Sound investment: clarifying the rules on capital and income in trusts

A short bill with only four sections, the Trusts (Capital & Income) Bill 2012, which received its first reading in the House of Lords on 29 February 2012, sets out some welcome reforms which will remove a number of old and complex rules on apportionment and simplify the position regarding the classification of demerger receipts.

The separation of capital and income is fundamental to trust law and is particularly relevant to both private trusts with an interest in succession and charitable trusts with a permanent endowment.

The classic life interest trust is the best illustration of the need to distinguish between income and capital; income must be paid to the life tenant and capital retained for the remaindermen. Balancing the life tenant and the remaindermen's interests is central to the role of trustees. The distinction is also important when considering taxation and treatment of trust expenses as certain expenses may be chargeable only to income thereby reducing the income tax payable.

Concerns about the treatment of capital and income were raised during parliamentary debates over the Trustee Act 2000. These were referred to the Law Commission which, some nine years later, published its report 'Capital and Income in Trusts '“ Classifications and Apportionment' (report No. 315). This identified corporate receipts as a particular area of difficulty for trustees and resulted in the proposed reforms in three key areas: the classification of corporate receipts, the rules of apportionment, and the rules allowing charitable trusts with permanent endowments to adopt a total return investment policy.

Corporate receipts: unsuitable classification

In most circumstances, the distinction between capital and income is straightforward and does not pose a problem for trustees. However, the difficulty with corporate receipts is that their classification relies on concepts of capital and income derived from company law, which are distinct from the usual trust law concepts.

The starting point for the classification of corporate receipts is the rule in Bouch v Sproule. The rule, restated and expanded in subsequent cases, provides that every distribution by a company in money or money's worth must be treated as income unless it is a distribution in liquidation, a repayment in reduction of the company's capital or an issue of bonus shares. When applied to trusts, this has led to some surprising results.

In Re Sechiari a distribution of gilts in the form of British Transport stock to shareholders in Thomas Tilling & Co Ltd was held to be trust income on the grounds that the distribution could only have been capital in the hands of the trustees if the share capital of the company had been reduced (which it had not). The distribution of gilts was in consideration of the nationalisation of the company's road haulage and road transport undertaking and the company's share price fell by more than 75 per cent as a result. Still, the distribution was considered to be one of income. It was received by trustees as such, who were bound to hand it over to the life tenant even though the capital value of the shares in Thomas Tilling (and so the capital value of the trust fund) was severely diminished.

Similar results were seen more recently when large companies sought to reorganise themselves by demerger '“ for instance, British American Tobacco and Argos, or Racal Electronics and Vodafone.

A demerger involves the transfer by a company (ABC Ltd) of part of its business to a new company (XYZ Ltd). Shareholders in ABC Ltd are compensated for the fall in value of that company by receiving shares in XYZ Ltd by way of a declaration of dividend. Since the shares in the demerged company (XYZ Ltd) are not bonus shares, they have to be treated by trustee shareholders as a distribution of income and so must be passed onto the life tenant. This is despite the reduction in the value of the ABC Ltd's shares by virtue of the demerger.

Matters came to a head in 1993 with the proposed demerger of ICI and Zeneca. At the time, the Inland Revenue reported that it knew of 190,000 life interest trusts. Many (if not most) held shares in ICI. ICI had consolidated its bioscience activities into its wholly-owned subsidiary Zeneca Ltd.

It then planned to demerge Zeneca Ltd by transferring all its shares in Zeneca Ltd to Zeneca Group plc and compensating ICI shareholders by issuing them with paid-up shares in Zeneca Group plc. For trustee shareholders, the rule in Bouch v Sproule should have meant that the shares they received in Zeneca Group plc were income and therefore belonged to the life tenant even though the demerged shares represented more than half the value of a trust's original holding in ICI.

Another bizarre side effect is that the trustees, still holding ICI shares, would have kept the full acquisition cost of those shares.

Trustees who sought advice on their position were told that they had a duty to at least consider selling shares in demerging companies in order to preserve capital. However, if all the trustee shareholders holding ICI shares had sold just before the demerger, the market for ICI shares would have collapsed. ICI therefore went to court, via Sinclair v Lee, for a determination on how the shares in Zeneca Group plc should be treated.

To the palpable relief of trustees everywhere, Sir Donald Nicholls V-C held that the shares in Zeneca Group plc should be treated as trust capital and not income. He was able to distinguish Bouch v Sproule by looking at the structure of the demerger and drawing a distinction between a 'direct demerger' (where shareholders take shares directly in the demerged company) and this, an 'indirect demerger'.

This decision, while helpful for ICI, gