation purposes; settlors have understandably been
unwilling to venture on to unknown territory in that respect. The second
problem is presented by the rule against excessive accumulations.
Percentage trusts technically involve the accumulation of income receipts
by the trustees. The current rule against excessive accumulations limits
the maximum duration of accumulation to one of a number of permitted
periods.29 Government accepted in 2001 the Law Commission’s
recommendations that any limitation on accumulation should be abolished
for private trusts, but at the time of the publication of the CP the rule
against excessive accumulations in effect limited the duration of
percentage trusts to 21 years. As we noted in Part 3, a Bill has been
introduced to remove this difficulty.
25 CP, para
5.58.
26 CP, paras 5.67 to
5.76.
27 See CP, para 5.36 and
following.
28 Such as the fact that such a
structure will not be suitable for all types of trust property, the lack
of general awareness of the model and scarcity of
precedents.
29 See The Rules Against
Perpetuities and Excessive Accumulations (1998) Law Com No 251 for a full
account of the current law and the Law Commission’s recommendations for
reform. |
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4.26 The CP
made no recommendations about percentage trusts. Instead, it invited the
views of consultees on the advantages and disadvantages of promoting
percentage trusts in England and Wales.
CONSULTATION RESPONSES
Consultees’ general comments on total return
investment
4.27 Many of
our consultees’ specific comments about the proposed power of allocation
have connotations for total return investment generally. Likewise,
comments in response to the CP’s discussion of percentage trusts and
investment by charity trustees30 provide some general comment
on the utility of total return investment.
4.28 A number
of consultees expressly supported the adoption of total return investment
by trustees. For example, the Wills and Equity Committee of the Law
Society considered that “it is not helpful for trustees to be constrained
in their investment policy by the requirement to generate a certain level
of income”. STEP’s response included an analysis of comparative returns
demonstrating the improved results which should be achieved under a total
return policy.31 We also note below support from various
consultees for percentage trusts, which by definition operate on a total
return basis. Moreover, many of our respondents who focused on charitable
trusts were in agreement that total return investment is a desirable
objective for many trusts with charitable status.
4.29 However,
other responses were more cautious about the widespread adoption of total
return investment. Some consultees questioned the economic argument that
the requirement imposed by the current law to invest so as to balance
income and capital returns really does obstruct trustees in maximising
returns for the trust. For example, the Law Reform Committee of the
General Council of the Bar did not necessarily agree that
… the need for balance in the
choice of investments means that total returns are not maximised. The best
returns on many family trusts have been secured over the last generation
or two by those which invested in property, particularly for occupation.
That investment has not been recognised as a balanced one by the courts,
yet it has often maximised returns. The need for balance has not prevented
an unbalanced investment strategy. We believe that the failure to achieve
the best returns over the past decades has arisen from a misunderstanding
of how to balance investments.32
4.30 Others
concentrated on the potential effects on trustees and beneficiaries, and
noted that total return investment was not suitable for all trustees. They
argued that where trusteeship was taken on by inexperienced lay trustees
(or, in effect, imposed on them in the case of a trust arising on
intestacy), total return was likely to be an overly complicated concept to
expect trustees to deal with.
30 See paras 4.50 to 4.56 and 8.50 and
following below.
31 See analysis of responses, available at http://www.lawcom.gov.uk/citcat.htm. |
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4.31 Some were
concerned about the potential effect of some forms of total return
investment on life tenants in periods during which there was a negative
total return. If the vehicle for total return provided the life tenant
with no income in such circumstances, the life tenant, who might be wholly
reliant on trust income, would be placed in a difficult position. This
might be remediable by the exercise of a power of capital advancement, but
such a power is not available in all cases. These consultees argued that
such a problem is less likely to occur under the current approach to
investment which can provide a level of income return independent of
capital performance.33
4.32 It is
important to note that not all these concerns apply to all types of total
return trust. Most obviously, where a proportion of the value of the trust
(rather than the return in any period) is paid to the income beneficiary,
a relatively stable level of income is guaranteed. We therefore turn to
consultees’ comments on the particular mechanisms of total return
investment discussed in the CP.
Reactions to the power of allocation
4.33 The
following paragraphs do not describe consultees’ comments on every aspect
of the CP’s provisional proposals for a statutory power of
allocation.34 Instead, we concentrate on general support for
and opposition to the CP’s proposal that there should be such a power, and
on the more contentious areas of the policy provisionally proposed in the
CP.
General response
4.34 Over
two-thirds of those who answered the question agreed that a statutory
power of allocation should be made available to the trustees of private
trusts. However, some qualified their agreement with misgivings about
issues such as the creation of uncertainty, potential tax consequences and
the possibility that the power might be used for dispositive rather than
merely administrative purposes.
4.35 Those who
opposed the introduction of a statutory power of allocation raised two
major areas of concern. The first was the practical implications of such a
power for trust administration. Consultees pointed to a number of
undesirable possible consequences. These included: exposure to more
lawsuits; changes to accounting procedures and computer systems; increased
use of suspense accounts and the delayed distribution of trust receipts to
income beneficiaries;
32 See also the comments of David
Palfreyman, Bursar of New College, Oxford University, whose response,
specifically addressing investment by permanently endowed charities, is
reproduced at length in our analysis of responses to the
CP.
33 In the course of 2008 our
Advisory Group echoed this concern, noting that for many trusts the
provision of a steady income stream for the life tenant is more important
than maximising total return.
34 In particular, we do not comment
on reaction to the provisional proposals that the exercise of the power of
allocation should be subject to a time limit from the date of a particular
receipt or expense, that the power should be reviewed by the courts on the
same basis as any other discretionary power conferred upon a trustees or
that an action for breach of trust should lie against trustees who fail to
discharge their duty to balance by exercising the power of allocation, all
of which were supported either unanimously or by the vast majority of
those who commented. Nor do we discuss reactions to the suggestion of a
special protocol for dispute resolution. These issues are covered in
detail in the analysis of responses. |
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difficulties for inexperienced
trustees; and the need for more detailed record-keeping. It was argued
that these consequences, in particular the increase in the current
workload of trustees, would give rise to an increase in trust management
expenses to the detriment of beneficiaries.
4.36 For many
of these consultees, the introduction of requirements that trustees take
any steps on receipt of returns other than the distribution of such
returns would be an unwelcome addition to trust administration. Such
consultees preferred to continue to follow current practice of investing
with the aim of creating a balance rather than investing solely to balance
risk and return and then to take steps to adjust the fruits of investment
on a total return basis.
4.37 The
second area related to the tax consequences of the power of allocation. A
number of consultees were concerned about the potential tax implications
of the introduction of a power of sort described in the CP. Some were
concerned that HMRC would not accept the CP’s view that the power could
genuinely be classified as administrative. Others saw difficulties in
integrating the proposed regime within the existing tax system for trusts,
leading to difficulty in persuading HMRC to adopt a tax-neutral approach
to the provisional proposals.
Opt-in or opt-out?
4.38 Most of
the consultees who answered the CP’s question thought that the CP’s
proposed power of allocation should be available on an opt-out basis. The
main reason for this view was that, in the words one consultee, “the
proposals are intended to provide a better and more equitable trust
regime, and … should plainly apply automatically and immediately to all
new trusts”.35 It was also suggested that those trustees who
were unaware of the existence of the new power were unlikely to be
affected “in the sense that they’re closer than some of the present rules
to the approach they do or would probably take
anyway”.36
4.39 It is
difficult to assess how far those consultees who favoured the introduction
of an opt-out power of allocation truly supported the effective imposition
of total return investment. Moreover, the CP’s proposed simple
classification rule for corporate receipts (discussed below) was closely
connected with the power of allocation, so that it was difficult to
support the former (as a suggested replacement for very unpopular current
classification rules) without accepting the latter as an opt-out power.
Equally, the consultees who thought that the power of allocation should be
introduced on an opt-in basis were generally those who were concerned
about the possible practical consequences of operating that particular
power. These concerns do not translate to all forms of total return
investment.
4.40 It is
therefore not possible to determine conclusively on the basis of
consultation responses the wider question of whether any total return
investment power should operate on an opt-in or an opt-out
basis.
Reactions to the duty to balance
4.41 The vast majority of consultees who
answered the relevant question agreed that
35 Mr Justice Etherton.
36 Simon Gardner, University of
Oxford.
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trustees should be subject to the
duty to balance, except in so far as the settlor expressly, or by
necessary implication, excluded or modifies that duty in the terms of the
trust. A similar majority agreed that the duty should not be impliedly
excluded merely on the basis that the subject matter of the trust
constituted an unauthorised investment or a specific gift.
4.42 As to
placing the duty on a statutory footing, a majority of consultees who
answered this question were in favour of doing so – some because of its
fundamental importance, others on the basis of the new role the duty would
play in underpinning the CP’s proposed power of allocation.
4.43 Some
consultees were, however, concerned that to place the duty to balance on a
statutory basis would give it artificial prominence, and might even
detract from trustees’ other fundamental trust obligations. Two consultees
highlighted the difficulties in drafting the concept of “balance” given
the wide range of possibilities for which the statutory definition would
be intended to cater. One consultee observed that placing the duty to
balance on a statutory footing would detract from the flexibility of
equity.
4.44 The vast
majority of those who answered the question agreed that statute should not
set out a list of factors relevant to determining whether or not a balance
has been struck between income and capital. Consultees commented that such
a list would not be suitable for all circumstances and would be unlikely
to meet all possibilities. STEP suggested that a list of factors “would
potentially create a ‘box-ticking’ compliance mentality”.
4.45
Consultees were evenly split on the question of whether or not the
personal circumstances of beneficiaries should be a relevant factor in the
exercise of the statutory power of allocation. Some consultees made the
general point that allowing trustees to take account of personal
circumstances would blur the distinction between interest in possession
and discretionary trusts. For example, Mr Justice Lloyd agreed with the CP
that “if a settlor wishes [the trustees] to take [personal circumstances
of the beneficiaries] into account, he should give them a dispositive
discretionary power for the purpose”.
4.46 Other
consultees emphasised the practical implications of allowing trustees to
take account of personal circumstances in the context of the proposed
power of allocation. The British Bankers’ Association and Barclays Bank
Trust Company commented that “bringing the personal circumstances of the
beneficiaries into account would not only impose a greater burden on
trustees, but would also have a strong tendency to promote conflict
between the beneficiaries and also between beneficiaries and trustees”.
Another consultee, Charles Russell solicitors, made what we considered to
be a critical point when drafting the CP: that “allowing trustees to take
account of personal circumstances may create difficulties with the tax
implications of the power of allocation”.
4.47 In
contrast, a number of consultees thought that trustees should be
permitted, but not obliged, to take account of beneficiaries’ personal
circumstances when exercising the power of allocation. Several emphasised
the importance of trustees’ flexibility in exercising their discretions.
The Trust Law Committee commented that trustees “are not mechanical
administrators of an impersonal fund of investments”, and that in reality
“many trustees would find [taking into
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account personal circumstances]
irresistible in practice … ”. It was also suggested that there might be
difficulties with excluding personal circumstances in a way which made
clear exactly what are the circumstances to be disregarded.
4.48
Consultees were similarly split as to the relevance of personal
circumstances to the duty to balance in the traditional pre-investment
context. Slightly more than half of the consultees who responded to this
question agreed with the Nestle approach and thought that personal
circumstances should be a relevant factor when formulating a balanced
investment portfolio. Several consultees noted that personal circumstances
are just one of many factors taken into account, whether consciously or
unconsciously, when trustees exercise their powers of investment. One
consultee commented that in small family trusts it is fair to assume that
the settlor would have wanted the beneficiaries’ personal circumstances to
be taken into account.
4.49 The
remainder of those who replied to the question considered the Nestle
approach to be incorrect. The Association of Corporate Trustees and
HSBC observed the “practical difficulties for trustees knowing and
accommodating beneficiaries’ personal circumstances when making investment
decisions”. Simon Gardner commented “I am glad that you have noticed the
overtly dispositive note in Nestle, and regard it as objectionable
– I’d begun to think I was in a minority of one in troubling over
this”.
Reactions to percentage trusts
4.50 A number
of consultees who commented on percentage trusts were not in favour of
their promotion. Several noted the practical obstacles to such trusts in
the context of private trusts, identified above. Just as the CP implied
that the jump from current trust structures to the percentage trust model
was too great a leap, so too a number of consultees were put off by the
impediments to the adoption of the model identified above.
4.51 Some went
further and questioned the desirability of percentage trusts. Christopher
McCall QC argued that the percentage trust model “… suffer[s] from almost
as many objections as the present law in being inflexible and all too
likely to do as much harm as good. Even in the period in which the Trust
Law Committee has been discussing this subject the level at which a fair
percentage return might have been set has changed radically, and in my
view percentages assume a degree of arithmetic exactitude which simply
does not fit the multifaceted world of trusts.”
4.52 The Trust
Law Committee summarised its position in the following terms: “If [the
rule against excessive accumulations] is abolished, there can be no
objection in principle to percentage trusts … . There does not, however,
appear to be any considerable pressure for change in this area of the law
and we do not believe the Law Commission should feel obliged to recommend
that the law should be changed merely to facilitate their adoption.” This
suggests a certain ambivalence towards percentage trusts, perhaps
equivalent to that exhibited in the CP.
4.53 However,
other responses, including responses from bodies representing large
numbers of trust practitioners, were more positive.
4.54 STEP commented that percentage trusts
have “considerable merit“. In a similar
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vein, the Wills and Equity
Committee of the Law Society could “see some merit in promoting percentage
trusts, which would be particularly useful where trustees wish to operate
on a ‘total return’ basis. It would remove much of the artificiality which
often occurs in operating a trust and would clearly make distribution
calculations easier.”
4.55 Mr
Justice David37 strongly supported the development of
percentage trusts for the furtherance of total return investment. He
commented that “the time has come to introduce the ‘percentage trust’ or
‘unitrust’ into English (and Welsh) law” and encouraged the Law Commission
to “take this opportunity so as comprehensively to deal with capital and
income and the total return approach to investment”. He suggested that the
introduction of such trusts would, amongst other things, lessen the
administrative burden on trustees and remove the problematic issue of the
relevance of factors such as the personal circumstances of beneficiaries.
Mr Justice David Hayton suggested that “the function of the Law Commission
is to be bold and look at things with fresh eyes, starting with a clean
sheet of paper” and concluded by encouraging us to “be bold: go the whole
way and not three quarters of the way”.
4.56 However,
Mr Justice David Hayton, in common with a number of the consultees
supportive of percentage trusts, and those opposed to them, recognised the
importance and difficulty of formulating an appropriate tax structure for
such trusts.38 Although some consultees suggested ways of
taxing percentage trusts,39 HMRC in its consultation response
was less positive, stating that “we still see significant practical
difficulties in determining the correct tax treatment of such
entities”.
CLASSIFICATION RULES
The CP’s provisional proposals
4.57 The CP
stressed the utility of the power of allocation in overcoming the
deficiencies of the rule-based classification of trust receipts. The
provision of a flexible power to change a default classification would
enable trustees to overturn any inappropriate results produced by the
underlying rules. However, the CP recognised that, whether the power was
provided on an opt-in or opt-out basis, there would be trustees who were
unable to rely on the power of allocation to correct inappropriate
classifications. Consequently, the problems with the rules of
classification of corporate receipts could not be ignored, and there
remained a need to reform the current law. In any case, as the power of
allocation would operate following classification there remained an onus
to put in place as straightforward and accurate a set of base rules as
could be reasonably achieved.
4.58 As we explained in Part 2, the CP
expressed the view that the current rules
37 Of the Caribbean Court of
Justice, formerly Professor of Law at King’s College London, and current
editor of Underhill and Hayton: Law of Trusts and
Trustees.
38 STEP noted that percentage trusts
would require “an appropriate adaptation of the taxation framework of such
trusts”.
39 The Wills and Equity Committee of
the Law Society said that they could see no reason why percentage trusts
could not be accommodated by analogy with the rules relating to annuities
within the present trust tax regime. |
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governing the classification of
corporate receipts rest on principles of questionable relevance and fail
to deliver either certainty or fairness.40 It described this
position as “illogical and capricious” and provisionally proposed that the
current rules governing the classification of corporate receipts should be
abolished.
4.59 In
examining what should take the place of the current law, the CP expressed
a preference for a rule of general application rather than a list of
specific provisions for particular distributions. It accepted that it
might not be possible to draft a general rule that would give a perfectly
acceptable result in all situations,41 but it noted that the
power of allocation would allow trustees to achieve a balance in
circumstances where the rule did not.42
4.60 The CP
provisionally proposed a simple rule based on the form of the receipt
whereby cash distributions to trustee-shareholders by corporate entities,
or distributions which trustees could have taken in cash, should be
classified as income and non-cash distributions should be classified as
capital.43 In order to preserve the classification of receipts
that Bouch v Sproule appropriately classifies as capital, the CP
noted that the treatment of payments made on liquidation and authorised
reductions of capital would be unaffected by the
rule.44
4.61 The CP
suggested that the new rule would give rise to a default classification if
the proposed power of allocation were available and to a conclusive
classification if it were not. The proposed rule of classification would
be subject to any contrary provision in the terms of the trust. The CP
stressed the relative simplicity of the proposed new rule as opposed to
the complexity of the rule in Bouch v Sproule. It also suggested
that the rule would operate in the majority of circumstances to produce an
economically appropriate result, so providing an acceptable balance
between those interested in income and those interested in
capital.
Reaction of consultees
4.62 All the
consultees who answered our question about the rule in Bouch v Sproule
agreed that it should be replaced. The Wills and Equity Committee of
the Law Society stated “in our view the existing classification rules
result in confusion and uncertainty and random outcomes”. In a similar
vein, STEP stated that “the current rules of classification generate
arbitrary and illogical results and can create considerable complexity and
uncertainty for trustees and their advisors”.
4.63 Almost
all of those who addressed the question agreed that the rules of
classification for trust receipts should be subject to any contrary
provision in the terms of the trust.
40 See para 2.35 and following
above. See para 2.55 and following above for a discussion of non-corporate
receipts.
41 CP, para 5.4.
42 CP, para
5.11.
43 CP, paras 5.6 to 5.12. This
approach is similar to the classification rule in the UPIA and the
Massachusetts rule.
44 See para 5.54 below for the
similar treatment of the proceeds of the repurchase and redemption of
shares. |
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4.64 Most of
the consultees who commented on the proposed cash/non-cash classification
rule supported it. Responses stressed the need for a clear and simple
rule, particularly if a power of allocation were also available. The
Association of District Judges thought that it was “important that the
replacement rules should be as simple as is possible to avoid the
necessity in the vast majority of cases for trustees to have to take
expensive advice and/or court proceedings to clarify treatment”. One
consultee favoured the provisional proposal “in the interests of
simplification, in place of the current rules, so long as it were coupled
with availability to the trustees of a separate power to allocate in order
to deal with any perceived imbalance”.
4.65 While a
number of consultees expressly predicated their support for the CP’s
proposed rules of classification on the availability of a power of
allocation, some thought that a simple rule was desirable in its own
right. One consultee commented that the rule “would provide a clear and
certain rule which would help trustees know what to do and make for less
difficulty in the administration of
trusts”.45
4.66 Despite
this high level of support, a number of important concerns were raised in
relation to the proposed cash/non-cash rule. A few consultees commented on
the mismatch between the classification produced by the proposed rule and
the treatment of receipts under the tax rules. We discuss the interaction
of our proposed reform to the classification rules and tax at paragraphs
5.75 to 5.78 below.
4.67 Some
consultees expressed concerns about how the cash/non-cash distinction
would be drawn. Obviously, if the definition of cash were not sufficiently
clear and relatively easy to apply, then the introduction of the CP’s
proposed rule could shift disputes from the meaning of income/capital to
cash/non-cash.
4.68
Consultees acknowledged that, as well as being simpler and more
certain than the current law, the CP’s proposed rule of classification
would produce more appropriate results in a number of areas; for example,
in cases of a direct demerger.46 However, a number of responses
pointed out that the proposed rule also had the potential to produce what
they considered to be inappropriate results, in particular by classifying
as income certain types of cash receipts which are properly treated as
capital. These included unusually large dividends paid in cash, and
enhanced scrip dividends where the cash option would be worth very much
less than the shares.
4.69 The CP
acknowledged that its proposed rule would produce the same result as the
current law in the case of capital profits dividends47 and for
large distributions of accumulated trading profits. If the profits were
distributed in the form of an enhanced scrip dividend the rule would
produce an arguably less appropriate result than the current law (where
part of the dividend may be apportioned to |
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45 Moore & Blatch.
46 See CP, para
5.10.
47 CP, para
5.11. |
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capital).48 |
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CONCLUSION
4.70 We have presented the CP’s
proposals, and consultees’ responses in 2004, as a “package”, because that
is where matters rested for over three years. We explained in Part 1 that
our work on this project had to be suspended because of other urgent law
reform work. As a result, a fresh start was made in 2008. By then,
Government policy on the taxation of private trusts had changed
dramatically. That very different tax climate, as well as the lapse of
time, led us to undertake further informal consultation in 2008. The
outcome of that final year of work, so far as it concerned classification
and total return investment, is presented in Part 5. |
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48 |
CP, paras 2.35 to 2.36. |
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PART 5 RECOMMENDATIONS
INTRODUCTION
5.1 The
response to our 2004 consultation demonstrated that there is widespread
dissatisfaction with the existing rules for the classification of
corporate receipts. Most consultees supported the CP’s provisional
proposal of a simple cash/non-cash rule to replace the rule in Bouch v
Sproule, in the context of the provisional proposal for a power of
allocation. Most also supported the power of allocation. But it was
equally clear that the extent and diversity of the trusts sector make it
extremely unlikely that there would ever be unanimity as to the way
forward.
5.2 In
re-opening this project in 2008, our task was to respond to the breadth of
views expressed in consultation, as well as to pursue the taxation aspects
of the project which, in 2004, had been left for future discussion in the
light of consultation responses and of the planned reform of the trust
taxation system. We had made it clear in the CP that any change we might
recommend must be tax-neutral, neither increasing the tax burdens on trust
beneficiaries nor threatening tax
revenue.1
5.3 In 2004,
HMRC was in the process of consultation in preparation for its Trusts Tax
Modernisation programme. We held preliminary discussions with HMRC before
publication of the CP, but at that stage it was not possible to say for
certain how trusts would be taxed if a power of allocation were made
available to trustees; as the CP acknowledged, the tax treatment for
trusts subject to any new apportionment and classification regime would
“need to fit within the modernised system of trust taxation on which the
Inland Revenue is currently consulting”.2 The CP therefore
recognised HMRC’s interest in this area and underlined the need to design
reform which was tax-neutral and so did not give rise to concerns about
tax savings or the potential for abuse.
5.4 HMRC’s
formal response to the CP noted that a power of allocation would give rise
to a number of tax issues. First, HMRC expressed concern that the power
might offer tax avoidance opportunities by allowing trustees to treat as
income what HMRC viewed as capital, and to treat as capital what HMRC
viewed as income.
5.5 Secondly,
HMRC took the view that if the exercise of the power had the effect of
changing the nature of the receipt, that is, overturning an initial
classification,3 then the result might be that two identical
corporate receipts would be classified differently, depending on whether
they were paid to an individual or a trustee. This would run counter to
the aim of HMRC’s Trust Tax Modernisation programme to reduce any tax
distinction between asset-holding by trusts and by
individuals.
5.6 On the other hand, if the exercise of
the power did not change the classification
1 CP, paras 5.63 and
5.100.
2 CP, para
5.101. |
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of a receipt but allowed the
trustee to decide whether to pay it to the income beneficiary or retain it
as capital, HMRC warned that the power might cause an interest in
possession trust to lose its status as such for both income tax and, where
relevant, inheritance tax purposes,4 thereby increasing its
income tax and inheritance tax liabilities. This was a concern that we
raised in the CP, and indeed is well-established as a reason why a power
of allocation is not currently a normal feature of trusts for interests in
succession, despite the availability of precedents for such a
power.5
5.7 The CP had
expressed the hope that HMRC would either find itself able to approve our
proposed scheme as tax-neutral within the current law or to co-operate in
the modification of the tax rules in order to allow the scheme to operate
tax-neutrally.6 HMRC’s consultation response explained that, as
things stood, there was a range of obstacles to both of those objectives.
However, as noted, trust taxation was in a state of flux at the time of
consultation and further engagement was planned.
5.8 There have
been a number developments in trust taxation since the close of the
consultation period. The most significant for this project relates to
inheritance tax. The Finance Act 2006 introduced sweeping changes to the
taxation of trusts. The tax advantages previously enjoyed by accumulation
and maintenance trusts were removed,7 and the circumstances in
which the income beneficiary of an interest in possession trust will be
regarded for inheritance tax purposes as beneficially entitled to the
underlying assets were restricted.8 As a result, the range of
trusts that now fall within the “relevant property regime”9 has
been significantly expanded. It is important for those trusts that now
fall outside the relevant property regime to remain outside it (unless
they choose otherwise). We would not make any recommendation for reform
that would automatically deprive them of that status. Nor would there be
any realistic likelihood of take-up for any reform which required trustees
to change the tax treatment of the trust.
5.9 Since work
on this project recommenced in 2008 we have held extensive discussions
with HMRC about the tax consequences of the type of trust law reform that
we would wish to see introduced. We are grateful to officials at HMRC for
their assistance while we have been formulating policy. Our objective has
remained to work with HMRC to devise ways in which trust law reform might
be introduced tax-neutrally.
3 This was the intention behind the
CP: see CP, para 5.64.
4 See
paras 5.67 and following below. We use the term “interest in possession”
to describe both an interest in possession for inheritance tax purposes
and a trust in relation to which one or more beneficiaries have an
immediate entitlement to the income of the trust as it arises and s 479 of
the Income Tax Act 2007 (“ITA 2007”) does not apply for the purposes of
income tax.
5 See
paras 3.27 to 3.28 above.
6 See CP,
para 5.63.
7
Inheritance Tax Act 1984 (“IHTA 1984”), s 71 as amended by the Finance Act
2006.
8 IHTA
1984, s 49 as amended by the Finance Act 2006.
9 That
is, the provisions set out at Chapter III of Part III IHTA 1984 applying
to “relevant property” as defined at s 58(1). See further para 5.70
below. |
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5.10 However,
that objective has proved to be attainable only to a very limited extent.
HMRC has explained the tax consequences that would follow from our desired
reforms in the context of current tax law and policy. We believe that the
settlors, trustees and beneficiaries of interest in possession trusts
would find such consequences unacceptable. Debate on the interpretation of
the current tax legislation and case law cannot overcome these
consequences as they flow from trust tax policy which could be reinforced,
if necessary, by provisions in a Finance Act. We do not consider it
appropriate to make recommendations for reform which cannot be implemented
without adverse tax consequences - either for the Exchequer or for trusts
and their trustees and beneficiaries.
5.11 This Part
therefore includes two sorts of proposals for law reform. First, we say
what we consider, from a trust law perspective, the law should be. Our
proposals include the replacement of the rule in Bouch v Sproule
with new classification rules, and the provision of a statutory power
of allocation on an opt-in basis to offer flexibility and, for those who
wished to achieve this, facilitate total return investment. However, as
these proposals cannot be put into effect without unacceptable tax
consequences, they are not the subject of formal recommendations. Instead,
we make recommendations for immediate consideration by Government which
can be implemented without adverse tax consequences either for the
Exchequer or for trusts and their beneficiaries.
OUR PREFERRED POLICY
5.12 We start
by outlining our conclusions on total return investment as a necessary
precursor to a discussion of the rules of classification for corporate
receipts.
Total return investment
5.13 Three
things were clear from the consultation exercise. One was that there is
considerable support for total return investment within the trust industry
as a profitable approach to investment. Many trustees would like to be
able to operate it and are frustrated by their current inability to do so.
Secondly, we are satisfied that total return investment would not be
suitable for all trusts. It requires a level of expertise and confidence
on the part of the trustees which not all possess. Thirdly, we were
encouraged by the response to the CP’s discussion of percentage trusts.
The CP treated percentage trusts with some caution, because of their
unfamiliarity and the current impediments to their adoption, and indeed
many respondents did not comment on them. But although a number of
consultees were opposed to the promotion of percentage trusts, there were
significant supporters, including STEP and the Wills and Equity Committee
of the Law Society, who together represent a great many practitioners and
trustees, as well as Mr Justice David Hayton.10
The power of allocation
5.14 We remain
of the view that total return investment should be facilitated for private
trusts by means of the power of allocation advocated in the CP, but on an
opt-in basis. We would like settlors of private trusts who believe that
the trust fund should be invested on a total return investment basis to be
able to provide their
10 Of the Caribbean Court of Justice, formerly
Professor of Law at King’s College London, and current editor of Underhill and
Hayton: Law of Trusts and Trustees.
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trustees with a defined power of allocation, without fear of
adverse taxation
consequences.11
5.15 In light
of concerns raised in consultation we no longer consider that the power
should operate on an opt-out basis as we do not think that a power of this
kind is appropriate for all trusts. We have in mind particularly the
position of lay trustees, many of whom act for trusts implied on intestacy
and who may not have investment expertise. We consider that a power of
allocation should be a facility offered to settlors, not a power that all
trustees are under a duty to exercise. It should, however, be open to the
trustees of existing trusts to opt into a total return investment regime
and in effect provide themselves with such a power, with the consent of
their beneficiaries.12
5.16 The power
of allocation would allow trustees, taking the trust’s receipts over a
given period, to allocate all or part of one or more trust receipts as
necessary in order to ensure that a balance was kept between classes of
beneficiaries entitled to capital and to income. The power would therefore
allow trustees to overcome inappropriate classifications produced by the
default rules (if there remained a net imbalance, looking at receipts as a
whole over the period) and to maintain a balance where investments made
with a view to income return or capital protection had not performed as
expected. It would also enable trustees to ignore the likely form of
receipt when making investment choices and so invest on a total return
basis.
5.17 The power
would be framed so as to make it clear that it was administrative rather
than dispositive. There would be a time-limit from the receipt of an
investment return, after which the default classification would become
conclusive.13 The power should be reviewable by the courts on
the same basis as any other discretionary power conferred upon trustees.
We see no case for any statutory protection or immunity and an action for
breach of trust should lie against trustees who failed to discharge their
duty.
PRACTICAL
IMPLICATIONS OF A POWER OF ALLOCATION
5.18 We reach
these conclusions after reflection on the points raised about the power in
consultation. Overall, we are not convinced by the concerns of some
consultees about the practical implications of a power of
allocation.
5.19 We remain
of the view that the introduction of such a power would rarely give rise
to successful claims against trustees, on the basis that perceived
imbalances could usually be redressed by further exercise of the power. We
do not envisage that the power would have to be used regularly, or in
relation to a significant number of receipts, in order to achieve a
balance, taking investments as a |
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11 See paras 3.27 to 3.28
above.
12 Arrangements would have to be
made to safeguard minors and others incapable of consenting. Further
consultation and discussion would be required to settle the details of
arrangements for existing trusts to opt in, given the strong majority view
in consultation that a court application in these circumstances would make
opting in extremely unattractive.
13 Consultees commented on a number
of options linked with the tax year or the date of receipt; a rule would
have to be agreed with HMRC. |
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whole.14 The
conclusions we reach below about the appropriate meaning of balance in the
context of the exercise of the power of allocation would further simplify
its operation.
5.20
Crucially, the type of power of allocation that we are now proposing
would be made available on an opt-in basis. Consequently, those trustees
who were concerned about the relative benefits of total return investment
for their trusts would not need to concern themselves with the power; nor
would those without the skill and experience necessary to invest on a
total return basis.
PERSONAL CIRCUMSTANCES
5.21 We
consider in the light of consultation responses that the balance
underlying the power of allocation should be tightly defined so as to
indicate to trustees that they should be aiming to achieve an impartial
balance between income and capital. Their only relevant consideration
would be to ascertain what would represent a reasonable rate of income
return. In practical terms, this would allow trustees to settle on a level
of return falling within a relatively narrow range,15 and would
make for ease of administration. It would also emphasise that the power is
an administrative rather than a dispositive one.
5.22 It
follows from this that we think that a power of allocation should be
defined so as to prevent trustees from taking account of factors such as
the personal circumstances of beneficiaries.
Percentage trusts
5.23 In view
of the support for percentage trusts expressed on consultation, we would
also like to see more work done in order to develop a model of percentage
trust for this jurisdiction. However, some respondents took issue with
whether it was the Law Commission's role to promote percentage trusts. For
example, the Law Reform Committee of the General Council of the Bar
doubted that “… law reform is the appropriate tool for the promotion of a
new type of trust”. We agree that that work must be the task of the trust
industry itself, in partnership with HM Treasury and HMRC; we revert to
that point later.
The duty to balance
5.24
Consultation responses demonstrated that the meaning of the duty to
balance depends on the context in which the duty is being
applied.
5.25 We are
content that the general meaning of that duty, including the relevance of
the personal circumstances of beneficiaries to investment decisions,
should remain subject to developments in the law of equity. We note that a
narrow majority of the consultees who addressed the CP’s questions about
the relevance of personal circumstances to investment decisions supported
the approach advocated by Mr Justice Hoffmann at first instance in
Nestle and by Lord Justice Staughton in the Court of Appeal.
Nevertheless, we retain the concerns
14 See CP, paras 5.47 to 5.48 and
5.80 to 5.82 for a discussion of the reasons for our view that the
introduction of the power would rarely provoke litigation and that its
exercise should not be excessively onerous in
practice.
15 Guidance could be provided,
either by the trust industry or conceivably by HMRC.
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expressed in the CP about the
effect of what we called the “Nestle approach”. Consultation has
emphasised that it remains controversial for many. In the absence of
re-examination by the courts, settlors who wish their trustees to ignore
the personal circumstances of their beneficiaries when investing may make
express provision to that effect in the trust instrument.
5.26 It
follows that we do not consider that the general duty to balance should be
placed on a statutory footing. As consultees warned, any attempt to
“capture” the duty may have unintended consequences.
5.27 We have
commented above on the meaning of the duty to balance in the context of
the exercise of the power of allocation. The CP discussed whether the duty
in that context would mean the same as it currently does in relation to
trustees who have to keep a balance in the selection of investments. A
duty to balance applying post-investment when exercising a power of
allocation would be a positive obligation, going beyond the negative sense
of the current duty as it applies to the selection of investments; this is
a new context for the duty, and its meaning in that context would need to
be spelt out in the statute.
5.28 The CP
commented that “it is difficult to frame a principled justification for
the position where the same duty informs trustees’ decisions in two
different contexts but the content of that duty is significantly different
in each context”.16 We have concluded in the light of
consultation that this is not a real difficulty. There is no reason why
these two manifestations of the trustee’s equitable duty to balance should
give rise to the same considerations in different contexts. Accordingly,
we consider that a statutory requirement to balance investment returns
arising under a power of allocation should apply solely in the context of
the exercise of the power of allocation. The obligations of trustees in
selecting investments on a traditional basis with a view to achieving a
balanced return would not be affected by such legislation.
5.29 In
conclusion, we consider that it would be preferable for the general duty
to remain as an equitable duty of general application and for any
statutory provision setting out a power of allocation to spell out the
basis on which that power operates for those purposes only.
Classification of corporate receipts
Abolition of existing rules
5.30 In the
light of the difficulties generated by the rule in Bouch v Sproule,
in particular its illogical basis, its tendency to produce unexpected or
arbitrary results, and the difficulties of applying it in
practice,17 we remain of the view that it should be abolished
and replaced. All the consultees who answered our question about the rule
agreed.18 Rather more difficult is the decision what to put in
its place. That decision is made all the more difficult by the range of
trustees for whom the rule will apply; experienced paid trustees taking
professional advice, trust companies conducting high-volume business and
lay trustees acting for low-16 CP, para
5.72.
17 See para 2.35 and following
above.
18 See para 4.62
above. |
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value trusts. Although, as we go
on to explain, we think that it should be open for settlors to specify
their own classification rules if they wish to do so, any rule that we
recommend should be capable of being operated by all types of
trustee.
Rules or discretion?
5.31 The first
step is to decide whether to replace the rule in Bouch v Sproule
with a rule or rules, or with discretion. We received a very detailed
consultation response from Mr Arthur Weir, on behalf of the City of
Westminster and Holborn Law Society, arguing strongly against any
rule-based approach to classification and advocating an alternative
approach to classification to be guided by good accountancy practice,
possibly underpinned by a Statement of Recommended
Practice (“SORP”).19
5.32 The City
of Westminster and Holborn Law Society approached the classification rules
from the basis that “the function which trustees must perform when
allocating a receipt is an accountancy function”. It took the view
that:
… classification is a matter of
judgment. [It] does not require an esoteric science unique to trusts and
charities. It is a routine function in accounting for an organisation to
classify each receipt and payment according to what the accounting person
judges to be its true nature in relation to the organisation and the
purpose for which the accounting is required. As in all exercises of
judgment the accounting person … must consider all the circumstances of
the case and give weight to those deemed relevant.
5.33 The
adoption of such an approach to classification would avoid the problems
inherent in any rule of classification and would be sufficiently flexible
to cater for future changes in corporate distributions. Professional
trustees with accountancy skills, or trustees employing accountancy
professionals to deal with tax, would not find it onerous.
5.34 However,
many trustees are not accountants, and do not employ them, or would be
unwilling to give their accountants more extensive instructions. The
content of “generally accepted accounting practice” is not understood by
non-professionals and the correct application of SORPs would not be
straightforward. The approach suggested by the City of Westminster and
Holborn Law Society would, we think, give rise to other practical
problems. Critically, if classification depended on the trustees’
decision, receipts would be left unclassified until trustees had reached a
view, which could potentially have tax consequences and also delay the
administration of the trust to the detriment of the
beneficiaries.
5.35 It is
open to debate how far the sort of approach advocated by the City of
Westminster and Holborn Law Society should properly be viewed as
“discretionary”. We consider that such an approach is ultimately
discretionary. There would be no underlying rule for the classification of
receipts as they arise
19 The Accounting Standards Board explains that
“SORPs are recommendations on accounting practices for specialised
industries or sectors. They supplement accounting standards and other
legal and regulatory requirements in the light of the special factors
prevailing or transactions undertaken in a particular industry or sector”:
Accounting Standards Board Statement, SORPs: Policy and Code of
Practice (July 2000).
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to the trust; classification
would be based on the individual judgement of the trustee. The fact that
such judgement should be in some way guided by accountancy practice (and
possibly a SORP) does not, in our view, render the judgement
non-discretionary. While accountants may regard such practice and SORPs as
professionally binding, most trustees are not accountants, and many
trustees will not be professional. Even to accountants, SORPs provide
guidance, but are not in the final analysis determinative. The team was
referred to examples of SORPs for investment trusts and unit
trusts.20 While these establish a number of principles, and set
out quite detailed guidance in certain circumstances, the user of the SORP
is left with significant discretion depending on the circumstances of the
case.
5.36 We
discussed the City of Westminster and Holborn Law Society’s suggestions
with HMRC and are satisfied that such an approach to classification would
cause changes to the tax treatment of interest in possession trusts. It
would also add to administrative burdens since it would lead HMRC to
require full accounts from all trusts. We discuss below the taxation
consequences of any element of decision-making, even falling short of
discretion, in classification; a discretionary approach, even one a
involving a narrow discretion, would certainly attract these
consequences.
5.37
Accordingly, we do not favour the classification scheme advocated by
the City of Westminster and Holborn Law Society, or any other
discretionary approach to classification.
Cash/non-cash
5.38 We
consider that consultation has confirmed our view that the basis for the
classification of corporate receipts should be the form-based rule
proposed in the CP: that cash distributions to trustee shareholders, or
distributions which trustees could have taken in cash, should be
classified as income and all other distributions from corporate entities
should be classified as capital. As we discuss at paragraph 5.54 below,
the rule would be formulated to ensure that the treatment of certain sorts
of payment made by companies to their shareholders which are properly
classified as capital under the current law would not be affected by the
new rule.
5.39 A
form-based approach has the merit of simplicity. The CP’s proposal was
rooted in a desire to avoid complex provisions that we thought would be
difficult for many trustees to apply, at least without professional
advice. The CP accepted the difficulty of formulating a sufficiently
certain rule capable of operating appropriately in all circumstances, but
noted that its proposed approach would overcome some of the inappropriate
classifications of corporate receipts generated by the current law.
However, as Part 4 describes, while consultees generally supported the
CP’s proposed rule, a number of respondents outlined
20 See The Association of Investment Trust
Companies, Statement of Recommended
Practice: Financial Statements
of Investment Trust Companies (revised December 2005) (available
at
http://www.theaic.co.uk/files/technical/aitcrevised%20SORPDecember2005.pdf)
and Investment Management Association, Statement of Recommended
Practice: Financial Statements of Authorised Funds (November 2008)
(available at http://www.investmentfunds.org.uk/news/standards/sorp.pdf).
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circumstances in which it would
not give rise to what they considered a fair classification.
5.40 It is
important that the simple rule advocated in the CP is viewed in the
context of the CP’s overall policy recommendations. In particular, the
CP’s provisional proposals for classification were premised on the
availability of a power of allocation which would be available to trustees
to smooth the outcomes produced by a new rule of classification. The
potential problems created by the CP’s proposed rule of classification
would be of reduced significance where a power of allocation was
available, as that power would enable the trustee to create an overall
balance between the capital and income beneficiaries whatever the
classification of individual receipts.
5.41 However,
our preferred policy is now an opt-in power of allocation, and we accept
that many trusts would not opt into the power. Accordingly, any rule of
classification introduced in substitution to the rule in Bouch v
Sproule must work in isolation, without the assistance of a power of
allocation.
5.42 The most
significant problems with a cash/non-cash rule concern cases, such as
abnormally large cash dividends or scrip dividends, where the capital
value of the shareholding is materially reduced by a distribution which is
classified as
income.21
5.43 Our
preferred policy builds on the basic approach taken by the CP (and
supported by consultees) in order to address the classification of large
dividends, so far as we consider it practicable to do so. It attempts a
slightly more refined exercise than that demanded by the CP’s proposed
rule, by introducing a further test (see paragraph 5.44 and following,
below), but still places a premium on ease of operation by trustees.
However, no rule, however nuanced, can produce an entirely satisfactory
outcome in every case, and so our preferred policy also incorporates an
additional opt-in power to adjust individual corporate
receipts.
A 20 per cent threshold
5.44 A number
of consultees commended the provisions of the UPIA as a means of providing
a more adequate rule of classification than that proposed in the CP. These
included STEP, the largest trust industry body in the UK and
world-wide.
5.45 The basic
approach of the CP to the classification of corporate receipts was in line
with that of the UPIA; both rely to a greater or lesser degree on a
default rule based on the form of receipt which can be adjusted by a
trustee power. However, the UPIA modifies its basic form-based rule with a
number of additional provisions not replicated in the rule provisionally
proposed in the CP.22
5.46 One of
the most significant sophistications provided by the UPIA is the way in
which it deals with proportionately large corporate distributions which
take a form which the simple form-based rule would classify as income.
Section 401(c)(3) of the UPIA allocates money received in “total or
partial liquidation” to capital. Partial liquidation is defined in section
401(d)(2) to include a distribution or series of
21 See para 2.20 above.
22 A copy of the relevant provisions of the
UPIA can be found in Appendix D.
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related distributions totalling
more than 20 per cent of the entity’s gross assets. Such receipts are
therefore classified as capital no matter what form they take.23
The effect of this provision is to supplement the basic form-based
classification rule with a percentage cut-off.
5.47 In the
US, percentages have, in the past, been used as a means of classifying
corporate stock distributions. Small stock dividends were classified
entirely as income and large stock dividends were classified entirely as
capital, with the size of the dividend being determined by the relative
size of the stock distribution to the company’s capital. The rule is
commonly known as the “six per cent rule” on the basis that it was common
for stock dividends of less than six per cent to be classified as income,
and those above six per cent to be classified as
capital.24
5.48 We do not
consider that this sort of percentage approach would, on its own, be an
appropriate rule of classification, since it is to some extent arbitrary
and can give rise to unusual or inappropriate results. Perhaps most
significantly, a rule which in practice requires trustees to gather
information as to the percentage of every distribution as against the
company’s existing capital (which may not be obvious from the
documentation provided by the company) is clearly onerous. However, we do
consider that it would be appropriate to adopt the UPIA’s 20 per cent
figure as the cut-off under a new classification rule. The practical
effect of the cut-off would be that very large cash distributions would be
prevented from benefiting the income beneficiary. As a result, some of the
potentially inappropriate results of the CP’s proposed rule of
classification would be avoided.
5.49 20 per
cent is rather a high threshold for this purpose. However, it would be
performing a significantly different function than the threshold under an
entirely percentage-based rule such as the six per cent rule. The
threshold supplements a form-based classification which itself provides an
imperfect, but nevertheless useful, classification. Its purpose, however,
is to limit the exception to the form-based rule to distributions which
are clearly extraordinary. This is essential to ensure that trustees need
not be concerned to quantify run-of-the-mill distributions which will
clearly fall below the 20 per cent threshold. We commented above that the
application of a percentage rule to classify all receipts as income or
capital would be onerous. A 20 per cent threshold will only need to be
considered for obviously abnormally large receipts. Receipts in excess of
20 per cent will be very rare and it will be obvious to trustees when they
need to consider whether the threshold has been crossed. When sufficiently
large receipts do arise they will almost certainly be flagged by the
distributing entity.25
5.50 In
addition, the basis of valuation that we would advocate would make the
trustees’ task rather easier. The UPIA rule applies the 20 per cent test
to gross assets as shown by the entity’s year-end financial statements
immediately preceding the initial receipt. While we understand the reasons
for imposing a test based on statements of gross assets, we see practical
problems in requiring trustees to obtain the information necessary to make
such a calculation. A
23 The entire receipt is classified
as capital, not just the amount that exceeds 20 per
cent.
24 See MC Devine, “Principal and
Income Allocation of Stock Distributions: the Six Per Cent Rule” (1966)
64(5) Michigan Law Review 856.
25 Note that provision would be
required to cater for the application of the 20 per cent threshold to a
series of linked distributions by analogy with s 401(d)(2) of the
UPIA. |
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company may not have filed
up-to-date accounts and so available information may be out of
date.
5.51
Accordingly, we would prefer a valuation based on the total market
value of its shares. That would be relatively simple to calculate for a
listed company and would broadly reflect the proportionate value of the
distribution as against the trust’s shareholding in the company. Applying
the rule to unlisted companies would be far less easy. There might not be
any recent valuation of the company, and it would not be realistic (or in
many cases possible) to require one. Therefore, although distributions of
over 20 per cent will be rare (and those on the borderline of the 20 per
cent threshold would be still more unusual) we are concerned that imposing
a 20 per cent test based on the market value of an unlisted company could
be onerous.26
5.52 We
therefore propose that the 20 per cent threshold rule should be limited to
listed companies.27 If settlors of shares in unlisted companies
are concerned that the basic form-based rule is capable of causing
unfairness then they should consider opting into the power to adjust,
discussed below.
Summary of our proposed new classification
rule
5.53
Accordingly, our preferred policy for the classification of
corporate receipts is that cash distributions to trustee shareholders, or
distributions which trustees could have taken in cash, should be
classified as income and all other distributions from corporate entities
should be classified wholly as capital; but that in any event and
regardless of form, if the distribution of which the receipt forms part
represents more than 20 per cent of the market value of a listed company
then it should be classified as capital. Our proposed new rule would be
applicable to receipts from all companies (UK and overseas).
5.54 We have
said that the rule should apply to “distributions”. That term is not used
in the technical company law sense;28 but, as the CP suggested,
the framing of the application of the new rule is important. The proposed
rule would apply solely to replace the rule in Bouch v Sproule in
respect of payments made by companies to shareholder trustees in their
capacity as shareholders. As the CP made clear, payments made to trustees
by companies for other reasons, such as in repayment of principal or
interest on a loan, would not be affected by the rule. The CP also
explained that the rule would not apply to payments “made on liquidation
or otherwise on an authorised reduction of capital”.29 Equally,
form-based classification should not apply to share repurchases and
redemptions, payments which are properly classified as capital under the
current law. Neither the form-based nor the 20 per cent threshold elements
of our proposed rule would affect the treatment as capital of payments
made in exchange for all or part
26 It might also be inappropriate;
the value of shareholdings in an unlisted company may vary depending upon
whether or not they amount to a controlling stake. Moreover, it is
arguable that, irrespective of valuation issues, the rule should not be
extended to unlisted companies as such companies are more likely to make
irregular distributions which could exceed the threshold but which most
would consider should be classified as income.
27 Shares listed on a recognised
stock exchange.
28 For the company law definition of
“distribution”, see Companies Act 2006, s 829.
29 See CP, para 5.9, n
5. |
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of the trust’s shareholding.30
5.55 We
consider that our proposed rule would overcome many of the shortcomings of
the current law identified by the CP and in consultation. The rule would
be more easily understood than the current law, as it is not wholly
reliant on company law concepts. Nor does it require trustees to obtain
information from companies about the detailed mechanics of payments.
Although simple in comparison to existing law, the rule would be
sufficiently sophisticated to produce appropriate results in the majority
of cases. In particular, in classifying distributions of shares (on
demerger or otherwise) and very large cash distributions by listed
companies as capital, the rule would overcome many of the unrealistic
outcomes of the current law.
5.56 Settlors
who wished, for whatever reason, to take a different approach to
classification could do so by means of express contrary provision in the
terms of the trust, which could adjust or disapply part of the rule, or
provide an alternative rule entirely. In addition, we suggest, they should
be able to choose to give their trustees a more flexible power to classify
receipts.
A power of adjustment for corporate
receipts
5.57 The
classification rules outlined above would classify the majority of
corporate receipts in a way that most would consider appropriate. However,
in the absence of the power of allocation there remains scope for further
refined classification. The new rule proposed above is still capable of
producing results that some would view as incorrect; for example, a large
one-off dividend that fell just short of the 20 per cent threshold and
classified as income.
5.58 We
therefore consider that there is scope for enabling trustees to hone the
classification of receipts from companies further and reduce the risk of
an inappropriate classification. This cannot be achieved by more detailed
rules. To achieve this level of sophistication it is necessary to provide
trustees with a more flexible power to adjust the classification of
individual corporate receipts. The objective of the power would be to
classify a receipt more precisely than is possible by means of rules. It
might, for example, be relatively clear that the distribution referred to
in paragraph 5.57 above would consist wholly or largely of capital and
should be adjusted accordingly.
5.59 Such a
power should not apply by default to all trusts. We are content that the
refined rules of classification outlined above produce an appropriate
result in most cases. The extra layer of sophistication that a power to
adjust would bring may be considered valuable by some settlors and by some
trustees, but it is not a necessity. Consequently, a power of adjustment
should only be available where there is an express provision to that
effect in the trust deed.31 It should be seen
30 There are obviously various ways
in which legislation could achieve that outcome. We note the approach
taken under section 401(c)(2) of the UPIA where money received in one
distribution or a series of related distributions in exchange for part or
all of a trust’s interest is expressly allocated to principal.
Alternatively, the ambit of the rule could be limited so that it did not
apply at all in such circumstances. In deciding on a particular
formulation the concern would be to produce a rule which is as
straightforward as possible.
31 There would also be scope for
provisions to enable trustees of existing trusts to opt in to this power;
but see para 5.14 and n 12 above. |
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as a facilitative tool for trustees rather than something
imposed upon them.
5.60 The power
to adjust should be clearly distinguished from the power of allocation
provisionally proposed by the CP. The power of allocation would enable
trustees to invest without regard to the likely form of return and to
adjust as necessary to achieve balance across an entire portfolio. A power
to adjust would attach to individual receipts. Trustees with a power to
adjust would therefore need to continue to invest on the basis of a
balanced portfolio, aiming to balance income and capital returns. They
could not rely on the power to adjust to create a balanced set of returns
where they had failed to take account of balance in formulating investment
policy.
5.61 The power
would be a narrow one. It would be available only where the trustee
reasonably considered that the classification rule for corporate receipts
had produced a substantial imbalance between the income and capital
interests, having regard to the preservation of the real value of capital
and to the need to achieve a reasonable return on the trust
investment.32 The power would not be exercisable where the
trustees foresaw or ought reasonably to have foreseen that the investment
would perform so as to favour income or capital.33 This is
necessary to take account of the fact that some investments will have been
specifically selected at the portfolio-building stage even though they
were likely to produce predominantly income or capital returns; the power
to adjust should not apply to those investments merely because they have,
as anticipated, favoured one class over another.
5.62 The
considerations in the preceding paragraph determine the circumstances in
which the power would be available. Where it was available, the trustee’s
objective in exercising the power would be to restore, so far as
reasonably practicable, a reasonable balance between the income and
capital interests. In determining a reasonable balance, the trustee would
be required to have regard to the preservation of the real value of
capital and to the need to achieve a reasonable return on the trust
investment, and to any special reason why the particular investment was
made.
5.63 The
effect of the exercise of the power would depend on whether it was
exercised before or after the distribution is received by the
trustees.
5.64 If
exercised prospectively, the power would allow the trustees to overturn
the classification that would otherwise be produced by the classification
rule. This is particularly important in relation to a receipt which would
otherwise be income; by exercising the power prospectively, the trustees
would be able to ensure that the income beneficiary never became entitled
to the receipt.
5.65 Trustees would also be able to
exercise the power to adjust after receipt of the
32 We are grateful to Christopher
McCall QC for drafting suggestions made in the course of Advisory Group
discussions which assisted us greatly in formulating the proposed
power.
33 The most obvious example of a
receipt excluded on those grounds would be a share purchased at a high
price at a point when a dividend is expected. The power of adjustment
could not rectify the inevitable imbalance created by the decision to
invest in those circumstances. Likewise, if an investment chosen as part
of a balanced portfolio was expected to produce capital returns, the
capital returns produced could not be adjusted on the basis that they
favoured the remainderman at the expense of the life
tenant. |
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distribution, subject to a
time-limit, by making a compensatory payment. Compensating income out of
capital would be straightforward. Compensating capital out of income would
be less easy. The power would not allow trustees to “claw-back” a receipt
paid out to the income beneficiary, but would allow compensatory payment
to be made from future income. Provision would have to be made to ensure
that the income beneficiary was not entitled to further payments until the
compensatory amount had been recovered.
5.66 It is
important to stress that we see the power to adjust as a power that would
not have to be exercised as a matter of course; and we have suggested that
it should be framed in a way which limits the circumstances in which it
would be engaged. The power should only be exercisable to rectify
classifications of corporate receipts which substantially failed to keep
an objective economic balance between income and capital and where the
trustee reasonably considers that to be the case. Imbalanced returns which
were intended or objectively foreseeable when the investment was made
should be excluded. A power framed in these terms would only be engaged
where necessary and not in relation to all, or indeed to most, corporate
receipts. This would limit the cost of exercising, and considering the
exercise of, the power and would protect trustees from criticism that they
had not used the power when they could have done so. Section 61 of the
Trustee Act 1925 would provide further protection for trustees from
liability for any wrongful exercise or failure to exercise the power.
Settlors choosing to provide the power might also consider it appropriate
to offer trustees exemption from liability arising from the exercise of
the power in good faith.
THE TAX CONSEQUENCES OF THOSE PROPOSALS
5.67 The
measures outlined above form a package: a power of allocation offering
flexible classification and enabling total return investment on an opt-in
basis, together with revised classification rules in the form of a basic
cash/non-cash classification subject to:
(1) a
20 per cent threshold: any distribution from a listed company, worth more
than 20 per cent of the value of the company, would be capital; together
with
(2) an opt-in power to adjust the
classification of individual receipts.
5.68 As we
indicated at the beginning of this Part, proposals for reform in this area
are only workable if they do not have adverse taxation consequences for
the trusts that would make most use of them. Key to understanding those
consequences is the distinction for tax purposes, to which we have already
referred, between trusts with an interest in possession and those
without.34 The distinction affects both the income and capital
taxation of the trust.
5.69 By
default, the general rule is that trustees are charged to income tax on
trust income at the dividend ordinary rate of 10 per cent (dividend
income) or the basic rate of 20 per cent (other income), as appropriate.
However, if the trustees can decide what to do with income, to accumulate
it or pay it out at their discretion, they will be liable for tax on
income received at the dividend trust rate of 32.5 per
34 On the use of the expression “interest in
possession” see n 4 above.
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cent (dividend income), or the
trust rate of 40 per cent (other income).35 Hence, a trust fund
that is not subject to an interest in possession for income tax purposes
is taxed at the trust rates regardless of the marginal rate of any
beneficiary who may receive the income (which may be lower).36
In addition, certain receipts which in trust law are classified as
capital, but are treated as income for the purposes of income tax, are
charged at the trust rate even in the context of a trust fund which is
subject to an interest in possession for income tax
purposes.37
5.70 For
inheritance tax purposes, since the reforms in the Finance Act 2006, only
limited categories of new interest in possession trusts are now treated
for inheritance tax purposes as though the income beneficiary were
beneficially entitled to the underlying assets. Accordingly, the trusts
for which our preferred policy would have the most impact from the
inheritance tax perspective are trusts with a pre-22 March 2006 interest
in possession,38 and trusts created after 22 March 2006
establishing an interest in possession which is an immediate post-death
interest within section 49A Inheritance Tax Act 1984 (“IHTA
1984”)39 or a disabled person’s interest within section 89B
IHTA 1984. It is of great importance to such trusts that the interest in
possession remains a qualifying interest in possession for inheritance tax
purposes.40 If the fund ceased to be subject to a qualifying
interest in possession, it would suffer a 20 per cent charge to
inheritance tax at the point of entering the relevant property
regime41 and thereafter periodic charges, at a maximum rate of
6 per cent on every 10-year anniversary of the trust, and proportionate
exit charges on property leaving the trust between 10-year
anniversaries.42
5.71
Accordingly, any reform that caused an involuntary change to the
income tax and/or inheritance tax regime applicable to an interest in
possession trust would be one that we could not recommend. We take the
three elements of our preferred “package” in order. |
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35 36 |
ITA 2007, s 479.
When income is distributed by the
trustees of such a trust, the recipient beneficiary will receive a credit
at the trust rate (40 per cent) reflecting the tax paid by the trustees. A
beneficiary who is a basic-rate taxpayer, or a non-taxpayer, may be able
to claim repayment of some or all of this tax. However, this introduces an
additional administrative step. In addition, if the tax pool of the trust
is not sufficient to give the beneficiary’s payments the benefit of the 40
per cent tax credit, the trustees will be liable to additional income tax
under ITA 2007, s 496.
ITA 2007, ss 481 and 482.
Including those in relation to
which a transitional serial interest within IHTA 1984, s 49B has arisen
following the pre-22 March 2006 interest in possession.
These can only be created by will or under the intestacy
rules.
There can also be capital gains
tax implications; under Taxation of Chargeable Gains Act 1992 (“TCGA
1992”), ss 72 and 73, on the death of a person entitled to such an
interest in possession no chargeable gain accrues on the trustees’ deemed
disposal of the trust property.
An event whereby assets which were
previously treated under IHTA 1984, s 49 as assets to which the income
beneficiary is beneficially entitled become instead relevant property is a
chargeable transfer which is not potentially exempt, and is charged to tax
at half the death rate under s 7(2); this may be increased to a maximum of
40 per cent in the event of the income beneficiary’s death within seven
years.
Pursuant to IHTA 1984, ss 64 to 69. |
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37 38
39 40 |
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Total return investment vehicles
5.72 HMRC’s
position is the same for both the power of allocation and for percentage
trusts. They take the view that if a trust opted into a power of
allocation, or were to adopt a percentage trust format, its income would
then be regarded as accumulated or discretionary income for income tax
purposes and the trust fund as falling within the relevant property regime
for inheritance tax purposes. This is because they analyse the power of
allocation as enabling trustees to make a decision as to the entitlement
of the income beneficiary.
5.73 That
reasoning might seem more obviously relevant to a power of allocation than
to a percentage trust. For percentage trusts the procedure for
determination of the appropriate percentage for distribution to the income
beneficiary would vary depending upon the type of percentage trust
adopted; but in some models, at least, it would be determined by the
settlor or by statutory instrument, or would have to be within a range
fixed by statutory instrument, thus involving far less scope for real
discretion by the trustees. But HMRC’s position is the same in both cases
because in either case the form of the trust means that something that
would otherwise be income can become capital.
5.74 As the CP
explained, the purpose and effect of our proposed measures would be to
define income and capital, rather than changing entitlement to them, but
HMRC regards entitlement from the point of view of conventional
classification and would take no account of the trust classification. This
accords with the current policy to promote consistency of treatment for
trust beneficiaries and individuals; and of course an individual cannot
choose whether to treat a receipt as income or as capital.43
Accordingly, HMRC’s position remains that, without tax legislation, the
introduction of a power of allocation or percentage trusts would give rise
to adverse consequences for interest in possession trusts.
Classification rules: cash/non-cash and the 20 per cent
rule
5.75 It
follows from what we have said already that taxation difficulties are
likely to arise from any classification rules that run contrary to
Government policy that individuals and trusts should receive equivalent
tax treatment, and accordingly from any rule – or facility, for example to
turn income into capital – that applies to trusts and not to
individuals.
5.76 Revised
classification rules for trusts would mean that receipts classified by
HMRC as income might be treated as capital, and vice versa. There
is already special provision for receipts that would in some circumstances
be treated as income but are capital for other purposes, in section 383 of
the Income Tax (Trading and Other Income) Act 2005. Pursuant to that
section, any such receipts would be taxed as income, but at the basic
rate. HMRC’s concern is that the diversion to the trustees of what would
otherwise be income might deprive them of the higher rate tax which would
be payable if the income were received by an income beneficiary who paid
income tax at the higher rate.
5.77 Accordingly, HMRC’s view is that,
because of the potential for tax avoidance,
43 We do not question that policy, but are
concerned to ensure that trusts are not penalised, in tax terms, for
behaviour that would not penalise an individual; for an individual there
is simply no equivalent to the tax treatment of discretionary and
accumulation trusts.
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either of the two elements of our
revised classification scheme would be likely to result in an extension of
the deeming provisions of sections 481 and 482 Income Tax Act 2007. The
effect of this would be that the corporate receipts to which our new rules
applied would be taxed at 40 per cent (the trust rate; or, where
appropriate, the dividend trust rate of 32.5 per cent). In effect, the
main income tax advantage of non-discretionary trusts would be entirely
lost.
5.78 The
extension of the deeming provisions in response to the proposed
classification rules would render the latter impracticable, and indeed
would lead to the disappearance of the interest in possession trust as a
meaningful concept, in so far as the income taxation of corporate
distributions is concerned. Such a move would be unacceptable to the trust
industry and we cannot recommend it.
Power of adjustment
5.79 The
likely taxation consequences referred to above in the context of the rest
of our preferred “package” would be equally relevant to the power of
adjustment. Legislation making available a power to adjust would again, in
HMRC’s view, run the risk of the extension of the deeming provisions of
sections 481 and 482 of the Income Tax Act 2007. Moreover, and more
seriously, trusts with the power to adjust would lose their status as
interest in possession trusts for both income tax and, where relevant,
inheritance tax purposes. Legislation would be needed to prevent that
consequence. Even if that were forthcoming, HMRC would be concerned with
the need to impose safeguards to ensure that the power was being exercised
objectively, such as: very tight definitions; the involvement of an
accountant to certify the legitimacy of a decision to adjust; perhaps a
Financial Reporting Standard to cover the situation. HMRC personnel were
also concerned about the practical implications of policing the exercise
of the power.
5.80 There is
a possible analogy here with Statement of Practice 4/94, which states that
HMRC will abide by trustees’ decisions as to classifications in the
unusual case of enhanced scrip dividends.44 In such a case a
dividend can be taken in cash, or in the company’s own shares, but the
shares are worth more than the cash. The existence of Statement of
Practice 4/94 could be taken to suggest that there might be potential for
an extension of the circumstances where the tax classification might
follow the trusts classification as determined by the trustees. However,
HMRC officials observed that the Statement of Practice was devised in
response to very specific circumstances; HMRC would oppose any suggestion
that Statement of Practice 4/94 be widened.
The effect of taxation on our preferred
policy
5.81 The
consequence of the tax considerations set out above is that we cannot
recommend that a power of allocation be made available to trusts, because
the taxation consequences would be such that very few settlors (or
trustees, subject to transitional arrangements for existing trusts) would
regard it as worthwhile to opt in. The same is true of the power to
adjust.
5.82 As to our
preferred classification rules, we cannot recommend these because of the
likely consequence in the extension of the “deeming provisions” described
above, which would lead to the income in trusts being taxed at the trust
rate |
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regardless of the marginal rate
of the income beneficiary. This is all the more serious since, as a
classification rule, our preferred approach to the classification
of distributions from companies would affect all interest in possession
trusts and therefore the taxation consequences would be inescapable,
whereas the power of adjustment would of course be optional for settlors.
In any event, aside from those tax consequences, we would be reluctant to
recommend the introduction of such a rule in isolation from the other
reforms that we have indicated we would like to take place. As our
discussion of the adequacy of our preferred classification rule
indicates,45 we consider that its introduction should be
accompanied by the option of more refined classification (via a power of
adjustment) or of total return investment (in the form of a power of
allocation or a percentage trust). We have referred above to “the three
elements of our preferred ‘package’” of reform.46 Careful
thought would need to be given to any suggestion to introduce some, but
not all, of that package.
5.83 Tax
considerations therefore prevent us from making the recommendations that
we would like, from a trust law perspective, to make for reform of the law
for private trusts. That does not, however, mean that there is nothing
that we can recommend that would improve the current law.
OUR RECOMMENDATIONS FOR REFORM
Classification
5.84 One of
the particularly unhelpful results arising from the rule in Bouch v
Sproule is that shares distributed in a direct demerger are classified
as income, despite the fact that the shares distributed represent the
capital of the trust.47 It should be noted that the similar
situation that arises on an indirect demerger has been addressed by the
courts.48 In Sinclair v Lee49 the Chancery Division
of the High Court distinguished Bouch v Sproule and held that the
shares issued pursuant to an indirect demerger were to be classified as
capital. This was a formalistic distinction made in order to avoid what
the Court clearly regarded as an absurd
result.50
5.85 We
recommend that shares distributed in demergers be classified as capital.
For direct demergers, this would reclassify shares currently received as
income. We have referred above to the tax consequences of changing the
classification of income receipts to capital.51 However, this
does not apply in relation to shares received after a demerger. Despite
their current classification as income, the income beneficiary does not
have to pay income tax on them, because they are
44 See para 2.24 to 2.25
above.
45 See para
5.57.
46 See para 5.71
above.
47 See paras 2.27 to 2.29
above.
48 See paras 2.30 and following
above.
49 [1993] Ch 497 (Sir Donald
Nicholls VC). This is a decision of a lower Court and therefore vulnerable
to judicial amendment.
50 See paras 2.30 to 2.34
above.
51 See para 5.82
above. |
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defined as exempt distributions.
Accordingly, a change to the classification of such distributions has no
tax implications and is not a concern to HMRC.
5.86 We raised
the potential for reform of the classification of exempt demerger shares
with our Advisory Group, focusing on the desirability of overturning the
current treatment of some demerger shares as income and introducing more
consistency of treatment between direct and indirect demergers. We have
discussed with the Trust Law Committee how a new rule should be
framed.
5.87 The Trust
Law Committee had, in 2001 in the light of its own consultation on
classification and apportionment, similarly narrowed its reform proposals
from the general discretion to re-allocate, advocated in its consultation
paper, to more targeted reform. The Trust Law Committee’s revised view at
that time was that a direct demerger should be classified as capital, with
a discretion in exceptional cases to benefit
income.52
5.88 The Trust
Law Committee takes the view that there should be a discretion for
trustees to make a payment out of capital to the income beneficiary
following the distribution of demerger shares. It does so because of a
concern that the demerger may give rise to a loss of dividend income. The
Committee has outlined circumstances in which a company planning a
demerger will decide to “roll up” profits in the demerger shares rather
than making a dividend. For individual shareholders this merely provides a
different means of realising value, since the shares can be sold if an
immediate return is wanted; but for trustee shareholders such a procedure
would, absent any discretion, prejudice the income
beneficiary.
5.89 There is
also a more technical reason why the interests of income beneficiaries
might suffer in the case of a demerger. For a company to effect a
demerger, distributable reserves have to be available in order for the
company to be able to declare a dividend and are converted into share
capital where a demerger proceeds by way of dividend; even without
deliberate rolling up of profits in the demerger shares, this may lead to
a temporary diminution in the funds available for dividends.
5.90 In many
cases it would not be in the interests of the company to interrupt the
normal flow of dividends in this way. Where a direct demerger would use up
distributable reserves to an appreciable extent, the directors would opt
for a different method of demerger, for example by way of indirect
demerger by means of reduction of capital which would not affect the
distributable reserves.
5.91 The Trust
Law Committee accepts that prejudice to the income beneficiary would be a
relatively rare occurrence. Nevertheless, it reports cases concerning
trusts of company shares in which, absent any discretion, significant
hardship would be suffered by the income beneficiary if the shares were
classified as capital.
5.92 We share the Trust Law Committee’s
concern that the unsatisfactory current
52 A similar rule was considered appropriate for
enhanced scrip dividends. STEP also identified demergers as a distinct
problem which could be addressed by legislation, in its response to our
CP. While on balance favouring an approach akin to the UPIA model, STEP
remained “open-minded as to the best way to proceed” and noted that “where
specific legislation might be considered is in the area of ‘direct’
demergers”.
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classification rules for
demergers should not be reformed in a way which is capable of causing
significant prejudice to one set of beneficiaries over another. We are
anxious not to impose unhelpful complications upon trustees in order to
deal with what we think will be quite a rare occurrence, but we have
concluded that on balance it would be appropriate to provide a discretion
to make a payment of the sort envisaged by the Trust Law
Committee.53 Of course, as indicated earlier in this Part, our
preference would be for a straightforward general classification rule for
corporate receipts supplemented, where the settlor considers it
appropriate, by a power of allocation or adjustment. However, given that
at this stage it is not possible to recommend these powers, we accept that
a more limited discretion for some demergers is required.
5.93 If the
trustees did exercise their discretion to advance capital to the income
beneficiary to compensate him or her for the fact that the demerged shares
now form part of capital, there would be no income tax consequences as the
beneficiary would not be receiving income. For qualifying interest in
possession trusts, there would be no charge to inheritance tax, since the
income beneficiary in such cases is already treated as the owner of the
property for inheritance tax purposes. In the case of relevant property
trusts, there would be an exit charge when the property left the trust.
There would be a disposal for capital gains tax purposes54 in
respect of the assets advanced, but in the case of relevant property
trusts a holdover claim could be made55 since this is also an
occasion where inheritance tax is payable.
5.94
Accordingly, we recommend that shares distributed in an exempt
demerger should be treated as capital of the trust. Trustees should have a
power to make a payment of capital to beneficiaries interested in income
where otherwise there would be prejudice to those
beneficiaries.
Recommendation
5.95 We
recommend that all distributions falling within sections 213(2) or 213A of
the Income and Corporation Taxes Act 1988 (defined as exempt distributions
in section 218) should be classified as capital for trust law
purposes.56 When such a distribution is made, the
trustees should have a power to make a payment of capital to beneficiaries
interested in income where otherwise there would be prejudice to those
beneficiaries.57
5.96 We would
have preferred not to single out any particular form of distribution for
reform, and it will be appreciated that we do so now only in the absence
of other tax-neutral options. We are mindful of the constantly changing
landscape of corporate distributions and of possible future changes in
taxation. Accordingly, the draft Bill makes provision for the Secretary of
State to be given power to extend this category, with the consent of HM
Treasury, in the event that new forms of exempt distribution - similar to
that currently available for demergers -
53 See draft Bill, cl
3.
54 Under s 71 TCGA
1992.
55 Under s 260 TCGA
1992.
56 Draft Bill, cl 2(1) and
(3)(a).
57 Draft Bill, cl
3. |
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are devised in the future.
Recommendation
5.97 We
recommend that the Secretary of State should be given power by statutory
instrument to provide, with HM Treasury consent, for similar amendments to
trust classification in the event that developments in tax legislation
create new exempt distributions.58
Total return investment
5.98 We share
the inevitable disappointment of many in the trust industry that in the
light of current tax law and policy we have decided not to make any
recommendations for total return investment for private trusts. We
appreciate that it is the prerogative of Government to determine tax
policy, in the context of numerous competing interests that affect any tax
regime. Nevertheless, we consider that our inability to recommend a total
return scheme at this time is a loss not only to individuals but also to
the economy, because total return investment would potentially generate a
higher overall tax revenue from trusts. We remain optimistic that it will
be possible in the future for our preferred policy, set out in this Part,
to be developed.
5.99 One of
the statutory functions of the Law Commission is to advise Government
departments about the reform of the law. Accordingly, we conclude this
Part with a recommendation that HMRC and HM Treasury work with the trust
industry to devise a mechanism for total return investment in a way that
facilitates investment while remaining satisfactory from the point of view
of taxation.
5.100 This is
a recommendation that envisages engagement and action over time rather
than a “quick fix”. The technical details would require close engagement
by HMRC, and the work we are recommending can take place only if there is
support from HM Treasury.
5.101 We would
add that in our view, the model for total return investment that we think
most likely to be successful is not the power of allocation, as originally
envisaged in the CP, but the percentage trust. In discussing total return
investment vehicles with HMRC, it became clear that any legislation to
facilitate total return investment would probably have to include some
percentage measure for the distribution of income.59 In other
words, of the two models, the percentage trust, while probably more alien
at present to HMRC due to its unfamiliarity, is less
inimical.
5.102 As tax
law stands, a percentage trust would not be regarded as an interest in
possession trust, and therefore a percentage mechanism would be
unacceptable for interest in possession trusts. But we take the view that
a percentage model should be far less troublesome in principle, from a tax
point of view, than a power of allocation, because it need not involve a
decision on the part of the trustees about the entitlement of individuals
to a particular receipt; the percentage rate may be set by the settlor or
indeed by statutory instrument. It is possible,
58 Draft Bill, cl 2(1) and
(3)(b).
59 See para 5.73 above.
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therefore, to devise a model that
incorporates the elements of objectivity and predictability that would be
important to HMRC. This should allay concerns about the abuse of the
structure; and it would be possible to devise a method for taxing such
trusts in a manner that is satisfactory to the trust industry while
safeguarding tax revenue.
5.103 We are
disappointed that we are unable, as things stand, to make more
recommendations for legislative reform. Nevertheless, we are confident
that our conclusions offer immediate improvements and map out potential
future developments.
Recommendation
5.104 We
recommend that HMRC and HM Treasury in the longer term enter into
discussions with the trust industry as to the feasibility and mechanics
for total return investment for trusts within the parameters of current
tax policy, to the extent that is possible, or in the event of future
developments in policy. |
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PART 6
THE RULES OF
APPORTIONMENT
INTRODUCTION
6.1 It is a
fundamental principle of equity that trustees must not favour one
beneficiary or class of beneficiaries over another in exercising their
powers and fulfilling their duties. We have discussed the equitable duty
to balance and its implications in the context of the classification rules
and the possibilities for developing total return investment for private
trusts. The rules under consideration in this Part arise from the view
taken by the courts, often many decades ago and in circumstances much less
likely to arise today, of the implications of the duty to balance in
specific circumstances.
6.2 The “rules
of apportionment” encompass a number of situations where receipts or
expenses classified as income or capital have to be shared. Most derive
from case law and one from statute. That general description traditionally
encompasses the trust for sale imposed by the first limb of the rule in
Howe v Earl of Dartmouth which, rather than requiring
apportionment, imposes a trust for
sale.1
6.3 We
commented in Part 4 that the duty to balance can be understood in both a
positive and negative sense. The rules of apportionment, like the exercise
of the CP’s proposed power of allocation, can be regarded as a positive
manifestation of the duty to balance, which requires trustees actively to
balance the interests of income and capital in circumstances where the law
presumes an imbalance. We can summarise the rules as follows.
The implied trust for sale
under the first branch of Howe v Earl of Dartmouth
6.4 The
equitable rule commonly known as “the first branch of the rule in Howe
v Earl of Dartmouth” creates an implied trust for sale, putting the
trustees under a duty to convert (sell and reinvest) residuary personal
estate, held on trust for persons in succession, if it is an unauthorised
investment and of a wasting or hazardous nature.
6.5 Trusts for
sale do not only arise under the rule in Howe v Earl of Dartmouth;
they may also be created expressly. 2
The equitable apportionment rules
6.6 There are several rules:
(1) the second branch of the rule
in Howe v Earl of Dartmouth compensates the capital beneficiary for
loss pending conversion of trust investments;
1 (1802) 7 Ves Jr 137 and 2 Ves Jr
Supp 14.
2 Trusts
for sale may also be imposed by statute, as was the case before 1996 in
relation to trusts arising on intestacy and to the conveyance of a legal
estate to joint owners: see CP, para 3.5 and n 7 below.
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(2) the
rule in Re Earl of Chesterfield’s Trusts compensates the income
beneficiary for loss of present income from future property where trustees
have exercised a power to defer sale;
(3) the
rule in Allhusen v Whittell apportions debts, liabilities, legacies
and other charges payable out of the residuary estate between capital and
income beneficiaries;
(4) the
rule in Re Atkinson apportions the loss caused to the trust by
authorised investments in loan stock where the borrower is unable to meet
his obligations and there is insufficient security to make up the
shortfall; and
(5) the
rule in Re Bird apportions the loss caused to the trust by
unauthorised investments in loan stock where the borrower is unable to
meet his obligations and there is insufficient security to make up the
shortfall.
6.7 The second
branch of Howe v Earl of Dartmouth and the rule in Re Earl of
Chesterfield’s Trusts only operate where the trustee is under a duty
to convert. The other apportionment rules operate independently of the
duty to convert.
Apportionment Act 1870 and Re Joel
6.8 Section 2
of the Apportionment Act 1870 is a rule of time apportionment. The effect
of the section is that income beneficiaries are entitled only to the
proportion of income that is deemed to have accrued during their period of
entitlement.
6.9 Re Joel
is a necessary interpretation of section 2 of the Apportionment Act
1870. Many trustees have a power to apply trust income for the maintenance
of a class of minors, for example under section 31(1) of the Trustee Act
1925. The rule in Re Joel is that trustees are only permitted to
maintain an individual member of the class out of the income which can be
apportioned to a period when they were alive and therefore eligible to
receive the benefit of the income.
General points
6.10 With the
exception of the statutory time apportionment rule, these rules are based
on the presumed intention of the settlor or testator that the life tenant
and the remainderman should enjoy the benefit of the trust equally. All
are theoretically logical and sensible developments of the classification
rules and the duty to balance. The difficulty is that they are commonly
excluded from express trusts, because they generally require complex
calculations relating (usually) to very small sums. They are without doubt
honoured more in the breach than in the observance in implied trusts,
where it is unlikely that the trustees will be aware of their existence.
That said, there may be trusts set up expressly with a view to the
trustees holding a type of property - perhaps reversionary interests -
where one or more of the rules might be useful.
6.11 The CP
discussed the equitable rules of apportionment, the implied trust for sale
and section 2 of the Apportionment Act 1870, in the context of its
provisional proposal for a power of allocation, and proposed that the
rules be abolished. We discuss the details of the current law and the
reasons for the CP’s proposals
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below, and the response of our
consultees. Clearly, in the absence of a recommendation for a power of
allocation, the CP’s reasoning has had to be re-examined, but our
conclusion, as we go on to explain, remains largely the same.
CURRENT LAW
Trusts for sale
6.12 A trust
for sale is a trust where the trustees are under an obligation to sell or
convert the trust property, known as a duty to convert. A trust for sale
may be expressly created by a settlor or testator. No specific form of
words is required, but the terms of the trust must place the trustee under
a duty to sell or reinvest the trust property.
6.13 A trust
for sale may also be implied under the first limb of the rule in Howe v
Earl of Dartmouth.3 The scope of the rule is very limited.
A trust for sale will only arise in relation to residuary estate; it does
not apply to realty; it only applies where the trust is for persons in
succession; and it only applies to unauthorised investments (of which
there are very few since the Trustee Act 2000), not to authorised
investments that are either wasting or hazardous.4
6.14 The
implied trust for sale is said to be based on the presumed intention of
the testator that the income and capital beneficiaries should benefit
equally.5 Consequently, there is no implied trust for sale
where it can be demonstrated that it was the intention of the testator
that the trustee should not be placed under an immediate duty to convert,
nor where it can be demonstrated that the testator intended to make an
in specie gift.
6.15 An
express power to retain existing investments, or an express discretionary
power to sell, will be sufficient to exclude the implication of a trust
for sale under the rule.6 The rule is excluded in relation to
trusts arising on intestacy, as the power of sale under section 33(1) of
the Administration of Estates Act 1925 is inconsistent with the duty to
sell.7 However, a power to postpone sale is not generally
sufficient to exclude the rule,8 unless it amounts to a power
to postpone |
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3 (1802) 7
Ves Jr 137 and 2 Ves Jr Supp 14. See J Mowbray QC et al (eds), Lewin on
Trusts, (18th ed, 2008), paras 25-70 to 25-87.
Halsbury’s Laws of England (4th ed 2007 (Reissue))
Volume 48, para 966, suggests that an implied duty to convert arises in
relation to hazardous and unauthorised investments more generally.
However, the cases cited therein are better explained on the basis of an
express trust for sale coupled with a power to postpone sale, or a
discretionary power of sale.
4 Re Gough [1957] Ch
323.
5 See Hinves v Hinves (1844) 3
Hare 609.
6 Gray
v Siggers (1880) LR 15 Ch D 74; Re Sheldon (1888) LR 39 Ch D
50; Re Pitcairn [1896] 2 Ch 199; Re Bentham (1906) 94 LT
307; Re Bates [1907] 1 Ch 22; Re Wilson [1907] 1 Ch 394; and
Re Nicholson [1909] 2 Ch 111.
7
Previously a trust for sale with a power to postpone sale was imposed
where a person died intestate under s 33(1) of the Administration of
Estates Act 1925. However, this was amended by the Trust of Land and
Appointment of Trustees Act 1996 which replaced the trust for sale with a
trust with a power of sale, without amending the accompanying sidenote
describing the section as imposing a trust for sale.
8 Re Berry [1962] Ch
97. |
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and retain permanently for the benefit of the tenant for
life.9
The equitable rules of apportionment
6.16 The
rationale of the equitable rules of apportionment is to balance the
competing interests of successive beneficiaries in circumstances where
there would otherwise be an imbalance. The rules are premised on the
presumed intention of the settlor or testator and consequently will be
excluded by express or implied contrary intention.
Apportionment pending conversion
6.17 When a
trustee is under either an express or implied duty to convert, trustees
must sell and convert the trust property within a reasonable
period.10 Two complementary apportionment rules were developed
to remedy the imbalance arising in the period between the imposition of
the duty to convert and actual conversion: the second limb of the rule in
Howe v Earl of Dartmouth apportioning hazardous or wasting
investments and the rule in Re Earl of Chesterfield’s Trusts
apportioning reversionary interests.
6.18 The
second limb of the rule in Howe v Earl of Dartmouth applies to all
trusts for sale, whether express or implied,11 where hazardous
or wasting property is held for persons in succession. The rule is that
pending actual conversion of the property, the life tenant is not entitled
to the actual income that the property produces but rather to a sum
calculated by applying a specified level of interest (usually four per
cent) to the estimated value of the property. This sum is intended to
reflect the “fair equivalent” of what he or she would have received had
the property been converted into authorised
investments.12
6.19 The
second limb of the rule in Howe v Earl of Dartmouth is wider than
the first (discussed above) in two respects. First, it is not limited to
residuary estates of testators. Secondly, it is not limited to personalty;
it extends to leasehold (but not
freehold) interests.13
6.20 The rule
in Re Earl of Chesterfield’s Trusts is complementary to the
apportionment rule in Howe v Earl of Dartmouth, in that it secures
income from property that does not produce any income until it falls into
possession. The rule |
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9 See
Re Thomas [1891] 3 Ch 482; Re Chaytor [1905] 1 Ch 233; Re
Inman [1915] 1 Ch 187; Re Rogers [1915] 2 Ch 437; and Re
Berry [1962] Ch 97.
10 Usually taken to mean one year
(Bate v Hooper (1855) 5 De GM & G 338). That is the case even
where the duty is stated to be at the trustees’ absolute discretion: Re
Atkins (1899) 81 LT 421.
11 Gibson v Bott (1802) 7 Ves
Jun 89.
12 See CP, paras 3.15 to
3.30.
13 Section 8 of the Trustee Act 2000
authorises investments by trustees in leaseholds. However, under section 9
the trust instrument may expressly exclude leasehold interests from the
list of authorised investments. In these circumstances the second limb of
the rule in Howe v Earl of Dartmouth will still apply where there
is an express or implied duty to convert. Consider further AJ Oakley,
Parker & Mellows: The Modern Law of Trusts (9th ed
2008), p 759. |
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provides that where a
reversionary interest14 which ought to be converted is retained
until it falls into possession, part of it is to be treated as arrears of
income and paid to the life tenant. The calculation is complicated, but
broadly the amount to be treated as capital is that which, if invested at
four per cent compound interest with yearly rests (and subject to
deduction of income tax), would have produced the sum actually received.
The difference between those two amounts is to be treated as the arrears
of income.15
Apportionment of debts, legacies and
annuities
6.21 Where a
testator’s residuary estate is left to persons in succession, the rule in
Allhusen v Whittell16 functions to apportion
debts, legacies, annuities and other charges payable out of the residuary
estate between income and capital beneficiaries. The rule demands that
payments made to discharge the obligations of the residuary estate should
be taken to consist of a combination of income and capital. The purpose of
the rule is to place the beneficiaries in the same position as they would
have been in had the debts been paid at the moment of the testator’s death
so as to prevent the life tenant from benefiting from the portion of
capital required for discharging debts.
6.22 The rule
requires a calculation of the net average income of the estate from the
date of death to the date of payment. The income beneficiary is then
charged with interest at the rate of the net average annual income, so
that once the debt is paid it is regarded as having been paid partly from
income and partly from capital.
6.23 The rule
also applies where a testator has personally covenanted to pay a life
annuity and bequeathed residuary estate to persons in succession; each
instalment of the annuity should be apportioned between income and capital
in accordance with Allhusen v Whittell.17 Where a legacy
is contingent, the life tenant is entitled to the income that arises until
the contingency occurs,18 but contingent liabilities are to be
apportioned.19
6.24 As with
the second limb of the rule in Howe v Earl of Dartmouth and the
rule in Re Earl of Chesterfield’s Trusts, the rationale of the rule
is the settlor or testator’s presumed intention to maintain a fair balance
between income and capital beneficiaries. However, this rule is not
dependent on any duty to convert.
6.25 The rule in Allhusen v Whittell
may be more flexible than the other equitable rules
14 Although the paradigm application
of the rule is reversionary interests, the rule also applies to
outstanding personal estate which falls in after the exercise of a power
to postpone sale, such as mortgage debt with arrears or arrears of an
annuity with interest: see J Mowbray QC et al (eds), Lewin on Trusts
(18th ed 2008), para 25-118.
15 See CP, para 3.31 to 3.35. See
further AJ Oakley, Parker & Mellows: The Modern Law of Trusts
(9th ed 2008), pp 757 to 759.
16 (1867) LR 4 Eq
295.
17 Re Perkins [1907] 2 Ch 596. See further Capital and Income in Trusts (1999) Trust Law Committee
Consultation Paper, para 4.3.
18 Eg Re Fenwick’s Will Trusts
[1936] Ch 720.
19 Re Whitehead [1894] 1 Ch 678. |
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of apportionment. In Re
McEuen20 it was
expressly stated that the court did not wish to lay down a single
mechanical approach to apportionment in this context, and in Re
Poyser21 it was held that the method of apportionment is in
the discretion of court.
Apportionment of deficient
securities
6.26 A
successful investment in loan stock benefits both the life tenant and the
remainderman; the remainderman is interested in the return of the
principal debt while the life tenant receives income in the form of
interest paid. Where the borrower defaults, the security for the loan (if
any) will sometimes not be sufficient to make up the shortfall of
principal, and while some interest may have been paid on the investment,
further interest repayments may be outstanding on the debt. Receipts from
the sale of authorised and unauthorised securities are apportioned between
income and capital by the rules in Re Atkinson22 and
Re Bird23 respectively.
6.27 The rule
in Re Atkinson provides that a deficient security taken on an
authorised loan must be apportioned rateably between income and capital in
proportion to the outstanding debt owed to each beneficiary.24
The rule is not limited to mortgages, but extends to the situation where
on the winding up of a company there are insufficient funds to pay off
debenture stock plus the interest due thereon.25 The rule only
applies once the security has been realised; until then the life tenant is
usually entitled to the income arising from the security.26
However, any income received before realisation in excess of any
arrears due on a mortgage, for example, should be apportioned to
capital.27
6.28 The
position is different where the securities are unauthorised.28
Generally the rule does not apply to investments made by trustees in
breach of trust where no loss of capital is sustained; in these
circumstances the income beneficiary is entitled to retain the full amount
of income. However, where an investment is made in breach of trust which
causes loss to the capital beneficiary then neither the income beneficiary
nor the capital beneficiary should be able to gain an advantage. In these
circumstances “from the very nature of the transaction one has to consider
the rights of the parties at the time when the investment was made. Almost
of necessity one must go back and adjust the rights as they stood at that
time”.29 In Cox v Cox30 the general principle
was stated that neither the life tenant nor the remainderman should gain
an advantage from the trustee’s breach |
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20 [1913] 2 Ch 704.
21 [1910] 2 Ch 444.
22 [1904] 2 Ch 160.
23 [1901] 1 Ch
916.
24 See CP, paras 3.55 to
3.59.
25 Re Walker’s Settlement Trusts
[1936] Ch 280.
26 Re Broadwood’s Settlements
[1908] 1 Ch 115.
27 Re Coaks [1911] 1 Ch 171.
28 See CP, paras 3.60 to
3.62.
29 Re Atkinson [1904] 2 Ch 160, 167.
30 (1869) LR 8 Eq
343. |
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of trust: “The two must share the
loss in the same way as they would have shared it had it occurred when
they first became entitled in possession to the fund”.31 This
was applied in Re Bird,32 where it was held that the
life tenant and the remainderman should bear the loss rateably in
proportion to the total income and capital that would have been received,
in the same period, from an authorised security.
6.29 The
apportionment rules do not apply after the security is realised following
an order for foreclosure (where the borrower’s equitable right to redeem
is extinguished and the security holder becomes the owner of the property
subject to the security both at law and in
equity).33
Time apportionment under section 2 of the Apportionment Act
1870
6.30 Section 2 of the Apportionment Act
1870 provides that:
All rents, annuities, dividends,
and other periodical payments in the nature of income (whether reserved or
made payable under an instrument in writing or otherwise) shall, like
interest on money lent, be considered as accruing from day to day, and
shall be apportionable in respect of time accordingly.
6.31 The
apportionment required by the Act is known as “time apportionment”. In the
trusts context, the effect of section 2 is to apportion the income paid in
respect of a period during which the entitlement to receive trust income
changes. Rather than accruing on a particular date and being allocated to
the person who is entitled to income on that date, income is deemed to
accrue at a uniform rate across the entire period. Each beneficiary is
entitled only to the proportion of the income which is deemed to accrue
during the period of his or her entitlement. This is not necessarily
realistic; a company’s profits may accrue very unevenly between dividends,
and it may even operate at a loss from time to time.
6.32 Time
apportionment also applies in relation to trusts for the maintenance out
of capital of a class of minors who are contingently entitled to the trust
capital on attaining a specified age. This is known as the rule in Re
Joel.34 The rule, which is a necessary interpretation of
section 2, provides that, where a child is born into the class of
beneficiaries entitled to income, the “trustees can only maintain the new
beneficiary out of income that arises after the birth, so the income has
to be apportioned at the date of birth”.35
6.33 Section 2
expressly applies to rents, annuities and dividends,36 but it
also applies to other periodical payments in the nature of income, such as
mortgage and other
31 (1869) LR 8 Eq 343,
344.
32 [1901] 1 Ch
916.
33 In Re Horn’s Estate [1924]
2 Ch 222 it was held that following an order for foreclosure the life
tenant is entitled to receive the whole of the net income from property,
and that there is no general rule of apportionment dealing with income of
property which had become discharged from the right of redemption by an
order for foreclosure.
34 [1967] Ch 14. See CP, para
3.79.
35 J Mowbray QC et al (eds),
Lewin on Trusts (18th ed 2008), para
25-139.
36 See Apportionment Act 1870, s
5. |
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interest. Periodical, in this
context, means “recurrent”; it is not limited to income that is “payable
in respect of a period”.37 The rule also applies to a liability
to make payments, so apportionment is required in respect of trust
expenses.38 Certain income receipts have been held not to be
subject to time apportionment: policies on assurance of any
description;39 natural produce40 and profits of a
business or partnership.41
PROVISIONAL PROPOSALS
Trusts for sale
6.34 In the CP
we noted that, following the Trustee Act 2000, most investments are now
authorised, and that the notion of converting an unauthorised investment
into an authorised investment has become somewhat outdated.42
Moreover the requirement of the first limb of the rule in Howe v Earl
of Dartmouth to sell wasting or hazardous investments is arguably no
longer relevant. Trustees are under a duty of care in selecting a balanced
portfolio and it may be that there is a place for such investments
alongside other holdings. The CP consequently provisionally proposed the
abolition of the Howe v Earl of Dartmouth implied
trust
for sale.43
6.35 The CP
provisionally proposed retaining express trusts for sale.44 It
was felt that there was no reason to prevent a settlor or testator
creating an express trust for sale, but equally that there was no reason
to impose a duty to sell in trusts which do not have an express duty. This
proposal was made on the basis that there are better ways of discharging
the duty to balance than a prescriptive duty to sell. The CP preferred the
policy of allowing trustees to choose whether or not to exercise the
general power to sell investments.
The equitable rules of apportionment
6.36 In the CP
we criticised the apportionment rules individually, but the main thrust of
the criticisms was that the rules are routinely excluded in professionally
drafted trusts, and for trusts where the rules still technically apply,
they are honoured more in their breach than in their
application.
6.37 The
second limb of Howe v Earl of Dartmouth and the rule in Re Earl
of Chesterfield’s Trusts were criticised for being overly
complex.45 In many cases they are disproportionately expensive
to apply. It was also pointed out that
37 Re Griffith (1879) LR 12
Ch D 655 and Re Jowitt [1922] 2 Ch 442.
38 Bishop of Rochester v Le Fanu
[1906] 2 Ch 513 and Re Joel [1967] Ch 14.
39 Apportionment Act 1870, s
6.
40 Hassell v Perpetual Executors
Trustees & Agency Co (WA) Ltd (1952) 86 CLR 513 (HCA), cited in J
Mowbray QC et al (eds), Lewin on Trusts (18th ed 2008),
para 25-134.
41 Jones v Ogle (1872) 8 Ch
App 192.
42 CP, paras 3.8 and 3.13. See para
2.69 above for the general power of investment provided by the Trustee Act
2000. But note that investments may still be made unauthorised by the
express terms of the trust.
43 CP, paras 5.90 to
5.91.
44 CP, para
5.89.
45 CP, paras 3.36 to
3.39. |
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changing economic circumstances,
and the changes brought about by the Trustee Act 2000 (referred to above),
have undermined the rationale of these
rules.46
6.38 Although
the justice of the rule in Allhusen v Whittell was not doubted,
there was concern that the rule requires cumbersome calculations, in many
cases affecting only small sums of money.47 Similar criticisms
to those made of the rule in Allhusen v Whittell were noted in
relation to the apportionment of deficient
securities.48
6.39 The CP
provisionally proposed that all the existing equitable rules of
apportionment should be abolished,49 an approach already taken
in relation to the second limb of the rule in Howe v Earl of Dartmouth
in Western Australia50 and New Zealand,51 and in
relation to the rule in Allhusen v Whittell in New Zealand52
and in a number of states and provinces in Australia53
and Canada.54 This was also in line with the Law Reform
Committee, Trust Law Committee and Scottish
Law Commission’s recommendations.55
Time apportionment under section 2 of the Apportionment Act
1870
6.40 The CP
criticised the time apportionment rule as inconvenient and unfair, causing
hardship in certain circumstances to life tenants56 and placing
an onerous burden on trustees to make difficult investigations into the
precise periods for which dividends have been declared.57 It
provisionally proposed that section 2 of the 1870 Act should cease to
apply to trusts except in so far as the terms of the trust expressly, or
by necessary implication, demonstrate a contrary intention.58
The policy underlying this was that periodic payments of income should be
paid to the beneficiary who is entitled to income at the time when the
payment becomes due.
46 CP, paras 3.41 to
3.43.
47 CP, para 3.53. The Trust Law
Committee commented in relation to one manifestation of the rule in
Allhusen v Whittell that it involves “minuscule amounts”: Capital
and Income in Trusts (1999) Trust Law Committee Consultation Paper, para
4.3.
48 CP, para
3.63.
49 CP, paras 5.83 to
5.85.
50 Trustees Act 1962, s
105.
51 Trustee Act 1956, s
85.
52 Trustee Act 1956, s
84.
53 Wills, Probate and Administration
Act 1898, s 46D (New South Wales), Trustee Act 1958, s 74 (Victoria),
Trusts Act 1973, s 78 (Queensland) and Trustees Act 1962, s 104 (Western
Australia).
54 Trustee Act RSO 1990, c T23, s
49(1)(a) (Ontario), Trustee Act RSBC 1979, c 414, s 101(1)(a) (British
Columbia) and Trustee Act RSM 1987, c T160, s 32
(Manitoba).
55 See CP, Part
4.
56 The CP provided the example of a
testator who bequeaths a life interest in his residuary estate to his
widow; the widow will not receive income from dividends paid after the
testator’s death which accrued during his life as these receipts will be
apportioned to capital: see CP, para 3.81.
57 CP, paras 3.81 to
3.87.
58 CP, paras 5.86 to
5.87. |
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6.41 In place
of the 1870 Act provision, the CP provisionally proposed that there should
be a new statutory power to apportion between successive income
beneficiaries, when and in the manner in which the trustees, in their
absolute discretion, deem it just and expedient.59
CONSULTATION RESPONSES
Trusts for sale
6.42 All
consultees who addressed implied trusts for sale agreed with the
provisional proposal to abrogate the first limb of the rule in Howe v
Earl of Dartmouth. One consultee noted that the rule could not
co-exist with modern portfolio investment:
… the application of the rule was
governed by the list [of authorised investments] both in its definition of
what investments were unauthorised and in its requirement that the
proceeds of sale of unauthorised investments should be invested within the
list. It epitomised the investment-by-investment, list bound approach to
trust
investing.60
6.43 A narrow
majority of consultees agreed that trustees should continue to be under a
duty to convert the trust property and reinvest the proceeds of sale where
the settlor or testator expressly creates a trust for sale. The
Association of District Judges could “see no valid reason to remove from a
settlor the right expressly to impose a trust for sale without power to
postpone”. A number of those who disagreed with the proposal did so on the
basis that settlors or testators “frequently settle individual assets of
personal connection or significance where there is an expectation that
they will be retained unsold”.61 Other consultees doubted
whether there was any usefulness in the trust for sale concept at all on
the basis that there is little or no demand from settlors and that “a
substantial part of the legal profession is unaware of its
implications”.62
The equitable rules of apportionment
6.44 All
consultees who considered the equitable rules of apportionment were in
agreement (or qualified agreement) with the provisional proposal to
abolish them. The Association of District Judges stated that the rules
have “outlived their usefulness”. A number of consultees drew attention to
the fact that the “problem with the equitable rules of apportionment is
not the nature of the rules but the cost of implementing them in
practice”.63 WA Lee commented that the rules “are now pretty
well totally irrelevant, although the general objective, of ensuring
fairness between capital and income accounts, is the same”. Mr Justice
Lloyd (now Lord Justice Lloyd) commented that the rules “serve little
purpose already, and would be wholly unnecessary if a statutory power of
allocation were
59 CP, para 5.88. A specific
statutory power was considered necessary as the CP’s proposed power of
allocation could not function in this context as that power allowed
receipts to be allocated between capital and income, but not between
successive income entitlements.
60 WA Lee.
61 Richards
Butler.
62 British Bankers’ Association;
Barclays Bank Trust Company.
63 Geoffrey
Shindler. |
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introduced”.
6.45 Some
consultees expressly qualified their agreement with concerns about the
proposal to replace the fixed rules with a new power of allocation. Others
took the contrary position, and emphasised the need for the power of
allocation to fill the gap left by the proposed abolition of some or all
of the equitable apportionment rules. Edward Nugee QC explained the
problem relating to the abolition of the rule in Re Earl of
Chesterfield’s Trusts:
Where assets subject to a trust
include a reversionary interest, it may well be imprudent for trustees to
try to sell it during the life tenant’s lifetime; but when it falls into
possession the life tenant may justifiably say that s/he should be
compensated for having had no enjoyment of it while it was in reversion.
The calculation in [paragraph] 3.33 [of the Consultation Paper]
demonstrates that there can be quite a large sum to which the life tenant
has a justifiable claim … . It needs to be made clear in some way that the
trustees’ duty to act fairly entitles them, and may require them, to carry
out a Chesterfield type of apportionment when a reversionary
interest falls in.
6.46 He
therefore agreed with the provisional proposal to abrogate all the
existing rules, “provided that there is no doubt that the power of
allocation can be used in appropriate circumstances where the rules now
apply”.
The statutory time apportionment rule
6.47 Nearly
all the consultees who considered time apportionment agreed that the
statutory apportionment rule should not apply to trusts except in so far
as the terms of the trust express a contrary intention. Edward Nugee QC
commented that “there is not much point in apportioning post-death income
to a deceased life tenant in most cases”.
6.48 A narrow
majority of consultees agreed with the provisional proposal to provide
trustees with a statutory power to apportion income receipts between
successive income beneficiaries. However, a significant number dissented,
some on the basis of the cost of administering such a power. The British
Bankers’ Association and Barclays Bank Trust Company made the following
comment on the introduction of such a power:
This proposal is really neither
one thing nor the other. Abolition of the application of the rule, but
leaving it open to trustees to apply it at their discretion, is a further
recipe for conflict between trustees and beneficiaries. Given the current
antipathy of professional trustees towards apportionment it is more likely
that such a power would never be used, but giving the trustee the power
will, at the very least, oblige him to consider its application (at
further expense to the trust).
6.49 Others
were concerned about the extent of the discretion proposed, arguing that,
in effect, it appeared to confer a new dispositive power on
trustees.64 |
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64 Mr Justice Lloyd; Mr Justice
Etherton. |
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REVISED POLICY AND RECOMMENDATIONS
Trusts for sale
6.50 The
Commission has noted the divided opinion of consultees with regard to
express trusts for sale. We consider that it is correct to question the
continuing relevance of a rule which requires trustees to sell and
reinvest in authorised investments where almost all investments are
authorised under section 3 of the Trustee Act 2000. Section 4 of the
Trustee Act 2000 requires trustees to review from time to time the
investments of the trust and consider whether they should be varied. In
considering whether investments should be varied, trustees are required to
have regard to the standard investment criteria.65 The
Commission considers that in the context of modern portfolio investment
this performs a comparable function to the duty to convert.
6.51
Nevertheless, it would be an odd step to deny settlors and testators
the opportunity to impose a trust for sale expressly. The decision to do
so may be accompanied by the express narrowing of the range of authorised
investments, in which case the duty to convert remains relevant. The
Commission therefore does not consider it necessary or desirable to
abolish express trusts for sale.
6.52 However,
in light of the unanimous support of consultees, the Commission recommends
the abolition of trusts for sale implied under the first branch of the
rule in Howe v Earl of Dartmouth in its entirety and in relation to
all future trusts. Underpinning this recommendation is the view that
trustees should no longer be placed under a specific duty to sell the
unusual investments to which that rule applies;66 rather, the
sale and reinvestment of trust property ought to form part and parcel of a
trustee’s investment duties under the Trustee Act 2000. This
recommendation should take effect for all trusts created after the
implementation of our recommendations; the rule will continue to apply to
trusts created already in existence at that point, except where it was
excluded expressly or by implication.
Recommendation
6.53 We
recommend that the first part of the rule known as the rule in Howe v
Earl of Dartmouth shall not apply to any future
trusts.67
The equitable rules of apportionment
Abolition, replacement or
retention?
6.54 The CP
took the view that all the equitable apportionment rules should be
abolished in parallel with the provision of a new power of allocation. The
power of allocation was the CP’s preferred means of achieving a flexible
classification of receipts, which would allow trustees to invest on a
total returns basis. The power of allocation was also presented as
replacing the equitable rules of apportionment, offering a modern
alternative to the rigid existing apportionment
65 Trustee Act 2000, s
4(2).
66 Their power to sell such
investments is implied by the power to invest in s 3(1) Trustee Act 2000;
in Re Pope [1911] 2 Ch 442, 446 Neville J held that “where there is
no special reason against it, a power to vary investments may be implied
from a power to invest”.
67 Draft Bill, cl 1(2)(a) and
(4). |
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rules.
6.55 As we
explained in Part 5, it has not been possible to recommend the
introduction of a new power of allocation. As the CP suggested and
consultees made clear, the equitable apportionment rules have a sound
underlying principle; the problem is that the rules are complex, unclear
in places and involve cumbersome calculations often relating to
disproportionately small sums of money. Given that the power of allocation
is no longer recommended, should the rules should be abolished, replaced
or retained?
6.56 A number
of considerations encourage us to recommend abolition. The rules are
routinely excluded in professionally drafted trusts, and both academic and
practitioner texts recommend their exclusion.68 For example,
Hanbury & Martin’s Modern Equity states:
The duty to apportion is in
practice nearly always excluded, both in respect of income from
unauthorised securities and in respect of reversionary
interests.69
6.57 James Kessler QC’s Drafting Trusts and
Will Trusts states:
The calculations involved are so
complex and the costs and administrative difficulties are quite out of
proportion to any advantage that arises. It is hardly surprising that the
rules are excluded in all well drafted trusts, and if not excluded are
more honoured in the breach
than in the observance.70
6.58 The rules
are not, of course, excluded from implied trusts, with the result that lay
trustees are burdened with rules which they cannot operate (in the
unlikely event that they are even aware of them). As noted above, a number
of other Commonwealth jurisdictions have already abolished some of the
equitable apportionment rules. The CP’s provisional proposal for abolition
was also overwhelmingly supported. We therefore take the view that the
existing rules should either be abolished or replaced.
6.59 Would it
be possible to replace the existing apportionment rules? The abolition of
the rule in Re Earl of Chesterfield’s Trusts without replacement,
for example, would, without express provisions to the contrary, mean that
the retention of
68 See JE Martin, Hanbury &
Martin’s Modern Equity (18th ed 2009), pp 584 to 590; G
Thomas and A Hudson, The Law of Trusts (2004), para 10.25; D Hayton
and C Mitchell, Hayton and Marshall’s Commentary and Cases on the Law
of Trusts and Equitable Remedies (12th ed 2005), para
9.157; J Mowbray QC et al (eds), Lewin on Trusts (18th
ed 2008), para 25-74. The Standard Provisions of the Society of Trust and
Estate Practitioners (1st ed) state that “Income and
expenditure shall be treated as arising when payable, and not from day to
day, so that no apportionment shall take place” (para 8, available in the
Encyclopaedia of Forms and Precedents (5th ed 2007)
Volume 40(1) Trusts and Settlements, p 326 [3582].
69 JE Martin, Hanbury &
Martin’s Modern Equity (18th ed 2009), para 19-008. Express
exclusion is not a straightforward option: CH Sherrin et al (eds),
Williams on Wills (9th ed 2008) states that “the rules
concerning … exclusion are by now a nightmare of complexity and
technicality” (Volume 2, [214.35]).
70 J Kessler QC, Drafting Trusts
and Will Trusts – a Modern Approach (8th ed 2007), para
19.32. |
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reversionary interests would
benefit the remainderman and no apportionment to the life tenant could
occur without express provision in the terms of the trust. Likewise, where
loan stock is invested for the benefit of both the life tenant (interest
payments) and the remainderman (preservation of real capital value) and
the debt is not repaid, this will be to the detriment of both the life
tenant and remainderman, but without an apportionment rule the realisation
of the security only compensates the remainderman. In such circumstances,
where a rule of apportionment is well-principled, the abolition of the
equitable rules without replacement may lead to an imbalance and
unfairness between successive beneficiaries.
6.60 The Law
Reform Committee, in its 1982 Report on the Powers and Duties of Trustees,
recommended that the existing apportionment rules be replaced by a general
discretionary power for trustees to adjust between income and capital
accounts.71 The Trust Law Committee also proposed that the
existing equitable apportionment rules, with the exception of the rule in
Allhusen v Whittell, should be abolished, and replaced with a
general discretion to apportion receipts and expenses in order to
discharge their duty to maintain a fair balance.72 The Scottish
Law Commission proposed a similar power.73
6.61 We have
considered whether it would be possible to provide a general discretion or
power of apportionment in place of the equitable rules of apportionment.
However, we have concluded that it would not be possible to do so for
three reasons. First, it would be difficult to provide a firm basis for
the exercise of such a discretion or power beyond the broad principles of
balance and fairness. Secondly, such a discretion or power may appear
overly dispositive. Finally, such a discretion or power would suffer the
same problems as those associated with the CP’s provisionally proposed
power of allocation, discussed above, and in particular would inevitably
give rise to unwelcome tax consequences.
6.62 Would it
be possible to provide a series of localised, limited discretions to
maintain the requirement of balance in contexts in which the current
equitable rules operate? This would allow, for example, a discretionary
adjustment between income and capital on the realisation of a reversionary
interest or a deficient security.
6.63 While
desirable in principle, there are a number of problems with creating a
series of discretions in this context. First, we consider in light of
consultation responses that such discretions may be considered burdensome
and would be routinely excluded. Secondly, the scope and operation of such
discretions would be difficult to define. Thirdly, even if new discretions
were tightly defined, such recommendations would be unlikely to appeal to
HMRC for the reasons outlined above. Finally, in particular in relation to
the rule in Re Earl of Chesterfield’s Trusts, it is questionable
whether trust law should unravel the outcomes of trustee investment
decisions where trustees are subject to the requirements of
71 The Powers and Duties of Trustees
(1982) 23rd Report of the Law Reform Committee, Cmnd 8733, para
3.36.
72 Capital and Income of Trusts
(1999) Trust Law Committee Consultation Paper, paras 6.1 to 6.7 and
6.15.
73 Apportionment of Trust Receipts
and Outgoings (2003) Scottish Law Commission Discussion Paper No 214, para
2.33. |
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the Trustee Act 2000 when
selecting investments. Trustees are under a duty to balance at the
pre-investment stage; trustees who purchase reversionary interests should
make balancing investments to compensate the income beneficiary if that is
desired.74
6.64
Accordingly, we take the view that the equitable rules of
apportionment should be abolished in relation to trusts created or arising
in the future; it would remain open to future settlors to incorporate
express provision in the trust deed if they wished to replicate the
rules.
Recommendation
6.65 We
recommend that the equitable rules of apportionment shall not apply to any
future trusts, subject to any contrary provision in the
trust
instrument.75
The statutory time apportionment rule
6.66 The CP
took the view that while the statutory apportionment rule was inconvenient
and unfair, there may be circumstances in which trustees consider that
apportionment is necessary to maintain a balance between beneficiaries in
circumstances currently covered by section 2 of the 1870 Act, for which
the power of allocation would not be available.76 On this
basis, the CP provisionally proposed a statutory power in place of section
2. On further reflection, and taking into account consultees’ concerns,
the Commission does not consider it desirable to recommend the
introduction of such a power. We accept that a statutory power of this
sort would be excessively wide and would therefore increase the likelihood
of disputes between trustees and beneficiaries and would lead to higher
trust management expenses.
6.67 However,
a significant majority of consultees supported the abolition of section 2
in its application to trusts (except in so far as the terms of the trust
express a contrary intention). As with the equitable apportionment rules,
time apportionment is routinely excluded in professionally drafted trust
deeds, and when not excluded it is likely that trustees are either unaware
of the rule or simply ignore it. The Commission therefore recommends
section 2 of the Apportionment Act 1870 should not apply to trusts created
after the commencement of the Act implementing the recommendations, unless
the terms of the trust expressly state that the section should
apply.
6.68 After the
disapplication of the section to trusts, periodic payments such as
dividends will accrue to the income beneficiary at the date when they
arise.
6.69 We do not
think that this will cause hardship between successive income
beneficiaries. In circumstances where it is important, settlors and
testators can include a duty to apportion on a time basis. Indeed, it has
been pointed out that
74 Alternatively, if the trust
contains a power to advance capital (see para 3.25 above), and where there
are sufficient liquid funds to do so, the disadvantage to the life tenant
of the reversionary interest could be compensated by an advancement from
another part of the trust fund.
75 Draft Bill, cl 1(2)(b) to (e) and
(4).
76 CP, para
5.88. |
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the abolition of the rule may be
of great assistance to a life beneficiary, typically a widow or widower,
who would otherwise lose income as a result of the application of the
rule. Consequently, the proposed change would establish a default position
more likely to accord with the wishes of the testator and the needs of the
beneficiaries.
Recommendation
6.70 We recommend that section
2 of the Apportionment Act 1870 shall not apply to any future trusts,
subject to any contrary provision in the trust
instrument.77 |
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77 Draft Bill, cl 1(1) and
(4). |
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PART 7
TRUST EXPENSES
INTRODUCTION
7.1 A settlor
or testator may make express provision for the incidence of trust
expenses, or may provide the trustees with a discretion to allocate them
between the beneficiaries. Where express provision has not been made,
expenses are to be classified as capital or income in accordance with the
general law of trusts.
7.2 This Part
is concerned with the general law of trust expenses. The question is: when
the trust incurs an expense, such as accountancy fees or the cost of
repairing buildings, are the trustees to charge that expense to income or
to capital?
7.3 An
instinctive response is to say that the income and capital beneficiaries
should bear the expenses that benefit them, respectively, and share those
that benefit both. But sharing is not simple. In what proportions should
they share? Would it be the same proportion for each expense or would that
proportion vary depending upon an assessment of the relative benefit to
each beneficiary? And how would such an assessment be made objectively?
How can we say how much each beneficiary benefits from an expense such as
investment management, since the income beneficiary receives the income,
while capital growth is important to the capital beneficiary?
7.4 A
different way of looking at sharing is to observe that if an expense is
paid from capital, both beneficiaries pay, because less capital remains to
generate income. That method of sharing has the advantage of certainty –
trustees do not have to take a view about relative benefit – but it can be
unfair if the benefit to the remainderman is relatively small while that
to the income beneficiary is disproportionately large. Accordingly, in a
range of cases a more proportionate sharing might be achieved by
apportioning the expense between income and capital in proportion to the
benefit to each.
7.5 Whatever
method of sharing is chosen has tax implications, because an expense that
is properly chargeable to income reduces the income tax payable; and in
contrast to the treatment of trust receipts,1 tax law currently
follows trust law for the purposes of the classification of expenses. In a
discretionary trust, the trustees are relieved of the difference between
the basic rate of tax and the trust rate to the extent of the income
expense; any provisions of the trust deed as to what is an income expense
are disregarded for that purpose, and the general law of classification is
applied.2 In an interest in possession trust3 the
income beneficiary’s taxable income is reduced by the amount of any
expenses incurred by the trustees that are chargeable to income either
under the general law or
1 See Parts 3 to 5.
2 Income
Tax Act 2007, ss 484 to 486 (formerly s 686(2AA) Income and Corporation
Taxes Act 1988).
3 See Part 5, n 4 above.
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under the terms of the
settlement.4 The classification of expenses has, therefore, a
direct impact upon tax liability. As Mr Justice Lindsay recently put
it:
It can thus behove trustees to
claim that their expenses are regarded as income expenses whilst,
conversely, it suits HM Revenue and Customs to see them as outgoings of a
capital nature.5
THE CONSULTATION PAPER
7.6 The CP’s
discussion of the classification of trust expenses centred on the leading
authority, the House of Lords’ decision in Carver v
Duncan.6 That case concerned the proper classification of
various expenses, including insurance premiums and investment advisers’
fees, for the purposes of the precursor to section 484 of the Income Tax
Act 2007.7 Their Lordships held that in this case the insurance
premiums and investment advisers’ fees were for the benefit of the whole
estate and therefore properly chargeable to capital. Lord Templeman stated
the following general principles:
Trustees are entitled to be
indemnified out of the capital and income of their trust fund against all
obligations incurred by the trustees in the due performance of their
duties and the due exercise of their powers. The trustees must then debit
each item of expenditure either against income or against capital. The
general rule is that income must bear all ordinary outgoings of a
recurrent nature, such as rates and taxes, and interest on charges and
encumbrances. Capital must bear all costs, charges and expenses incurred
for the benefit of the whole estate.8
7.7 The CP
expressed the view that “the classification of trust expenses should
depend on the purpose for which they were incurred”.9 It
recognised that “there is some uncertainty in the application of the rule”
in Carver v Duncan, but argued that it “achieves a broadly
impartial balance between the interests of competing beneficiaries” and
noted the difficulty of identifying a sensible alternative.10
The CP concluded that the law regarding the classification of trust
expenses should remain unchanged. However, that classification would
operate only by way of default if the proposed power of allocation were
available.11
7.8 The CP
invited the views of consultees on whether the rule in Carver v Duncan
should be placed on a statutory footing. It also provisionally
proposed that the rules of classification for trust expenses should be
subject to any contrary provision in the terms of the trust.
4 Income Tax Act 2007, s
500.
5
Revenue and Customs Commissioners v Trustees of the Peter Clay
Discretionary Trust [2007] EWHC 2661 (Ch), [2008] Ch 291 at
[1].
6 See CP,
paras 2.51 to 2.54.
7 Finance
Act 1973, s 16, subsequently the Income and Corporation Taxes Act 1988, s
686.
8 [1985] AC 1082, 1120. See CP, para 2.51 and following.
9 CP, para
5.16.
10 CP, para
5.16.
11 CP, para
5.16. |
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CONSULTATION RESPONSES
The rule in Carver v Duncan
7.9 The majority of consultees
who answered the question thought that the rule laid down in Carver v
Duncan should continue to apply. For example, the Association of
District Judges argued that “the treatment of trustee expenses is
reasonably understood to be classified in the way explained in Carver v
Duncan … and, although we accept that there will always be anomalies,
the rule is fair and provides an appropriate balance between income and
capital beneficiaries”.
7.10 Those who
disagreed generally did so on the basis of a lack of clarity as to the
proper application of the rule, leading to uncertainty. A number of
consultees commented on the apparent overlap between Lord Templeman’s
categories: the judgment appears to describe mutually exclusive
alternatives (namely “outgoings of a recurrent nature” or “costs etc
incurred for the benefit of the whole estate”), but those two forms of
expense are obviously not mutually exclusive. Simon Gardner12
observed that
[Carver v Duncan] depends
on the two categories of expenditure it uses being both mutually exclusive
and exhaustive. The two categories are “all ordinary outgoings of a
recurrent nature” and expenses incurred “for the benefit of the whole
estate”. But surely one could have ordinary, recurrent expenditure that
benefited the whole estate (eg the annual insurance premiums on the
estate’s commercial property investments); and also one-off expenditure
that did not (eg payment for professional advice towards raising the rents
on those investments).
7.11
Consultees also commented on the perceived unfairness and
illogicality of allocating some expenses wholly to capital. For example,
the Law Reform Committee of the General Council of the Bar said that it
“disagree[d] with Lord Templeman’s view that annual premiums on insurance
policies to protect the capital value of the trust fund should be paid out
of capital. Protection of the capital also protects income.” They also
disagreed with his classification of investment advisers’ annual fees as
capital, as such advice will clearly benefit both income and
capital.
7.12 A number
of consultees stressed the close relationship between trust classification
and tax law in this area. STEP stated that it is “fundamentally important
to ensure there [is] a proper alignment from a fiscal perspective in
allowing proper deductibility of appropriate income
expenses”.
Placing the rule on a statutory footing
7.13 A
majority of the consultees who answered this question considered that the
rule in Carver v Duncan should not be placed on a statutory
footing. Some favoured an approach whereby HMRC (in consultation with the
relevant professional bodies) would provide non-statutory guidance on the
incidence of trust expenses. Others argued for limited legislation
confirming the status of certain important expenses, for example, the
special case of recurrent trustee remuneration.
12 University of Oxford.
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7.14 The
minority who thought that the rule in Carver v Duncan should be
placed on a statutory footing suggested that legislation would clarify the
law and so reduce the scope for dispute between trustees and HMRC, and
that it would also increase transparency.
Classification of expenses
subject to contrary provision in terms of the trust
7.15 Nearly
all consultees who answered this question agreed that the general rule
ought to be subject to any contrary provision in the terms of the
trust.
SUBSEQUENT DEVELOPMENTS
7.16 Since the
publication of the CP there have been a number of developments in this
area. In particular, HMRC has published detailed Guidance on the
classification of trust management expenses, and the Court of Appeal has
recently considered the trust law classification rules in Revenue and
Customs Commissioners v Trustees of the Peter Clay Discretionary
Trust.13
HMRC Guidance on trust management expenses
7.17 In
January 2006, after the publication of the CP, HMRC issued guidance on
Trust Management Expenses (“TMEs”) setting out its interpretation of trust
law,14 which it subsequently also issued in the form of a Help
Sheet.15 The Guidance listed TMEs as allowable or not allowable
for income tax purposes.16 In that Guidance HMRC interpreted
Carver v Duncan to mean that only expenses that benefit the income
beneficiary alone can be charged to income (and so are “allowable TMEs”
for the purposes described at paragraph 7.5 above). All other TMEs must be
charged to capital. According to the Guidance, “there is no suggestion in
case law that there is any basis for apportioning expenses that are
incurred for the benefit of the whole estate into income and capital
costs”.17 Nevertheless, the Guidance went on to concede that
apportionment may be appropriate in certain circumstances (see paragraph
7.18 below).
7.18 The 2006
Guidance provided HMRC’s views on the proper trust law classification of
particular types of expense. The treatment of some TMEs was presented as
straightforward. Investment advice, and the costs of distributing income,
for example, were said not to be allowable. Travel and subsistence costs
might exceptionally be allowable when they were associated solely with
securing the trust’s income, but otherwise they were not allowable.
However, other expenses were presented as rather more complex, and the
Guidance suggested that some TMEs could be apportioned:
Generally, apportionment of TMEs between income and capital is
not
14 In a series TSEM8000 to TSEM8900,
available at http://www.hmrc.gov.uk/.
15 Help Sheet
IR392.
16 That is, in the calculation of
income tax as explained in para 7.5 above; note that, so far as interest
in possession trusts are concerned, expenses are not technically
deductions, but sums used in the initial calculation of taxable income;
see the general explanation at TSEM8020 and comment at
TSEM8230.
17
TSEM8140. |
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appropriate. In a few situations
it is appropriate to consider apportioning what is, after applying the
principle [that capital must bear all costs, charges and expenses incurred
for the benefit of the whole estate], apparently an expense of capital,
between income and capital. The governing principle here is that when what
is procured for the trust can properly be said to be for the income fund
as distinct from the capital fund, rather than the two matters being
inextricably bound together, then apportionment is
reasonable.18
7.19 Thus the
costs of accounting for the trust’s income were said to be allowable, but
the costs of accounting for the trust’s capital were not. As to the costs
of preparation of a tax return, the Guidance listed as allowable “those
that relate to income, apportioned on a just and reasonable basis, most
easily done by excluding the costs of preparing the Capital Gains Pages of
the Return”.19 As to audit, HMRC regarded as allowable “the
costs of auditing the trust’s income, on the basis of a just and
reasonable apportionment, best made by the person who carries out the
audit”.20
7.20
Accordingly, where apportionment was permitted, it was to be
achieved by demonstrating that a specific proportion of an expense (for
example, of a particular professional’s services) was incurred exclusively
for the benefit of income, such as by itemising the invoice or producing
two separate invoices. What was not permitted was the apportionment of an
expense where the benefit to income and capital was inextricably bound
together; an example might be the salary of the trustees’ secretary, where
it is not possible to say precisely the extent to which the secretary’s
services benefit the income and capital beneficiaries
respectively.
7.21 The
status of trustees’ fees has been a vexed source of dispute between HMRC
and the trust industry, to the extent that HMRC’s 2006 Guidance referred
explicitly to the disagreement and stated that it was likely to be the
subject of litigation.21 HMRC’s position in its Guidance was
that “trustees’ fees represent payment for work done by the trustee in
carrying out the terms of the trust as a whole” and that, on general
principles, are therefore properly payable out of capital.22
The trust industry’s position, as outlined in HMRC’s Guidance, was that
trustees’ fees are annual recurrent expenses which represent work done on
behalf of both income and capital, and that there is therefore a case for
apportioning the fees partly to income.23 This disagreement
came to a head in the Peter Clay litigation.
The Peter Clay litigation
7.22 The Peter Clay litigation
provided the Court of Appeal with the opportunity to
18 TSEM8815.
19 Help Sheet IR392, p
2.
20 The full catalogue of expenses is
best viewed in Help Sheet IR392 at www.hmrc.gov.uk/helpsheets/hs392.pdf.
21 See TSEM8880.
22 TSEM8883.
23
TSEM8882. |
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clarify the law relating to the
treatment of trust receipts. The action was brought by the trustees of a
large discretionary trust, who were in dispute with HMRC over two issues.
One was the status of the fees charged by the trustees, which HMRC were
not willing to treat as a TME at all, in accordance with the position
stated in the Guidance. The other was the proper allocation of a range of
expenses: investment management fees, bank charges, custodian charges,
accountancy and administration fees, and executive and non-executive
trustees’
remuneration.24
7.23 The case
was heard initially by the Special Commissioners,25 appealed to
the High Court and heard by Mr Justice Lindsay,26 and finally
appealed to the Court of Appeal.27 We examine the two issues in
turn.
The status of trustees’ fees
7.24 Where a
trust has professional trustees, a charging clause in the trust deed will
normally allow the trustees to charge a fee. From the beneficiaries’ point
of view this is an expense that the trust fund bears. However, HMRC argued
that, as a matter of trust law, trustees’ fees are not an expense, but a
gift of the settlor to the trustees; and that even if it was such an
expense in trust law, as a matter of tax law trustees’ remuneration is not
an “expense of the trustees”, the language used in the statutory
provisions.28
7.25 The
Special Commissioners and Mr Justice Lindsay held that trustees’ fees were
an expense of the trust, for tax purposes as well as in trust law; Mr
Justice Lindsay discussed the wording of the statute and concluded that
“in the context of an inept section it would, in my judgment, be wrong to
treat the expression ‘the expenses of the trustees’ as excluding their
remuneration”. The point was not appealed further.
The classification of trust
expenses
7.26 The
expenses in issue were calculated in a number of different ways. Some,
such as the executive trustees’ remuneration, were calculated in
accordance with time spent; the non-executive trustees charged a fixed fee
for preparing for and attending meetings; the investment managers charged
a fee calculated by reference to the capital value of the
fund.
7.27 Sir John
Chadwick, in the Court of Appeal, summarised the trustees’ and HMRC’s
positions as follows:
Put shortly, the trustees
contended that, where a particular expense of managing the trust related
partly to income, that expense could and should be apportioned fairly
between income and capital; so that
24 There was a further issue as to
the timing of allowable expenses, which does not concern us
here.
28 The relevant provision was s
686(2AA) Income and Corporation Taxes Act 1988; see nn 2 and 7
above. |
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part was attributed to income.
The Revenue contended that apportionment between capital and income was
not permissible in such a case: it was only those expenses which related
wholly and exclusively to income that could be attributed to income: an
expense which related partly to income and partly to capital was to be
charged
wholly to capital.29
7.28 A way of
describing the issue about classification in the Peter Clay case is
to say that it was a question about the relationship between the two kinds
of expense described in Carver v Duncan: the “income limb”
(“ordinary outgoings of a recurrent nature”) and the “capital limb”
(“expenses incurred for the benefit of the whole estate”). There is an
ambiguity here, as discussed above:30 how are expenses to be
attributed when they are ordinary and recurrent but benefit both income
and capital?
7.29 For HMRC,
the income limb was qualified by the capital limb, so that only expenses
incurred exclusively for the benefit of income were properly chargeable to
income, and all the rest were capital. Their initial position was that
this was the case for all the expenses in issue, including the trustees’
fees if they were indeed expenses. The trustees argued that the capital
limb was not a general rule without qualification, and therefore that some
ordinary and recurrent outgoings which benefit the whole estate could be
apportioned between capital and income. In other words, for the trustees
the income limb of the rule in Carver v Duncan provided a general
rule qualifying the capital limb. Accordingly, they claimed that it was
proper to allocate the various expenses between income and
capital.
THE SPECIAL COMMISSIONERS
7.30 At first
instance the Special Commissioners took the view that there was very
little authority on the classification of expenses that comprised both
income and capital elements. They considered that
… in the light of the general
principle of fairness “expenses incurred for the benefit of the whole
estate” should not be understood widely as meaning anything that is for
the benefit of both the income and capital beneficiaries should be charged
to capital and should not be attributed. We therefore prefer the approach
that one should attribute unless the expense really is a capital expense
where the interest of the income beneficiary is merely the consequential
loss of income on the capital that goes to pay the
expense.31
7.31
Consequently, in accordance with the requirement to achieve a fair
balance between income and capital beneficiaries, the Special
Commissioners held that a proportion of the accountancy fees, bank charges
and custodian fees should be apportioned between income and capital, and
those attributed to income are properly chargeable to income within the
tax provisions.32 The same was said of the executive trustee’s
remuneration. However, the investment management fees
29 [2008] EWCA Civ 1441, [2009] STC 469 at [4].
30 See para 7.10
above.
31 [2007] STC (SCD) 362 at
[17].
32 Above at
[23]. |
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were held to be wholly
attributable to capital on the facts. While the Special Commissioners
accepted that the work undertaken by investment managers was wider than
that described in Carver v Duncan (and that therefore Carver v
Duncan is not conclusive as to the classification of such fees), they
noted that since most of their work related to the accumulation of income
such fees were “predominantly attributable to capital, particularly when,
as here, the custodian does the bulk of the work relating to
income”.33
7.32 The
Special Commissioners also held that a fixed trustee fee such as that
charged by the non-executive trustees should not be shared between income
and capital on the basis that the fee does not change according to the
amount of work undertaken for the benefit of income or
capital.
CHANCERY DIVISION OF THE HIGH
COURT
7.33 Cross
appeals were made to the High Court. Mr Justice Lindsay held that the
Special Commissioners had erred in law.34 He distinguished the
income and capital limbs of the rule in Carver v Duncan, noting
that the income limb provides that income must bear all ordinary outgoings
of a recurrent nature although “it is not difficult to find instances
where [this] ‘general rule’ … would be unclear in its
applicability”.35 He also noted that the scope of the word
“ordinary” in “ordinary outgoings of a recurrent nature” is far from
clear. For example, the annual fee for a firm of investment advisers while
plainly recurrent was held in Carver not to be an “ordinary
outgoing”.36 Mr Justice Lindsay concluded that “it is possible
to point to real doubts as to the applicability of Lord Templeman’s
‘general rule’ as to ordinary outgoings of a recurrent nature”, and that
although described as general Lord Templeman “none the less contemplated
[it] as likely to require many
exceptions”.37
7.34 However,
Mr Justice Lindsay held that the capital limb of Carver v Duncan
was beyond doubt and took precedence over the income
limb.38 For this reason the Special Commissioners “were wrong
to resist that ‘all costs, charges and expenses incurred for the benefit
of the whole estate’ were inescapably to be treated as of a capital nature
for the purposes of section 686(2AA)”.39 The key question, he
said, is whether particular expenses are or are not for the benefit of the
whole estate.40 He was not persuaded that this principle can be
qualified by considerations of fairness, and rejected the arguments that
had convinced the Special Commissioners that it could.
7.35 By the
time of the hearing, HMRC had agreed an apportionment with the trustees in
respect of the custodian, accountancy and other professional fees,
narrowing the expenses in dispute to investment management fees and
trustee
33 Above at
[19].
35 Above at
[28].
36 Above at
[30].
37 Above at [31]
38 Above at [31] to
[36].
39 Above at
[36].
40 Above at
[37]. |
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remuneration. As to investment
management fees, Mr Justice Lindsay upheld the Special Commissioners’
decision that these were properly chargeable to capital; as the trustees
accumulated income the expense related to “advice as to how best to make
income into capital, advice which surely, redounded for the benefit of the
estate as a whole”.41 As to the fees of the executive and
non-executive trustees, Mr Justice Lindsay held that while trustee
remuneration was an expense of the trustees, both sets of fees were
chargeable to capital because they benefited the whole
estate.
COURT OF APPEAL
7.36 The
trustees appealed to the Court of Appeal in relation to the fees paid to
the executive and non-executive trustees and to the investment management
fees; HMRC accepted the apportionment of bank charges, accountancy and
other professional fees, and custodian fees.42 Importantly,
before the hearing HMRC accepted that “a proportion of the fees paid to
the executive trustee [were] properly chargeable to
income”.43
7.37 Sir John
Chadwick, with whom Lady Justice Arden and Lord Justice Lloyd agreed,
upheld Mr Justice Lindsay’s decision that the Special Commissioners had
erred in law:
It is … beyond argument that an
expense is incurred “for the benefit of the whole estate” in the present
context when the purpose or object for which that expense is incurred is
to confer benefit both on the income beneficiaries and on those entitled
to capital on the determination of the income trusts. The expression
“expenses incurred for the benefit of the whole estate” must be understood
in that sense. It is common ground … that expenses which are of that
nature are to be charged against capital.44
… Under the general law, expenses
incurred for the benefit of both the income and capital beneficiaries must
be charged against capital. It is only those expenses which are incurred
exclusively for the benefit of the income beneficiaries that may be
charged against income.45
7.38 However,
the Court of Appeal held that a single fee may be apportioned where an
element of it can be demonstrated to relate exclusively to income. On this
point the Court of Appeal accepted HMRC’s statement of the general law in
its skeleton argument:
HMRC do not contend that the rule
[in Carver v Duncan] is all or nothing, precluding apportionment of
a single expense. But apportionment is not based upon the general
principle of achieving fairness between beneficiaries. Instead it is based
upon the ability to demonstrate that part of the expense relates to the
trustee’s duties to
41 Above at [38]
42 [2008] EWCA Civ 1441, [2009] STC 469 at [17].
43 Above at [8].
44 Above at
[28]. |
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the income beneficiaries alone.
That is, if it can be shown that an identified or identifiable part of an
expense is for work carried out for the benefit of the income
beneficiaries alone, then that part is properly chargeable to
income.46
7.39 HMRC
conceded that where the fee is charged on the basis of the amount of time
undertaking work relating to the income and capital beneficiaries
respectively, trustees may apportion such fees as appropriate. For this
reason the Court of Appeal allowed the appeal in relation to the executive
trustees’ fees; Sir John Chadwick noted that given that professional fees
incurred for accountancy services had been apportioned between capital and
income on a time basis, “then it is impossible to see why the fees charged
by the executive trustee for time spent in applying his professional
judgment to the matters in relation to which those accountancy services
are required should not also be
capable of a proper apportionment”.47
7.40 What HMRC
continued to dispute was the apportionment of fixed fees which did not
change according to how much work was undertaken for the income or capital
beneficiaries. The Court of Appeal rejected HMRC’s argument and allowed
the trustees’ appeal in relation to the non-executive trustees’
fee:
The nature of a fixed fee is that
it does not vary with the amount of work actually done to earn it: whether
that work be attributable solely to income, solely to capital or to both
income and capital. But the fact that the fee is fixed does not of itself
prevent the fee from being apportioned into two or more parts. The amount
of each part is ascertained by applying the appropriate proportion to the
whole. So, if it could be established (say, by the keeping of time
records) that the non-executive trustees spent one half of their time
addressing matters which were exclusively for the benefit of the income
beneficiaries, there would be no difficulty in principle in making an
attribution of one half of the fixed fee to income. The hurdle which faces
the trustees’ claim to charge part of the fixed fee against income does
not arise because the fee is fixed: it arises because, in the absence of
time records, it will be difficult for trustees to establish whether any
(and, if any, what proportion) of the time of the non-executive trustees
was spent addressing matters which were exclusively for the benefit
of
income.48
7.41 The
effect of the decision is that the ability to apportion a single expense
is now clear as a matter of principle – trustees may apportion to income
any part of an expense relating solely to discharging the trustees’ duties
in relation to the income beneficiary, even if the invoice itself is not
itemised. The fact that an expense is a fixed expense does not in itself
prevent apportionment; rather, the difficulty facing trustees is one of
proof. As Lady Justice Arden stated, “the non- |
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45 Above at [29].
46 Above at [31].
47 Above at [32].
48 Above at
[37]. |
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executive trustees can be called
on within their retainer to give advice exclusively for the benefit of
income beneficiaries”.49 However, as with all fees, where an
expense is fixed the onus of showing that the fees were for the exclusive
benefit of the income beneficiaries rests on the trustees.50
Importantly, Sir John Chadwick noted that in this case the absence of time
records will necessarily make the estimation of the proportion of the work
done for income and capital imprecise, but that does not prevent
apportionment provided “a realistic estimate can be made”.51 In
the context of a discretionary trust of income, Sir John Chadwick
considered it self-evident that “the trustees may be expected to spend
part of their time in addressing matters which are exclusively for the
benefit of
income beneficiaries”.52
7.42 Applying
these principles to the investment management fees, the Court of Appeal
upheld the decision of the Special Commissioners:
The first question is whether the
expenses incurred in connection with the investment of income were
incurred before or after the trustees had made the decision to accumulate
that income. If the expenses were incurred after the trustees had made the
decision to accumulate, they cannot, as it seems to me, be said to be
expenses incurred exclusively for the benefit of the income beneficiaries.
They must be charged against the capital of the accumulated
funds.53
7.43 If the
trustees had been able to show that the expenses were incurred for the
temporary investment of income then the expenses “could be said to have
been incurred exclusively for the benefit of the income
beneficiaries”.54 However, on the facts this was not the
case.
Current law:
summary
7.44 The
Peter Clay litigation clarified three points on the classification
of trust expenses.
7.45 The first
is that trustees’ fees are an expense of the trust and therefore a TME for
tax purposes.
7.46 The
second is that the “capital limb” of the rule in Carver v Duncan is
not to be regarded as qualified by the “income limb”. If an expense is
incurred for the benefit of the whole estate, it is to be charged to
capital.
7.47 The third
is that where the trustees can show that part of a single fee relates to
work done for income alone (whether or not the invoice is itemised), then
the trustees can apportion the expense, detaching the income element and
charging it to income. In other words, while the Court of Appeal was very
clear that
49 Above at
[45].
50 Above at
[46].
51 Above at
[38].
52 Above at
[38].
53 Above at
[41].
54 Above at
[41]. |
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apportionment could not be
carried out simply on the basis of fairness, there can be an apportionment
on the basis of evidence. Accordingly, the classification of particular
expenses will be heavily dependent upon the facts of the
case.
7.48 To what
extent does that principle entail a practical difference from the position
for which the trustees were arguing, or indeed from a simple rule of
fairness that expenses are to be apportioned in accordance with the
trustees’ views as to who benefits? There may be very little difference in
practice. We have been offered considerable anecdotal evidence to the
effect that, before the Peter Clay litigation, it was accepted
professional practice that expenses could be apportioned and invoices were
itemised to reflect this. That practice has now been validated by the
Court of Appeal. In addition, the Court of Appeal has validated trustees’
ability to make an apportionment based on evidence of proportions of work
done.
7.49 The one
form of apportionment that is not permitted is an apportionment without
evidence. Where the trustees simply cannot tell how much of a particular
invoice relates to income and how much to capital, then they may not
apportion. If they cannot produce evidence of the proportionate benefits,
then the expense is to be regarded as incurred for the benefit of the
whole estate and charged to capital.
CONCLUSIONS
7.50 This is
an area in which it is particularly difficult to weigh the comments of
consultees. It remains significant that the majority of consultees were
satisfied with the law as stated in Carver v Duncan, and agreed
with the CP’s provisional proposal not to place it on a statutory footing.
But this agreement was premised on the law as it stood before HMRC issued
its Guidance and before the Peter Clay litigation.55 In
one sense the law has stayed the same – the leading authority remains that
of the House of Lords in Carver v Duncan. But of course in another
sense things have moved on a great deal, and whereas there have been
divergent views of the meaning of that authority we now have the Court of
Appeal’s authoritative interpretation.
7.51 As
outlined above, the CP concluded that the classification of expenses
should depend on whether they are incurred for the benefit of income or
capital, and that “Carver v Duncan achieves a broadly impartial
balance between the interests of competing beneficiaries”.56
The decision in Peter Clay confirms that the principle underlying
the classification of trust expenses is that the burden of the expense
should be borne by the beneficiary who receives the benefit.
7.52 In the
Peter Clay litigation, the trustees argued that expenses should be
classified in accordance with the general equitable duty to hold an even
hand between competing beneficiaries,57 which would have
required the trustees to make an
55 Consultees’ support was also
premised on the availability of a power of allocation which would have
operated in relation to both receipts and expenses, although we cannot
tell how far this weighed with consultees in their assessment of Carver
v Duncan. We have explained at para 5.72 why we cannot recommend a
power of allocation.
56 CP, para
5.16.
57 See para 4.10 and following
above. |
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assessment of what was “fair” as
between the beneficiaries.58 The Court of Appeal, agreeing with
HMRC, rejected this argument and held that in this context “apportionment
is not based upon the general principle of achieving fairness
between beneficiaries”.59
7.53 However,
we do not consider these two positions to be entirely incompatible; it can
be said that a fair apportionment of a single expense is achieved by the
principle that the burden of an expense is borne by the beneficiary who
benefits from that expense.
7.54 We noted
in paragraph 7.4 above that although it is possible to share an expense by
attributing it to capital, because there is as a result less capital to
generate income for the future, that way of sharing will not achieve a
fair balance in a situation where the income beneficiary gets a great deal
more benefit from an expense than does the capital of the trust fund. The
decision in Peter Clay narrows the circumstances in which that is
likely to arise. It is now clearly open to trustees to apportion expenses
between income and capital on the basis, not of fairness as such, but of
evidence; and they are free to do so even in cases where (as with the
non-executive trustees’ fees) in Peter Clay itself, the invoice is
not itemised, although in doing so they must have an evidential basis for
their decision rather than merely an impression. There will of course
remain cases where proportionate sharing cannot be achieved because
although both beneficiaries benefit, that sort of evidential support is
simply not available; and in that case the expense must be attributed, for
both trust and tax purposes, to capital. But such cases should be very
few. If settlors or testators desire a finer balance to be achieved
between income and capital beneficiaries where an expense is for the
benefit of the whole estate, it is of course open to them to make express
provision to this effect in the trust
instrument.60
7.55 The
decision in Peter Clay has also settled the status of trustees’
fees, making it clear that they are to be regarded as expenses of the
trust, in the context of the tax legislation.61 As to the
classification of trust expenses, in Peter Clay the Court of Appeal
not only clarified the ambiguity in Carver v Duncan62
but went a long way towards ensuring that, so far as possible, the burden
of an expense should rest with the beneficiary who benefits from
it.
7.56
Accordingly, we consider that the current trust law on the
classification of trust expenses is both acceptable in principle and
sufficiently clear, and make no recommendation for its
reform. |
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58 See [2008] EWCA Civ 1441, [2009] STC 469 at [4] and [2007] EWHC 2661 (Ch), [2008] Ch 291 at [9] and
[10].
59 [2008] EWCA Civ 1441, [2009] STC 469 at [31].
60 Such a provision will affect the
tax classification in the case of an interest in possession trust, but not
for a discretionary trust; see para 7.5 above.
61 See para 7.21 and 7.25
above.
62 See para 7.10
above. |
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PART 8 CHARITIES
BACKGROUND: CHARITIES WITH PERMANENT
ENDOWMENT
8.1 The rules
for the classification of investment returns apply to charitable trusts as
they do to private trusts. The impact of the distinction between capital
and income returns upon private trusts for interests in succession is
relatively easy to see, because different beneficiaries are entitled to
capital and income respectively; but the beneficiary of a charity is the
public, and so the distinction might be thought to be less crucial. For
private trusts, total return investment, in which the distinction is
disregarded in selecting investments, generates difficult taxation
consequences, whereas for charitable trusts – which are exempt from income
tax and inheritance tax – such consequences cannot arise.
8.2 So why are
the classification rules a problem for charities? The answer is that the
rules cause difficulties for a particular type of charity: charities set
up with permanent endowment. A charitable trust has a permanent endowment
where its terms impose restrictions upon the expenditure of some or all of
its capital.1 Where a charitable trust has a permanent
endowment the trustees may spend the income produced by the trust on
charitable purposes. The trustees are not, however, freely entitled to
convert capital into income for expenditure. This creates a distinction
between income available for current use and capital held to produce
future income, and consequently a tension between the interests of the
current recipients of charitable assistance and the future recipients.
This tension is analogous to – albeit distinct from – that between
beneficiaries interested in income and capital under private
trusts.
8.3 Most
charity trust deeds do not include express restrictions on the
distribution of a charity’s property; the existence of permanent endowment
is usually a matter of inference.2 And not all charities have
permanent endowment. For the sake of convenience many modern charitable
trusts are created without one.
8.4 However,
it was with regard to charities that concerns were first raised in
Parliament about the distinction between capital and income in trust law.
During the debates on the Trustee Bill in 2000, Lord Dahrendorf
asked:
Above all, will it be possible
for trustees to adopt what are called “total return policies” in which the
rigid and often quite inadvisable distinction between capital and income
is abandoned and to look at the total return of investments and thereby
have even more freedom to benefit the purposes for which trusts are set
up?3
8.5 The
difficulty of which Lord Dahrendorf and others complained in 2000 was the
practical consequence of the inability of charities with permanent
endowment to
1 A
statutory definition of permanent endowment is provided by the Charities
Act 1993, s 96(3): see para 8.12 and following below.
2 See J
Dutton, “Endowed Charities: A Total Return Approach to Investment?” (2001)
7(2) The Charity Law and Practice Review 131.
3 Hansard (HL) 14 April 2000,
vol 612, col 385.
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spend capital freely. If income
alone can be spent on the charity’s purposes, the charity’s trustees must
invest to produce enough income for a reasonable level of expenditure,
while maintaining capital growth, and so would be unable to invest on a
total return basis.
8.6 However,
as is the case with private trusts, total return investment is not for
all. It may require trustees to make more sophisticated judgements about
the construction of investment portfolios than they currently have to
make; it will certainly require them to make decisions about the division
of the total return, which under the current law is determined by the form
that the receipts take. Trustees who invest on a traditional basis,
selecting investments with a view to producing a balanced return, will
continue to be subject to the classification rules. That means that where
an investment return takes an unexpected or inappropriate form, the
charity’s capital or income will benefit or lose out disproportionately,
and the trustees will be unable to redress the balance.
8.7
Accordingly, the reforms to classification that we would have wished
to recommend, set out in Part 5, would have benefited charities not
operating on a total return basis by rationalising their investment
returns.4 As it is, however, charities will benefit from the
implementation of our recommendation as to the classification of shares
distributed in the course of demergers.
DEVELOPMENTS SINCE THE TRUSTEE ACT 2000
8.8 The CP
identified two main areas of difficulty for charities:
(1) the
circumstances in which permanent endowment may be spent; and
(2)
total return investment by charity trustees.
8.9 Since the
debates on the Trustee Bill, a number of important developments have taken
place affecting these issues. The first was the Charity Commission’s
publication in 2000 of a consultation document on investment by endowed
charities. This was followed in 2001 by Operational Guidance5
setting out the circumstances in which the Charity Commission would
authorise total return investment for charities with permanent endowment.
Accordingly, the concerns about total return investment aired in
Parliament have to some extent been remedied, although only within the
confines of the Charity Commission’s sanctioned total return investment
scheme.
8.10 The second development was
the Cabinet Office Strategy Unit’s consultation on charity law reform in
2002.6 This led to the publication, shortly before the
publication of the CP, of a draft Charities Bill. The Bill was implemented
as the Charities Act 2006 which, among other things, introduces new
provisions as to
4 We take
the view, and consultees agreed, that it would be undesirable for the
classification rules for charities to differ from those for private
trusts.
5 Charity
Commission, Operational Guidance 83 Endowed Charities: A Total Return
Approach to Investment (available at
http://www.charitycommission.gov.uk/supportingcharities/ogs/index083.asp),
hereafter “OG 83”.
6 Cabinet
Office Strategy Unit Report, Private Action, Public Benefit – A Review
of Charities and the Wider Not-For-Profit-Sector (September
2002).
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the circumstances in which a
charity’s capital may be freed from restrictions by way of amendment to
the Charities Act 1993.
8.11 We now go
on to examine the current law relating to the expenditure of permanent
endowment and then to discuss total return investment for charities. In
both cases, we explain the current state of the law, outline the issues
raised in the CP and consultees’ comments on the CP’s provisional
proposals, and finally describe the recommendations that we now
make.
PERMANENT ENDOWMENT
The current law
8.12 Section
96(3) of the Charities Act 1993 defines permanent endowment as
follows:
A charity shall be deemed for the
purposes of this Act to have a permanent endowment unless all property
held for the purposes of the charity may be expended for those purposes
without distinction between capital and income, and in this Act “permanent
endowment” means, in relation to any charity, property held subject to a
restriction on its being expended for the purposes of the
charity.
8.13 Permanent
endowment can in certain circumstances be spent as income, pursuant either
to section 43 of the Charities Act 2006 or to the Charity Commission’s
more general powers.
Statutory provisions
8.14 The CP
commented on the proposals to widen the circumstances in which statute
authorised charity trustees to expend permanent endowment set out in the
Strategy Unit’s consultation document and the draft Charities Bill. These
changes were put into effect by section 43 of the Charities Act
2006.
8.15 Section
43 substitutes new sections 75 and 75A of the Charities Act 1993 under the
heading “Power of unincorporated charities to spend capital: general”. The
old section 75 had allowed small charities, following public advertisement
and with Charity Commission approval, to distribute their permanent
endowment where they considered the charity’s assets to be too small “in
relation to its purposes, for any useful purpose to be achieved by
expenditure of income alone”. The power was available only where the gross
income of the charity in the previous financial year was £1,000 or less,
and was not effective in respect of permanent endowment that included
land.
8.16 In broad
terms, the new powers brought in by the Charities Act 2006 allow small
charities7 to expend capital without Charity Commission
authorisation (new section 75) and enable the Charity Commission to
authorise the expenditure of capital by larger charities (new section
75A). The two sections are mutually exclusive; section 75 does not apply
if section 75A does.
7 Defined as having
gross income in the last financial year of £1,000 or less or a market
value of the permanent endowment fund of £10,000 or less.
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8.17
Specifically, section 75 authorises the trustees to resolve that the
endowment fund, or a portion of it, ought to be freed from restrictions
with respect to expenditure of capital, where they are satisfied that
their charitable purposes could thus be carried out more effectively.
Section 75A enables the trustees of a larger charity to make the same
resolution, subject to the same condition as to satisfaction about the
effective carrying out of the charity’s purposes, and subject also to the
Charity Commission’s concurrence. The Charity Commission has power to
request further information and to require the trustees to give public
notice of the resolution. In deciding whether or not to concur, the
Charity Commission must take into account: any available evidence as to
the wishes of the donor(s); any changes in circumstances relating to the
charity since the making of the gift(s); and any representations by
interested persons where public notice has been given. The Charity
Commission must not concur with the resolution unless it is satisfied that
the charity trustees have complied with their obligations in making it and
that its implementation would accord with the “spirit of
the gift”.8
General powers of the Charity
Commission
8.18 In
addition to the specific statutory powers to expend endowment outlined
above, it has long been the Charity Commission’s practice to use its
general powers to authorise the expenditure of part of a charity’s
permanent endowment. The Charity Commission remains willing to consider
doing so in cases where the section 75 and 75A statutory powers are either
unavailable or inappropriate.9
8.19 The
powers in question are sections 26 and 16 of the Charities Act 1993.
Section 26 gives the Charity Commission power to authorise any action in
the administration of a charity which it considers expedient in the
interests of the charity. Section 26(4) enables the Commission to make an
order giving directions for “meeting any expenditure out of a specified
fund, for charging any expenditure to capital or to income, for requiring
expenditure charged to capital to be recouped out of income within a
specified period, for restricting the costs to be incurred at the expense
of the charity, or for the investment of moneys arising from any
transaction”. Section 26 cannot be used to authorise any action expressly
prohibited in the charity’s governing document; nor can it be used to
change the purposes of the charity. The latter restriction is relevant
where the property in question is “functional permanent endowment”:
capital held on express terms that it be used for a specific purpose of
the charity (for example, a village hall).
8.20 Section
16 gives the Charity Commission power by Order to exercise the same
jurisdiction and powers as are exercisable by the High Court in charity
proceedings for various purposes. These include establishing a scheme for
the administration of a charity. The Charity Commission will use section
16 where section 26 is unavailable.
8 Charities Act 1993, s
75A(9)(a).
9 Charity
Commission, Operational Guidance 44 Permanent Endowment (available at http://www.charitycommission.gov.uk/supportingcharities/ogs/index044.asp),
hereafter “OG 44”. OG 44 A1 replicates the Charity Commission Information
Sheet CSD-1347A, “Permanent Endowment – What is it and when can it be
spent?” (May 2008) (available at http://www.charity-commission.gov.uk/supportingcharities/csd1347a.asp).
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8.21 The
Charity Commission’s section 16 and section 26 powers may in theory be
employed to authorise the use of permanent endowment for any purpose, if
this is in the interests of the charity. However, the Charity Commission’s
guidance suggests “we expect that in most cases where we authorise
trustees to spend permanent endowment it will be used for repairing,
improving or extending buildings belonging to the charity”.10
The Charity Commission will usually require that the expenditure be
replaced (“recouped” is the term used) out of future income.11
But recoupment may not be required where the expenditure will provide
long-term value or if the charity cannot afford it.
Consultees’ comments
8.22 Because
the Charities Bill was in draft form at the date of the CP, no specific
question was asked about permanent endowment. However, a number of
consultees made helpful comments in response to the CP’s discussion of the
meaning of permanent endowment and of the law, as it then stood, as to
when it might be spent. A variety of views was expressed as to whether the
powers set out in what was to become section 43 of the Charities Act 2006
were too wide or too narrow. There was a suggestion from the Charity Law
Association that the definition itself might be re-examined; and argument
that the Charity Commission’s requirements for recoupment were not always
appropriate.
8.23 The
definition of permanent endowment, and the Charity Commission’s
requirements for recoupment, were the subject of debate in the course of
the passage of the Charities Bill, and we do not think it appropriate at
this point to re-open matters that have been considered so recently by
Parliament. Since those debates the Charity Commission has conducted a
review of its recoupment requirements, the results of which are set out in
its Operational Guidance on
permanent endowment.12
8.24 As to
section 43 itself, we have in the course of 2008 sought the views of the
Charity Commission and the Charity Law Association on the new powers
introduced by this section. Representatives of both bodies have told us
that the 2006 Act reforms make further Law Commission consideration of
this area unnecessary. We agree with that conclusion.
TOTAL RETURN INVESTMENT FOR CHARITIES
8.25 We have
referred above to the Operational Guidance on total return investment
which was published by the Charity Commission in May 2001.13
This stated that
10 OG 44, para
C4.1.
11 Recoupment currently involves
simple pound-for-pound repayment by regular instalments – no interest is
involved and so no account is taken of inflation, even if repayment is
made over, for example, 20 years. Annual payments are invested and the
income produced is then available for the charity’s purposes. However, the
Operational Guidance notes the need to “protect the charity’s capital and
the purchasing power of the income it produces against the effects of
inflation. This normally involves choosing a form of investment that
offers a good prospect of capital growth” (OG 44, para C5.8). Also see
Charity Commission CSD-1347A, “Permanent Endowment – What is it and when
can it be spent?” (May 2008), para C5.7.
12 OG 44 B2 (Expenditure and
Recoupment Orders).
13 OG
83. |
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the Charity Commission would
offer, on an individual basis, authority to undertake total return
investment using its power under section 26(1) of the Charities Act
1993.
8.26 The
Charity Commission’s section 26 authorisation is for the operation of a
specific total return investment scheme. The scheme is available
where:
(1) a charity holds endowed
gift;14
(2) it
is possible to distinguish the original gift and its accretions from
unapplied investment returns; and
(3) the power is in the charity’s
interests.
Where granted, the authorisation
will include directions that impose duties on the trustees in operating
the scheme.15
8.27 The
Charity Commission’s scheme requires trustees to identify the “total
return”, that is, the investment return from the charity’s endowed gift.
This is made up of income receipts and capital gains. They must then
divide it between the “trust for application” and the “unapplied total
return”.
8.28 The trust
for application is the portion of total return that has been allocated for
spending to meet present charitable needs. It must be spent within a
reasonable period on the charity’s purposes and (absent a separate power
to accumulate) may not be added back to the endowed gift or the unapplied
total return.
8.29 The
unapplied total return is the remainder of current and past total return.
Unapplied total return can be allocated to the trust for application at
any time. In deciding whether to allocate total return to the trust for
application, the trustees must have regard to their underlying duty to
take account of the present and future needs of the charity and to be
even-handed in their treatment of present and future beneficiaries. The CP
commented that this will require the trustees to establish a rational
policy taking account of the factors such as fluctuations in the value of
trust assets, investment risks, changes in the charity’s service
provision, past patterns of expenditure and anticipated demand for the
charity’s support.
8.30 The
Charity Commission’s scheme thus abolishes the distinction between capital
gains and income for the purposes of distributing investment returns. It
enables the trustees of charities with permanent endowment, where
appropriate, to expend capital gains as well as income on the charity’s
purposes. It also allows the trustees to withhold income (for example,
income from a large special dividend) within the unapplied total
return.
8.31 The
scheme does not, however, authorise trustees to expend what the Charity
Commission refers to as the “trust for investment” (that is, the endowed
gift and the part of the unapplied total return which, under the duty of
even-handedness,
14 We use the term “endowed gift” to
describe the original gift to the charity, and any future gifts, where
these are subject to restrictions on expenditure and therefore cannot be
spent.
15 These include a duty to identify
the total return, a duty to take advice and a duty to publicise the use of
the power (including providing information in the annual report and the
notes to the charity’s accounts). |
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may not properly be allocated to
the trust for application). The scheme does not include an express
requirement that the value of the endowed gift be maintained in real
terms; capital gain may, subject to the duty to balance the present and
future needs of the charity, be allocated to the trust for application.
But the endowed gift itself may not be touched. That is the case even in
periods of negative return where there is no remaining unapplied total
return.
8.32 The
relationship between the various funds is described pictorially in the
Charity Commission’s Operational Guidance, a copy of which is reproduced
as Appendix E to this Report.
8.33 The
Charity Commission’s Operational Guidance concludes its summary of the
policy of its scheme by stating that “it is therefore clear that the
concept of permanent endowment … is not affected by the power we propose
to give trustees. We recognise a donor’s right to create a charity that
will have future as
well as present beneficiaries”.16
The CP’s provisional proposals
8.34 The CP
was written against the background of the Charity Commission’s scheme for
total return investment. Accordingly, it first assessed the suitability
for charities of its own proposals to facilitate total return investment
for private trusts, and then considered the Charity Commission
scheme.
The duty to balance and the power of
allocation
8.35 The CP’s
proposed power of allocation, its favoured total return investment vehicle
for private trusts, was based upon a duty to balance, which we discussed
in Part 4 above.17 The CP took the provisional view that this
duty to balance should not extend to charitable trusts, on the basis of
the difference between the duties of trustees of private trusts for
interests in succession and the duty of charity trustees to consider the
present and future needs of the charity. The CP therefore concluded that
the power of allocation proposed for private trusts would not be
appropriate for charities; if that duty to balance was not to apply to
charities, neither could the power of allocation.
8.36 The CP
asked consultees whether they agreed with this conclusion. It also asked
whether the duty of charity trustees to consider the present and future
needs of the charity should be placed on a statutory footing.
8.37 In
response to the question whether the private trust duty to balance should
extend to charitable trusts, some consultees warned against drawing too
sharp a distinction between that duty and the duty to consider present and
future needs for charitable trusts. However, a majority agreed that
charity trustees should not be subject to the duty to balance
provisionally proposed in the CP for private trusts.
8.38 Despite
that, a majority of consultees who answered the question took the view
that the power of allocation proposed for private trusts ought to be
equally available to charity trustees. There may have been some
misunderstanding of the
16 OG 83 A2, para
1.5. |
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nature of our proposal; some took
it to represent a principled rejection of total return investment for
charities, which of course it was not. However, some may have seen it as a
route to total return investment that did not involve the constraints of
the Charity Commission’s scheme; while others may have regarded the power
as enabling them to deal flexibly with receipts when not operating total
return investment.
8.39 As
discussed in Part 5, we cannot recommend a power of allocation for private
trusts, and therefore the extension of that facility to charitable trusts
does not arise. In any event, we continue to take the view, as we did in
the CP, that it is desirable for charitable trusts operating total return
investment to follow a scheme specifically designed for that purpose by
the Charity Commission.
8.40 We move
on to the CP’s proposals for total return investment, and our
recommendations, below. Before doing so, we briefly address the question
of whether or not the duty of charity trustees to consider the present and
future needs of the charity should be placed on a statutory footing. A
number of consultees were in favour of putting the duty on a statutory
footing. But the majority were not in favour; they included the Charity
Commission, who did not consider there to be anything to be gained from
the statutory codification of the duty.
8.41 We have
explained why, in the light of consultation and our other recommendations,
we do not consider there to be a case for a general statutory statement of
the general trust law duty to balance.18 We do not think that
there is any need to place the duty of charity trustees on a statutory
footing. The Charity Commission has issued detailed guidance on the duty
of trustees of charitable trusts with permanent endowment, and we do not
consider that a statutory statement of the duty would offer significant
benefits.
Classification
8.42 The CP
provisionally proposed that the rules governing the classification of
receipts from corporate entities should be conclusive for charities,
rather than default. This was on the basis that the default nature of the
classification proposed for private trusts was intrinsically linked to the
operation of the power of allocation proposed for private
trusts.
8.43 A narrow
majority of consultees agreed with that proposal, although some noted that
the rules could be displaced by express wording in the trust and by the
court or by the Charity Commission in the exercise of their powers. The
minority who did not agree with the provisional proposal generally did so
on the basis that they wanted the CP’s power of allocation to extend to
charitable trusts, with the result that the classification rules would
give rise to default classifications.
8.44 Although
the overall shape of our proposals for private trusts has changed since
the CP, we still take the view that the classification rules should apply
to charities as they do to private trusts. Accordingly, corporate receipts
by charities will
17 See paras 4.10 to 4.23
above.
18 See paras 5.24 to 5.29
above.
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continue to be classified in
accordance with the rule in Bouch v Sproule, subject to the reform
we propose with respect to demergers.
8.45 The
application of the equitable and statutory apportionment rules to
charitable trusts was not directly considered in the CP and there is some
dispute as to the current law. Again, however, we see no reason why our
proposals for private trusts should not extend to charitable trusts, to
the extent that they can do so.
Total return investment for charities: the options in
the CP
8.46 Having
rejected the power of allocation as a suitable mechanism for charity
trustees to conduct total return investment, the CP went on to consider
how total return investment should be facilitated, in the context of the
availability of the Charity Commission’s scheme. It proposed three
alternative mechanisms:
(1) The
current system of individual Charity Commission authorisations could be
retained, possibly with legislative confirmation of the scope of the
Charity Commission’s powers to authorise such schemes.
(2) A
general statutory power could be granted to all permanently endowed
charities on similar terms to the Charity Commission’s current
scheme.
(3) As (2) but with additional
reporting and accounting requirements.
8.47 The CP
considered the advantages of Option 1 to be that it gave the Charity
Commission notice of the trustees’ intentions and gave the trustees access
to the Charity Commission’s Operational Guidance. The “obvious
disadvantage” was said to be that the application might be relatively
costly, time-consuming and inconvenient for the charity and had
operational implications for the Charity Commission. The advantage of
Option 2 was that it would allow for total return investment for all, and
so would overcome any problematic results generated by the classification
rules. The CP discussed the question whether trustees would, in effect,
have to use the power and concluded “we do not think that charity trustees
would necessarily commit a breach of trust by failing to make use of this
general power. Trustees would be under a duty to consider using the power
but we believe that a properly considered decision not to use the power
would discharge
this duty”.19
8.48 The CP
considered Option 3 to be the best in that it would reduce the burden on
the Charity Commission, while enabling it to retain some control over the
activities of charity trustees.20
8.49 The CP
did not consult on the option of giving charity trustees an entirely
unfettered power to distribute capital or accumulate income. It noted the
Charity Commission’s comment in its 2000 consultation document on
investment by endowed charities that such an approach would “effectively
eliminate” the duty to consider the present and future needs of the
charity, and that it would not “keep
19 CP, para 6.60.
20 CP, para 6.61.
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faith with those that set up charities with capital
funds”.21
Responses to the CP’s proposals about total return
investment for charities
8.50 Most
consultees agreed with our preference for Option 3, above, although some
expressed concern about the need for “safeguards” or about the
administrative burden on charities, particularly small organisations.
Some, including the Charity Law Association and the Wills and Equity
Committee of the Law Society, also took the view that, failing a provision
to make the Charity Commission’s scheme available without individual
authorisation, Option 1 should be pursued, to place the current system on
a statutory footing.22
8.51 Of those
who were unhappy with Options 2 and 3, some were concerned that total
return investment was too complex or too risky for charitable trusts.
Others expressed disagreement in the opposite direction, arguing in favour
of total return investment but criticising the Charity Commission’s
scheme. Those criticisms fall broadly under three heads.
RESTRICTIONS ON THE EXPENDITURE OF ENDOWED GIFT
8.52 First,
consultees criticised the absence of any ability under the Charity
Commission’s scheme to have any access to the original gift (or the
investments representing it) in order to fund charitable activity where
the unapplied total return has been exhausted. That ability is seen as an
important means of facilitating prudent long-term total return investment;
if there is no absolute bar on the expenditure of endowed gift, short-term
very low yields can be endured in the interests of longer-term gain, and
spending is not paralysed.
8.53 To
explain this concern, we have to go back to the model of percentage trust
explained in Part 3.23 It will be recalled that in a percentage
trust the trustees distribute as income every year a proportion of the
total assets of the trust – income or capital – without regard to their
source. In a bad year when investment returns are very low, or during a
planned period of low returns where the trustees have invested with a view
to later capital growth, the funds distributed may not constitute
investment returns at all, but may be part of the original capital
of the fund. Trustees may at times need to do this to tide the trust over
difficult periods or indeed to facilitate sophisticated financial
planning.
8.54 However,
the Charity Commission’s scheme makes this form of total return investment
impossible, because it does not make any provision for the
21 CP, para 6.41 referring to
Endowed Charities – A Fresh Approach to Investment Returns? (July
2000).
22 One reason why some consultees
supported this was a doubt, expressed in an article published in 2001,
about the Charity Commission’s power to use the section 26 power to
authorise total return investment. See J Hill and J Smith, “Permanent
Endowment and Total Return” (2001) 7(2) The Charity Law and Practice
Review 125 and J Dutton, “Endowed Charities: A Total Return Approach
to Investment?” (2001) 7(2) The Charity Law and Practice Review
131. We do not agree with Hill and Smith’s argument. It was not raised
during the passing of the Charities Act 2006 and does not appear to have
been picked up in other published works. There is no evidence that
charities have been deterred by it from applying under section 26, nor
that the Charity Law Association regards it as a live issue today. In the
light of our recommendation there is in any event no need for us to
consider it further: see para 8.80 below. |
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distribution of any part of the
charity’s endowed gift – that is, the original fund and any further gifts.
Clearly distribution of endowed gift would not be undertaken lightly. But
there might be circumstances where the inability to access that fund could
cripple a charity in the short term, where there is no “unapplied
total
return”.24
8.55 It is
this inability to distribute the endowed gift that lies at the heart of
the criticisms of the Charity Commission’s scheme expressed in the
responses to our 2004 CP.
NO REQUIREMENT TO CONSERVE THE
ENDOWMENT
8.56 A second
criticism of the Charity Commission’s total return investment scheme, made
by a number of consultees, is the absence of an absolute requirement to
retain the real value of the endowed gift. The ability of trustees to
expend capital gains arising on the endowed gift means that its value can
shrink over time. It was suggested that this makes the scheme’s
prohibition on expending the endowed gift artificial.
8.57 The
Charity Commission does not accept this criticism. Its view is that the
duty to keep a balance between current and future charitable purposes,
which underpins the scheme, makes an express requirement to maintain the
value of the endowed gift unnecessary. Moreover, it considers that it
would be arbitrary to limit expenditure by, say, a compulsory percentage
increase in the value of the retained fund or to a defined percentage of
total return or of the value of the trust. Any form of prescription would
produce irrational results in some of the wide variety of circumstances
which would arise.
INFLEXIBLE
PROCEDURE
8.58 Finally,
there is the issue of structural rigidity. The London Endowed Charities
Forum summed up the views of several consultees when it stated that the
current system “is not in practice seen as terribly workable or
attractive”. Trustees are obliged to operate on the basis of the Charity
Commission’s categories (endowed gift, total return, unapplied total
return and trust for application). They are subject to various reporting
and accounting requirements which many find cumbersome and inappropriate.
We have sympathy with this concern, although we recognise the need for
accounting safeguards.
OUR RECOMMENDATIONS FOR TOTAL
RETURN INVESTMENT FOR CHARITIES
Making total return investment more widely
available
8.59 In recommencing work on this project
in 2008, we endeavoured to ascertain, in
23 See paras 3.17 to 3.22
above.
24 Edward Nugee QC contrasted the
Charity Commission’s scheme with the type of total return investment
policy drafted by him and adopted by a number of Oxford and Cambridge
colleges. In these trusts the total value of the fund’s assets is
ascertained at the end of the relevant accounting period, and the trustees
then determine what proportion can properly be spent. These are exempt
charities, not currently subject to Charity Commission
control. |
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discussion with organisations and
with individuals, whether the range of views on total return investment
expressed in 2004 is still held. We found that it is. We have had very
constructive discussions with representatives of the Charity Commission
and of the Charity Law Association. We agree with them that total return
investment holds significant advantages for charity trustees. It enables
flexible investment which can maximise returns, and overcomes the problems
caused by the rules of trust classification, such as the receipts of large
and unexpected income returns which erode capital. Such receipts are a
particular problem for charities as the income must be spent within a
reasonable period.
8.60 Total
return investment may be unsuitable for smaller trusts where the
administrative burden of running a total return investment scheme would
outweigh the benefits. Such charities might invest more effectively on a
conventional basis; and the very small ones might reasonably choose to
place their endowed gift in a single income-producing investment which
offers predictable, if unspectacular, returns.
8.61
Accordingly, we favour a reform making total return investment
available to all charities, at the discretion of the trustees; it will be
for trustees to decide, in the light of the charity’s size and the nature
of its investment portfolio – and indeed of their own investment
competence – whether or not to do so. The trustees’ properly considered
decision would discharge their duty to consider exercising the power. It
should be noted that, in a sense, introducing the power would not alter
charity trustees’ responsibilities in this regard; charity trustees
currently have power to apply to the Charity Commission for authorisation
to conduct total return investment, and so are under a duty to consider
the exercise of that power. It should also be borne in mind that there is
precedent for introducing facilitative powers of this sort. The Trustee
Act 2000 widened investment powers for all existing trusts. In doing so it
enabled more effective trustee investment. It did so notwithstanding that
some elements of the Act’s “package” are potentially
burdensome.
Which total return investment scheme for
charities?
8.62 There are
clearly many different possible forms of total return investment. As to
the appropriate scheme for charities, we have heard two very clear
messages in discussions held in 2008.
8.63 The first
is that the Charity Commission considers that its scheme is now tried and
tested and should be made more widely available. Consequently, it
considers that where its section 26 scheme can apply, it generally should
do, on the grounds of public benefit. It remains confident in the terms of
its scheme, and has stressed to us that it consulted stakeholders before
settling on its total return investment policy, and that a range of
prescriptive schemes were put forward and considered. The Charity
Commission would therefore favour the extension of its scheme to all
charitable trusts: Option 2 of those put forward by the CP. It does not
favour Option 3, involving additional reporting and accounting
requirements.
8.64 The
second message is that there is still significant disquiet about the
Charity Commission’s scheme among charities, focused still on the
restrictions on endowed gift, the lack of requirement to retain the value
of endowed gift, and structural rigidity. That disquiet is now expressed
against a different statutory background, because section 43 of the
Charities Act 2006 is now in force, so that
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charities now have much wider
powers to spend their permanent endowment, as discussed
above.
8.65 Those
wider powers have a potential impact – perhaps an unexpected one -upon the
operation of the Charity Commission’s total return investment
scheme.25 They may make it unnecessary for charities who wish
to operate total return investment to follow the route of obtaining
section 26 authority to do so; instead, it would appear to be open to
charity trustees to exercise the power in section 75 or to make an
application under section 75A to remove the restriction on the expenditure
of capital and thereafter invest on a total return basis. The grounds for
the exercise of the power or for making the application would be that the
charity would be able to carry out its charitable purposes more flexibly
on this basis. Such trustees would, of course, remain subject to the duty
to be even-handed in their treatment of present and future charitable
purposes. But they would be free to devise their own scheme for total
return investment, including for example the facility to expend endowed
gift in a period of negative total return; they might impose their own
restrictions to prevent the erosion of capital, and they might devise
simpler accounting requirements than those imposed within the section 26
scheme.
8.66 This
proposition has not been tested because the relevant sections have only
recently come into force. Larger charities would require Charity
Commission concurrence with their plans under section 75A, and in the
current investment market it may be that many would be able to present a
strong application under section 75A on the basis that the Charity
Commission's section 26 total return scheme would not be effective. The
Charity Commission’s decision could, of course, be appealed to the Charity
Tribunal.
8.67 It
therefore appears that the changes made by the Charities Act 2006 to the
rules of expenditure of permanent endowment may have opened the way for
charity trustees to bypass the Charity Commission’s total return
investment scheme and to undertake a different sort of total return
investment.
8.68 We take
the view that that, where appropriate, charities should be able to take
advantage of the section 75 and 75A powers to conduct total return
investment in the manner of their own choosing, provided that it can be
demonstrated that this is in the interests of the charity. Those that do
so will remain subject to the duty to balance the present and future needs
of the charity and to the oversight of the Charity
Commission.
8.69 However,
we think that for many charitable trusts the Charity Commission’s scheme
remains the most appropriate form of total return investment. We would not
favour the widespread use of sections 75 and 75A as a mechanism of
bypassing the Charity Commission’s carefully designed scheme. Nor do we
think that all applications under section 75A would be successful, for the
reasons outlined above. We therefore do not think that the availability of
sections 75 and 75A negates the argument that there should be a general
statutory power to operate the Charity Commission’s total return
investment scheme.
8.70 We
understand the criticisms of that scheme, but we do not consider its 25 We are grateful to the
Charity Law Association for drawing this point to our
attention.
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prescriptive requirements to be a
disadvantage. The Charity Commission’s role is to regulate and assist
charities, in order to increase their efficiency and effectiveness and to
promote public confidence and trust in them. Although the concept of total
return investment is relatively straightforward, the mechanics of
operating it are not. We consider that it is appropriate, and indeed
necessary, that the Charity Commission design and provide support for a
detailed total return investment scheme for charity trustees. The fact
that the scheme spells out what the trustees need to do may irritate some
sophisticated charity trustees. But the structure of the scheme, together
with the Charity Commission’s voluminous Operational Guidance, is
extremely valuable for less experienced trustees. The duties that the
Charity Commission has put in place spell out to charity trustees what is
expected of them and allows the Commission to police the scheme’s
effective implementation.
8.71 We
therefore do not accept that it would be appropriate to recommend a less
structured total return investment scheme for charities. The Charity
Commission may be able better to present the scheme in a way which makes
clear the flexibility that it does offer.
8.72 We have
concluded, therefore, that there should be a general statutory power which
would enable all charities to operate total return investment in
accordance with regulations made by the Charity Commission.26
We do not consider that there is any need to impose more onerous reporting
requirements27 on charities taking advantage of a new general
statutory total return investment power. Various duties are already
imposed on charities taking advantage of the Charity Commission’s
scheme.28 The Charity Commission and other consultees have made
it clear that they do not think that the adoption of a total return
investment approach to investment requires the imposition of additional
obligations on charity trustees.
Remaining concerns about the Charity Commission’s
scheme
8.73
Nevertheless, we are aware of the claims that the scheme is
unpopular and we have discussed with the Charity Commission the concerns
that our consultees have raised with us. We commented above on structural
and accounting requirements, and the benefits we see in these; but it is
undesirable that they be expressed in a way that charities find
burdensome. We think that, in itself, the absence of any formal mechanism
to retain the real value of the endowed gift is not problematic, provided
that trustees who operate the scheme appreciate the need to keep in mind
the effect of inflation on the value in real terms of the endowed gift.
The Charity Commission should consider amplifying its guidance on this
issue and remain open to the concerns of charities on this point and to
the possibility of imposing further safeguards. Finally, the concern of
charities about the restrictions on the endowed gift are persistent, and
it seems inappropriate that there should be an automatic bar that prevents
charities from operating a model for total return investment that many
private trusts in other jurisdictions
26 See Draft Bill, cl 4 which sets
out the Charity Commission’s power to make regulations and gives examples
of the provisions such regulations may contain.
27 As envisaged in the CP’s Option
3: see para 8.46, above.
28 See OG 83 B2 (“Directions
relating to the use of the power”) and B5 (“Accounting for Total
Return”). |
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have found useful and workable, particularly in falling
markets.
8.74 We think
that while the passage of time is a reason for widening the availability
of the Charity Commission’s scheme, on the basis that fundamental flaws
have not become apparent, the passage of time also indicates that it would
be appropriate for the Charity Commission to consult afresh about the
details of the scheme.
8.75 We would
like that consultation to focus particularly upon endowed gift and the
circumstances in which it might be spent. The Charity Commission might
usefully give consideration to setting up a procedure, within its total
return investment scheme, whereby trustees might apply for authority to
spend it, and for the Commission to consider such applications with an
unfettered discretion but in the light of relevant criteria. These might
include:
(1) the
interests of the charity, taking into account the charity’s past, present
and future investment policy and the past, present and future calls on its
funds;
(2) the intentions of the donor of
the gift; and
(3)
whether or not provision is to be made to recoup the gift from
future investment.
8.76 Other
criteria might be suggested in consultation, and no doubt more flexibility
might be available where the authorisation is to spend endowed gift on
condition that it must be recouped from future investment returns. We
anticipate that such authorisation would be required only for larger
charities that cannot use the procedure under section 75 of the Charities
Act, since smaller charities may use that section to free their capital
from restrictions by resolution in any event.
8.77 The
additional ability for charities to apply for authorisation for the
expenditure of the original gift, within the Charity Commission’s own
total return investment scheme, would enable the Charity Commission to
control and provide targeted operational and policy guidance on the
circumstances in which expenditure of endowed gift would be
appropriate.
8.78 The
Charity Commission clearly values the preservation of permanent endowment,
but equally wishes charities to conduct total return investment. We
believe that a consultation about the detail of the scheme would lay the
foundations for improvements to it, which would make it more attractive to
charities; and that, in turn, would reduce the necessity for charities to
apply to operate schemes of their own devising under section
75A.
8.79
Accordingly, with the agreement of the Charity Commission, we make
two recommendations.
Recommendation
8.80 We
recommend that there should be a general statutory power which would
enable all charities to resolve that the endowment fund, or a portion of
it, ought to be freed from restrictions with respect to expenditure of
capital in order that they might operate total return investment in
accordance with regulations made by the Charity Commission without seeking
authorisation
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under section 26 of the Charities Act
1993.29
Recommendation
8.81 We recommend that the
Charity Commission should conduct a consultation about the details and
rules of its current scheme, with a view to amending the terms on which it
authorises total return investment in the
future. |
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29 Draft Bill, cl
4. |
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PART 9
SUMMARY OF
RECOMMENDATIONS
9.1 We
recommend that all distributions falling within sections 213(2) or 213A of
the Income and Corporation Taxes Act 1988 (defined as exempt distributions
in section 218) should be classified as capital for trust law
purposes.1 When such a distribution is made, the trustees
should have a power to make a payment of capital to beneficiaries
interested in income where otherwise there would be prejudice to those
beneficiaries.2
[paragraph 5.95]
9.2 We
recommend that the Secretary of State should be given power by statutory
instrument to provide, with HM Treasury consent, for similar amendments to
trust classification in the event that developments in tax legislation
create new exempt
distributions.3
[paragraph 5.97]
9.3 We
recommend that HMRC and HM Treasury in the longer term enter into
discussions with the trust industry as to the feasibility and mechanics
for total return investment for trusts within the parameters of current
tax policy, to the extent that is possible, or in the event of future
developments in policy.
[paragraph 5.104]
9.4 We
recommend that the first part of the rule known as the rule in Howe v
Earl of Dartmouth shall not apply to any future
trusts.4
[paragraph 6.53]
9.5 We
recommend that the equitable rules of apportionment shall not apply to any
future trusts, subject to any contrary provision in the trust
instrument.5
[paragraph 6.65]
9.6 We
recommend that section 2 of the Apportionment Act 1870 shall not apply to
any future trusts, subject to any contrary provision in the trust
instrument.6
[paragraph 6.70]
9.7 We
recommend that there should be a general statutory power which would
enable all charities to resolve that the endowment fund, or a portion of
it, ought to be freed from restrictions with respect to expenditure of
capital in order that they
1 Draft
Bill, cl 2(1) and (3)(a).
2 Draft
Bill, cl 3.
3 Draft
Bill, cl 2(1) and (3)(b).
4 Draft
Bill, cl 1(2)(a) and (4).
5 Draft
Bill, cl 1(2)(b) to (e) and (4). |
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might operate total return
investment in accordance with regulations made by the Charity Commission
without seeking authorisation under section 26 of the Charities Act
1993.7
[paragraph 8.80]
9.8 We recommend that the Charity
Commission should conduct a consultation about the details and rules of
its current scheme, with a view to amending the terms on which it
authorises total return investment in the future.
[paragraph 8.81] |
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(Signed) TERENCE ETHERTON,
Chairman
ELIZABETH COOKE
DAVID HERTZELL
JEREMY HORDER
KENNETH
PARKER |
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MARK ORMEROD, Chief Executive
3 April 2009 |
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6 Draft Bill, cl 1(1) and
(4).
7 Draft Bill, cl
4. |
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APPENDIX
A
DRAFT
TRUSTS (CAPITAL AND INCOME) BILL
AND
EXPLANATORY NOTES
The draft Bill begins on the following page.
Turn to page 129 for a background
note, summary and commentary on the clauses. |
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DRAFT
TRUSTS (CAPITAL AND INCOME) BILL: EXPLANATORY NOTES
BACKGROUND AND SUMMARY
Capital and income in trusts
A.1 This Bill will give effect to
the recommendations made in the Law Commission’s Report Capital and
Income in Trusts: Classification and Apportionment,1 which
examined: the rules classifying receipts and expenses, in the hands of
trustees, as income and capital; the rules apportioning receipts and
outgoings of trustees between income and capital; and the rights and
duties of charity trustees in relation to investment returns on a
charity’s permanent endowment. The Bill makes changes to a number of those
rules.
A.2 The Bill is relevant to those
trusts that have to distinguish between capital and income in the
management of their property. Such trusts fall into two
groups:
(1) private trusts for interests in
succession; and
(2) charitable trusts with a
permanent endowment.
A.3 The trustees of these trusts
have to distinguish between capital and income investment receipts. In the
case of private trusts for interests in succession, income receipts must
be paid to the life tenant while capital receipts must be held for the
remainderman; in the case of charitable trusts with permanent endowment,
capital receipts must generally be held as part of the permanent
endowment.
A.4 The Bill makes three changes.
First, it disapplies, for new trusts, the rules known as the equitable
rules of apportionment, which require adjustments to be made to the
entitlement to income and capital receipts, and to liabilities for income
and capital expenses, in certain instances. It also disapplies the
statutory time apportionment rule imposed by the Apportionment Act 1870 in
so far as it relates to trusts. Secondly, it changes the classification of
shares received by trustees by way of investment receipts when the company
in which they hold shares undergoes a demerger. Finally, the Bill makes an
amendment to the Charities Act 1993 in order to facilitate total return
investment for charitable trusts that have a permanent
endowment.
The rules of apportionment
A.5 The rules of apportionment
require the sharing of certain returns and outgoings of a trust between
capital and income, and in some cases impose a duty to sell certain
investments. Most derive from case law, and are often known as the
“equitable rules of apportionment”; one derives from statute. The rules
can be summarised as follows:
(1) Section 2 of the
Apportionment Act 1870 is a rule of time apportionment. The effect of the
section is that income beneficiaries are entitled only to
1 Law Com No
315.
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the proportion of income that is
deemed to have accrued during their period of entitlement.
(2) The
first part of the rule known as the rule in Howe v Earl of Dartmouth
creates an implied trust for sale, putting the trustees under a duty
to convert residuary personal estate, held on trust for persons in
succession, if it is an unauthorised investment and of a wasting or
hazardous nature.
(3) The
second part of the rule known as the rule in Howe v Earl of Dartmouth
compensates the capital beneficiary for loss pending conversion of
trust investments.
(4) The
rule in Re Earl of Chesterfield’s Trusts compensates the income
beneficiary for loss of present income from future property where trustees
have exercised a power to defer sale.
(5) The
rule in Allhusen v Whittell apportions debts, liabilities, legacies
and other charges payable out of the residuary estate between capital and
income beneficiaries.
(6) The
rule in Re Atkinson apportions the loss caused to the trust by
authorised investments in loan stock where the borrower is unable to meet
his or her obligations and there is insufficient security to make up the
shortfall.
(7) The
rule in Re Bird apportions the loss caused to the trust by
unauthorised investments in loan stock where the borrower is unable to
meet his or her obligations and there is insufficient security to make up
the shortfall.
A.6 The rules apply to private
trusts for interests in succession; the extent to which they apply to
charitable trusts is unclear. Professionally drafted trust instruments
generally exclude them. In most trusts where they have not been excluded
they are either ignored or cause considerable inconvenience by requiring
complex calculations in relation to very small sums of money.
A.7 The Bill abolishes the rules
for trusts coming into existence after commencement. But settlors and
testators who wish any or all of the rules to apply to the trust can make
express provision to that effect in the trust instrument.
The classification of shares received in the course of a
demerger
A.8 The trust law classification
of investment receipts from companies as income or capital is determined,
in most instances, by the rule known as the rule in Bouch v
Sproule.2 It was stated in its modern form in Rae v
Lazard Investment Co Ltd:
There is no doubt that every
distribution of money or money’s worth by an English company must be
treated as income in the hands of the shareholders unless it is either a
distribution in a liquidation, a repayment in respect of reduction of
capital (or a payment out of a
2 (1887) LR 12 App Cas 385.
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special premium account) or an issue of bonus shares (or it
may be
bonus debentures).3
A.9 Among the effects of the rule
is that any dividend paid by a company in which trustees hold shares is
classified as income.
A.10 The Bill changes that
classification, for the purposes of trustee shareholders, in the case
where the dividend is a distribution made in the course of a corporate
demerger. Such demergers can be of two kinds: direct and indirect. A
demerger involves the transfer of part of Company A’s business to a new
Company B, with the shareholders of the demerged company (Company A)
receiving shares in the new company by way of a declaration of dividend.
In a direct demerger the dividend is satisfied by Company A issuing to its
shareholders shares in Company B. In an indirect demerger the shares in
Company B are transferred to a separate holding company, Company C, whose
shares are owned by Company A. Company A satisfies the dividend by
transferring to its shareholders the shares in Company C.
A.11 Under the rule in Bouch v
Sproule, shares distributed in the course of a direct demerger are
classified as income. Shares distributed in the course of an indirect
demerger, on the other hand, constitute an exception to the rule in
Bouch v Sproule and are classified as capital, following the
decision in Sinclair v Lee.4 The Bill provides that the
shares distributed in defined direct and indirect demergers will for the
future be treated as capital for the purposes of the trust. This reform
affects both private and charitable trusts.
A.12 The classification of such
receipts may, in some circumstances, prejudice the income beneficiary. The
Bill provides a power to compensate the income beneficiary by way of a
payment from trust capital in these circumstances.
Total return investment for charitable
trusts
A.13 The trustees of charitable
trusts with permanent endowment must keep separate income available for
current use and capital held to produce future income, and consequently
must maintain a balance between the interests of the current recipients of
charitable assistance and the future recipients.
A.14 Those duties to balance have
an influence upon the selection of investments by the trustees of these
trusts. They must invest with a view to the likely form of the receipt –
as income or capital – in an endeavour to ensure that future investment
receipts do not favour income or capital disproportionately. As the
classification of investment receipts is governed by rules, the trustees
cannot take any corrective action in the event that the eventual return on
the investments does not produce the requisite balance.
A.15 The selection of investments
in this way prevents trustees from operating total return investment,
whereby investments are selected with a view to the level of return
without being constrained by the likely form of the return.
3 [1963] 1 WLR 555 at
565.
4 [1993] Ch 497.
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A.16 Trustees of charitable
trusts with permanent endowment can operate total return investment if
they apply to the Charity Commission for an order enabling them to do so,
in accordance with the Charity Commission’s scheme for total return
investment set out in its Operational Guidance.5 The Bill
enables trustees by resolution to operate total return investment in
accordance with Charity Commission regulations, without having to approach
the Charity Commission for an order.
COMMENTARY ON CLAUSES
Clause 1: Disapplication of apportionment etc
rules
A.17 Clause 1 disapplies the
statutory and equitable rules of apportionment and the first part of the
rule known as the rule in Howe v Earl of Dartmouth for trusts
created or arising after the clause comes into force.
A.18 Subsection (1) disapplies
the time apportionment imposed on trustees by section 2 of the
Apportionment Act 1870. The effect of section 2 is that income is deemed
to accrue at a constant rate from day to day, and apportioned accordingly
when the entitlement to income changes during the period before income was
received by the trustees. Thus where shares are held in trust for A for
life, then to B in remainder, A dies on 1 January, and a dividend is
declared on 1 February on shares that last yielded a dividend on 1
December, half the dividend is payable to B and half accrues to A’s
estate. The effect of subsection (1) is that the whole dividend is payable
to B.
A.19 A further effect of
subsection (1) is that the rule known as the rule in Re Joel will
not apply to trusts created or arising after the subsection comes into
force. This rule is simply a consequence of section 2 of the Apportionment
Act. The rule in Re Joel is that trustees are only permitted to
maintain an individual member of a beneficial class out of the income
which can be apportioned to a period when the member was alive and
therefore eligible to receive the benefit of the income. Accordingly,
where a fund is held upon trust for the children of X, and the trustees
have power to maintain the children out of income to which they are not
yet absolutely entitled, then, where a child is born, an apportionment
calculation must be carried out to ascertain the income from which that
child can be maintained. Without the rule in Re Joel, income as it
arises is available in equal proportions for the maintenance of all the
beneficiaries entitled to be maintained from it.
A.20 Subsection (2)(a) disapplies
the first part of the rule known as the rule in Howe v Earl of
Dartmouth, which imposes a trust for sale upon residuary personalty
where it consists of an unauthorised investment of a wasting and hazardous
nature. The effect of subsection (2)(a) is that trustees will not be under
an immediate obligation to sell such an investment. Normally, of course,
they would choose to do so in any event. But in some circumstances
immediate sale would be unwise, and without the rule the trustees can
exercise their discretion in the context of their general duty of care.
Subsection (3) confirms that the trustees have power to sell where
previously they had a duty to sell.
5 Charity Commission,
Operational Guidance 83 Endowed Charities: A Total Return Approach to
Investment (available at http://www.charitycommission.gov.uk/supportingcharities/ogs/index083.asp).
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A.21 Subsection (2)(b) disapplies
the second part of the rule known as the rule in Howe v Earl of
Dartmouth, which applies to all trusts for sale, express or implied,
where hazardous or wasting property is held for persons in succession. Its
scope is therefore wider than that of the first branch of the rule. It
states that the life tenant is not to be paid the actual income that
arises before sale; instead the life tenant is to receive a sum calculated
by applying a specified level of interest (usually 4 per cent) to the
estimated value of the property. This sum is intended to reflect a fair
income from the property, leaving the excessive income actually produced
by such an investment to be treated as capital. The effect of the
disapplication of the rule is that the income beneficiary will be entitled
to income from such investments as it arises.
A.22 Subsection (2)(c) disapplies
the rule known as the rule in Re Earl of Chesterfield’s Trusts,
which complements the apportionment rule in Howe v Earl of
Dartmouth. It ensures that the income beneficiary receives income from
property that does not in fact produce any income until it falls into
possession. An example would be where the trust fund includes property
held in reversion, that is, property that will fall into the possession of
the trust (and will start producing income for it) on the death of a life
tenant. The rule provides that where such an interest is retained until it
falls into possession, part of it is to be treated as arrears of income
and paid to the life tenant. The amount to be treated as capital is that
which, if invested at 4 per cent compound interest (and subject to
deduction of income tax), would have produced the sum actually received.
The difference between those two amounts is to be treated as the arrears
of income. The effect of the disapplication of the rule is that such
property will be treated as capital when it comes into the possession of
the trustees.
A.23 Subsection (2)(d) disapplies
the rule known as the rule in Allhusen v Whittell. Where a
testator’s residuary estate is left to persons in succession, the rule in
Allhusen v Whittell apportions debts, legacies, annuities and other
charges payable out of the residuary estate between the income and capital
beneficiaries. The purpose of the rule is to place the beneficiaries in
the same position as they would have been in had the debts been paid at
the moment of the testator’s death, so as to prevent the life tenant from
benefiting from the portion of capital required for discharging debts. The
effect of the disapplication of the rule is that such debts, legacies,
annuities and other charges will only be payable out of
capital.
A.24 Subsection (2)(e) disapplies
the rules known as the rule in Re Atkinson and the rule in Re
Bird. These rules apportion between capital and income beneficiaries
the loss suffered when the trust fund includes loan stock, the borrower
defaults, and the security taken on the loan is insufficient to meet the
shortfall. Such loans may be either authorised or unauthorised
investments, and the rules in Re Atkinson and in Re Bird
apply to the two cases respectively. The effect of subsection (2)(e)
is that if there is a shortfall in the interest payments due to the trust,
that loss will be borne only by the income beneficiary, and that the sum
received on the sale of such loan stock will be treated as capital.
However, where the investment was in fact unauthorised a beneficiary who
suffers loss as a result may have a remedy for breach of
trust.
A.25 Subsection (4) provides that
subsections (1) to (3) are subject to contrary provision in the trust
instrument. The effect of this subsection is that settlors or
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testators who wish to include any
of the rules disapplied in subsections (1) and (2) may do so by excluding
the clause or by expressly invoking the rule by name in the trust
instrument.
Clause 2: Classification of certain corporate distributions
as capital
A.26 Subsection (1) provides that
where a trust receives a tax-exempt corporate distribution it is to be
treated as a receipt of capital. Subsection (3) defines a tax-exempt
corporate distribution for the purposes of subsection (1). Subsections (1)
and (3)(a) change the classification of shares distributed to a trust by
way of dividend in the course of a demerger. They do so by reference to
the definition of an “exempt distribution” in sections 213(2) and 213A of
the Income and Corporation Taxes Act 1988. The effect of those sections is
that shares distributed in the course of certain direct or indirect
demergers are exempt from income tax. The effect of subsections (1) and
(3)(a) of the clause is that such shares are to be regarded as capital in
the hands of a trustee shareholder.
A.27 So far as private trusts for
interests in succession are concerned, that means that the shares will be
held as capital (producing income for the future), rather than being paid
out to the income beneficiary. Where the shareholders are the trustees of
a charity with permanent endowment, the shares will be held as capital by
the trustees and dealt with in accordance with the terms of the trust
instrument.
A.28 Subsection (1) makes it
clear that the change made by subsection (3)(a) applies in relation to all
trusts, including trusts created or arising before the commencement of the
clause. However, under subsection (2) this is subject to contrary
provision in the trust instrument as to the classification of such
receipts. This clause will not affect the classification of receipts
received prior to its commencement.
A.29 The clause also provides for
future developments. Subsection (3)(b) gives the Secretary of State a
power to specify by order other distributions by corporate bodies which
are to be treated as a receipt of capital by trustees; it does not allow
the Secretary of State to specify that certain tax-exempt corporate
distributions are to be treated as income. “Body corporate” includes all
Companies Act companies and limited liability partnerships and will also
cover foreign companies where they are corporate bodies, but it will not
cover unincorporated associations. “Distribution” here includes a
distribution of assets, whether in cash or otherwise, and whether by
dividend or otherwise.
A.30 Subsections (4) and (5)
limit the Secretary of State’s power to make such an order. Subsection (4)
provides that such an order can only be made where the distribution is not
subject to income tax or capital gains tax, for example where a similar
exemption from tax is extended to other corporate receipts. Subsection (5)
requires the consent of HM Treasury in the making of such an
order.
A.31 As with subsection (3)(a),
an order under subsection (3)(b) will apply in relation to all trusts,
including trusts created or arising before the commencement of the clause
(subsection (1)) and is subject to contrary provision in the trust
instrument (subsection (2)). |
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Clause 3: Power to compensate
income beneficiary
A.32 Clause 3 provides trustees
with a power to compensate income beneficiaries where there has been a
tax-exempt distribution classified as capital by virtue of clause
2.
A.33 Subsection (1)(b) makes it
clear that the power can only be exercised where the trustees are
satisfied that, but for the tax-exempt distribution, the body corporate
would have, for example, paid a dividend or a larger
dividend.
A.34 Subsection (2) enables
trustees to make a payment out of capital, or to transfer trust property
(such as shares) to the income beneficiary, to the extent necessary to
place the income beneficiary in the position that the trustees consider
they would have been in under section (1)(b). Trustees are only expected
to do this to the extent that it is practicable.
A.35 Subsection (3) defines
“income beneficiary” and includes a class of income beneficiaries. It is
not limited to beneficiaries who have an interest in
possession.
Clause 4: Total return investment by
charities
A.36 Clause 4 enables the
trustees of a charitable trust with permanent endowment to adopt, by
resolution, the Charity Commission’s scheme for total return
investment.
A.37 It does this by inserting
two new sections in the Charities Act 1993. New section 75BA sets out the
procedure for adopting the Charity Commission’s scheme and some of the
consequences of adopting it. New section 75BB allows the Charity
Commission to make regulations setting out the details of its total return
investment scheme, and procedural provisions regarding charity trustees’
resolutions to adopt the scheme.
A.38 Section 75BA is based on
sections 75 and 75A of the 1993 Act (as substituted by the Charities Act
2006). Those sections allow the trustees of a charitable trust with
permanent endowment to pass a resolution freeing that endowment from
restrictions. Smaller charities do not need to involve the Charity
Commission in this process (see section 75); larger charities do (see
section 75A).
A.39 Section 75BA(2) enables the
trustees of a charitable trust with permanent endowment to pass a
resolution where they are satisfied that the conditions in section 75BA(3)
and (4) are met. The conditions are, first, that the total return on an
available endowment fund of the charity, or a portion of such a fund,
would be greater if it were invested without regard to the form of the
receipts as income and capital. Secondly, that it is in the interests of
the charity that the fund or portion, and any income arising therefrom,
should be subject to the Charity Commission’s total return investment
regulations. Section 75BA(5) provides that the effect of such a resolution
is to free the available endowment fund of the charity from restrictions
on the expenditure of capital that would otherwise apply, while subjecting
it and income arising from it to the Charity Commission’s total return
investment regulations (which, as mentioned below, may include
restrictions on the expenditure of capital). It will not be possible for
any charity to pass such a resolution until the Charity Commission has
made regulations under section 75BB. |
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A.40 Section 75BA(1) makes it
clear that such a resolution may be passed only in the case of a charity
which is a trust (and not a charity which is a company or other body
corporate).
A.41 Under section 75BA(6)
“available endowment fund” has the same meaning in section 75BA as in
section 75. Subsection (7) of section 75 defines a charity’s “available
endowment fund” as “(a) the whole of the charity’s permanent endowment if
it is all subject to the same trusts, and (b) any part of its permanent
endowment which is subject to any particular trusts that are different
from those to which any other part is subject”. The effect of this
definition is that section 75BA will apply separately to each part of a
charity’s permanent endowment which is subject to separate trusts. A
charitable trust which has more than one available endowment fund and
which wishes to operate total return investment on all of its funds will
need a separate resolution for each fund.
A.42 Section 75BB(1)(a) and (2)
allow the Charity Commission by regulations to make procedural provision
about resolutions under section 75BA, and about the variation and
revocation of such resolutions.
A.43 Section 75BB(1)(b) and (3)
allow the Charity Commission to make regulations setting out the
investment of the relevant fund on a total return basis, and the
expenditure from such a fund. Charities will be subject to the regulations
once they have adopted the scheme by a resolution under section 75BA.
Section 75BB(3) contains an illustrative list of requirements and
restrictions that may be included in the regulations; the list is
permissive rather than mandatory and it will be for the Charity Commission
to decide on the specific provisions. For example, the Charity Commission
may make regulations concerning recoupment. Nothing in this clause affects
the general duties of charity trustees, for example to have regard to both
present and future needs of the charity.
Clause 5: Short title, commencement and
extent
A.44 Subsection (4) provides that the Bill extends only to
England and Wales.
Glossary |
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APPENDIX B
ADVISORY GROUP
MEMBERS
Rupert Allen (Fountain Court)
John Battersby (KPMG,
representing the Institute of Chartered Accountants in England and
Wales)
James Dutton (representing the Charity
Commission)
Murray Hallam (Withers, representing the Law
Society)
The Hon Mr Justice Henderson
(representing the Judges of the Chancery Division)
Simon Jennings (Rawlinson and Hunter, representing the Trust
Law Committee)
Christopher McCall QC (Maitland
Chambers, representing the Trust Law Committee)
Francesca Quint (Radcliffe
Chambers, representing the Charity Law Association)
Nigel Reid
(Linklaters)
Paul Saunders (Barclays Bank
Trust Company Limited)
Jeffrey Sultoon
(Ashursts)
Emma-Jane Weider (Allen and
Overy, representing the Financial Markets Law Committee)
Arthur Weir (representing the City of Westminster &
Holborn Law Society)
John Wood (representing the
Association of Contentious Trust and Probate
Specialists) |
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APPENDIX
C
RESPONDENTS TO
CONSULTATION PAPER
NO 175
Association of Contentious Trust
and Probate Specialists
Association of Corporate
Trustees
Association of District
Judges
Barclays Bank Trust
Company
Bircham Dyson Bell,
solicitors
British Bankers’
Association
Professor Catherine Brown,
University of Calgary
Charity Commission
Charles Russell,
solicitors
City of Westminster and Holborn
Law Society
Charity Law
Association
The Hon Mr Justice
Etherton
Mr Simon Gardner, University of
Oxford
Mr Toby Harris
The Hon Mr Justice David
Hayton
Her Majesty’s Revenue and
Customs
Herbert Smith,
solicitors
HSBC
Mr Ed Kisby
Professor John Langbein, Yale
University
Law Reform Committee of the
General Council of the Bar
Mr W A Lee
The Hon Mr Justice
Lloyd
London Endowed Charities
Forum
Mr John Ross Martyn
Mr Christopher McCall
QC
Moore & Blatch,
solicitors
Mr Richard Nolan, University of
Cambridge
Notaries Society
Mr Edward Nugee QC
Mr David Palfreyman
Mr Hubert Picarda
QC |
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Richards Butler,
solicitors
Mr Paul Saunders
Mr Geoffrey Shindler
Mr Tim Smith
Society of Pension
Consultants
Society of Trust and Estates
Practitioners UK Technical Committee
Trust Law Committee
The Rt Hon Lord Walker of
Gestingthorpe
Wills and Equity Committee of the
Law Society
Wrigleys,
solicitors |
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APPENDIX D
US UNIFORM PRINCIPAL AND
INCOME ACT
D.1 In the following pages we
reproduce the relevant provisions from the US Uniform Principal and Income
Act 1997.
D.2 We are grateful to the
National Conference of Commissioners on Uniform State Laws for permission
to reproduce these provisions. A full copy of the revised text of the Act,
with detailed commentary, is available at http://www.law.upenn.edu/bll/archives/ulc/upaia/2008_final.pdf.
SECTION 103. FIDUCIARY DUTIES;
GENERAL PRINCIPLES1
(a) In allocating receipts
and disbursements to or between principal and income, and with respect to
any matter within the scope of [Articles] 2 and 3, a
fiduciary:
(1) shall administer a trust
or estate in accordance with the terms of the trust or the will, even if
there is a different provision in this [Act];
(2) may administer a trust
or estate by the exercise of a discretionary power of administration given
to the fiduciary by the terms of the trust or the will, even if the
exercise of the power produces a result different from a result required
or permitted by this [Act];
(3) shall administer a trust
or estate in accordance with this [Act] if the terms of the trust or the
will do not contain a different provision or do not give the fiduciary a
discretionary power of administration; and
(4) shall add a receipt or
charge a disbursement to principal to the extent that the terms of the
trust and this [Act] do not provide a rule for allocating the receipt or
disbursement to or between principal and income.
(b) In exercising the power
to adjust under Section 104(a) or a discretionary power of administration
regarding a matter within the scope of this [Act], whether granted by the
terms of a trust, a will, or this [Act], a fiduciary shall administer a
trust or estate impartially, based on what is fair and reasonable to all
of the beneficiaries, except to the extent that the terms of the trust or
the will clearly manifest an intention that the fiduciary shall or may
favor one or more of the beneficiaries. A determination in accordance with
this [Act] is presumed to be fair and reasonable to all of the
beneficiaries.
SECTION 104. TRUSTEE’S POWER TO ADJUST
(a) A trustee may adjust between
principal and income to the extent the trustee considers necessary if the
trustee invests and manages trust assets as a prudent investor, the terms
of the trust describe the amount that may or must be distributed to a
beneficiary by referring to the trust’s income, and the trustee
determines, after applying the rules in Section 103(a), that the trustee
is unable to comply with Section 103(b).
1 NCCUSL
Copyright © 2003.
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(b) In deciding whether and
to what extent to exercise the power conferred by subsection (a), a
trustee shall consider all factors relevant to the trust and its
beneficiaries, including the following factors to the extent they are
relevant:
(1) the nature, purpose, and
expected duration of the trust;
(2) the intent of the
settlor;
(3) the identity and
circumstances of the beneficiaries;
(4) the needs for
liquidity, regularity of income, and preservation and appreciation of
capital;
(5) the assets held in the
trust; the extent to which they consist of financial assets, interests in
closely held enterprises, tangible and intangible personal property, or
real property; the extent to which an asset is used by a beneficiary; and
whether an asset was purchased by the trustee or received from the
settlor;
(6) the net amount
allocated to income under the other sections of this [Act] and the
increase or decrease in the value of the principal assets, which the
trustee may estimate as to assets for which market values are not readily
available;
(7) whether and to what
extent the terms of the trust give the trustee the power to invade
principal or accumulate income or prohibit the trustee from invading
principal or accumulating income, and the extent to which the trustee has
exercised a power from time to time to invade principal or accumulate
income;
(8) the actual and
anticipated effect of economic conditions on principal and income and
effects of inflation and deflation; and
(9) the anticipated tax consequences of an
adjustment.
(c) A trustee may not make an adjustment:
(1) that diminishes the
income interest in a trust that requires all of the income to be paid at
least annually to a spouse and for which an estate tax or gift tax marital
deduction would be allowed, in whole or in part, if the trustee did not
have the power to make the adjustment;
(2) that reduces the
actuarial value of the income interest in a trust to which a person
transfers property with the intent to qualify for a gift tax
exclusion;
(3) that changes the amount
payable to a beneficiary as a fixed annuity or a fixed fraction of the
value of the trust assets;
(4) from any amount that is
permanently set aside for charitable purposes under a will or the terms of
a trust unless both income and principal are so set
aside; |
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(5) if possessing or
exercising the power to make an adjustment causes an individual to be
treated as the owner of all or part of the trust for income tax purposes,
and the individual would not be treated as the owner if the trustee did
not possess the power to make an adjustment;
(6) if possessing or
exercising the power to make an adjustment causes all or part of the trust
assets to be included for estate tax purposes in the estate of an
individual who has the power to remove a trustee or appoint a trustee, or
both, and the assets would not be included in the estate of the individual
if the trustee did not possess the power to make an
adjustment;
(7) if the trustee is a beneficiary of the trust;
or
(8) if the trustee is not a
beneficiary, but the adjustment would benefit the trustee directly or
indirectly.
(d) If subsection (c)(5),
(6), (7), or (8) applies to a trustee and there is more than one trustee,
a cotrustee to whom the provision does not apply may make the adjustment
unless the exercise of the power by the remaining trustee or trustees is
not permitted by the terms of the trust.
(e) A trustee may release
the entire power conferred by subsection (a) or may release only the power
to adjust from income to principal or the power to adjust from principal
to income if the trustee is uncertain about whether possessing or
exercising the power will cause a result described in subsection (c)(1)
through (6) or (c)(8) or if the trustee determines that possessing or
exercising the power will or may deprive the trust of a tax benefit or
impose a tax burden not described in subsection (c). The release may be
permanent or for a specified period, including a period measured by the
life of an individual.
(f) Terms of a trust that
limit the power of a trustee to make an adjustment between principal and
income do not affect the application of this section unless it is clear
from the terms of the trust that the terms are intended to deny the
trustee the power of adjustment conferred by subsection (a).
SECTION 105. JUDICIAL CONTROL OF DISCRETIONARY
POWER
(a) The court may not order
a fiduciary to change a decision to exercise or not to exercise a
discretionary power conferred by this [Act] unless it determines that the
decision was an abuse of the fiduciary's discretion. A fiduciary’s
decision is not an abuse of discretion merely because the court would have
exercised the power in a different manner or would not have exercised the
power.
(b) The decisions to which subsection (a) applies
include:
(1) a decision under
Section 104(a) as to whether and to what extent an amount should be
transferred from principal to income or from income to
principal.
(2) a decision regarding
the factors that are relevant to the trust and its beneficiaries, the
extent to which the factors are relevant, and the weight, if any, to be
given to those factors, in deciding whether and to what extent to exercise
the discretionary power conferred by Section 104(a).
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(c) If the court determines
that a fiduciary has abused the fiduciary’s discretion, the court may
place the income and remainder beneficiaries in the positions they would
have occupied if the discretion had not been abused, according to the
following rules:
(1) To the extent that the
abuse of discretion has resulted in no distribution to a beneficiary or in
a distribution that is too small, the court shall order the fiduciary to
distribute from the trust to the beneficiary an amount that the court
determines will restore the beneficiary, in whole or in part, to the
beneficiary’s appropriate position.
(2) To the extent that the
abuse of discretion has resulted in a distribution to a beneficiary which
is too large, the court shall place the beneficiaries, the trust, or both,
in whole or in part, in their appropriate positions by ordering the
fiduciary to withhold an amount from one or more future distributions to
the beneficiary who received the distribution that was too large or
ordering that beneficiary to return some or all of the distribution to the
trust.
(3) To the extent that the
court is unable, after applying paragraphs (1) and (2), to place the
beneficiaries, the trust, or both, in the positions they would have
occupied if the discretion had not been abused, the court may order the
fiduciary to pay an appropriate amount from its own funds to one or more
of the beneficiaries or the trust or both.
(d) Upon [petition] by the
fiduciary, the court having jurisdiction over a trust or estate shall
determine whether a proposed exercise or nonexercise by the fiduciary of a
discretionary power conferred by this [Act] will result in an abuse of the
fiduciary's discretion. If the petition describes the proposed exercise or
nonexercise of the power and contains sufficient information to inform the
beneficiaries of the reasons for the proposal, the facts upon which the
fiduciary relies, and an explanation of how the income and remainder
beneficiaries will be affected by the proposed exercise or nonexercise of
the power, a beneficiary who challenges the proposed exercise or
nonexercise has the burden of establishing that it will result in an abuse
of discretion.
SECTION 401. CHARACTER OF RECEIPTS
(a) In this section,
“entity” means a corporation, partnership, limited liability company,
regulated investment company, real estate investment trust, common trust
fund, or any other organization in which a trustee has an interest other
than a trust or estate to which Section 402 applies, a business or
activity to which Section 403 applies, or an asset-backed security to
which Section 415 applies.
(b) Except as otherwise
provided in this section, a trustee shall allocate to income money
received from an entity.
(c) A trustee shall allocate the following receipts from
an entity to principal:
(1) property other than money;
(2) money received in one
distribution or a series of related distributions in exchange for part or
all of a trust’s interest in the entity; |
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(3) money received in total or partial liquidation of the
entity; and
(4) money received from an
entity that is a regulated investment company or a real estate investment
trust if the money distributed is a capital gain dividend for federal
income tax purposes.
(d) Money is received in partial
liquidation:
(1) to the extent that the
entity, at or near the time of a distribution, indicates that it is a
distribution in partial liquidation; or
(2) if the total amount of
money and property received in a distribution or series of related
distributions is greater than 20 percent of the entity’s gross assets, as
shown by the entity’s year-end financial statements immediately preceding
the initial receipt.
(e) Money is not received
in partial liquidation, nor may it be taken into account under subsection
(d)(2), to the extent that it does not exceed the amount of income tax
that a trustee or beneficiary must pay on taxable income of the entity
that distributes the money.
(f) A trustee may rely upon
a statement made by an entity about the source or character of a
distribution if the statement is made at or near the time of distribution
by the entity’s board of directors or other person or group of persons
authorized to exercise powers to pay money or transfer property comparable
to those of a corporation’s board of directors. |
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APPENDIX
E
CHARITY COMMISSION
TOTAL RETURN
INVESTMENT
SCHEME
E.1 This appendix reproduces the
Charity Commission’s pictorial representation of the relationship between
a charitable trust’s funds when operating its total return investment
scheme from Operational Guidance 83 C2. |
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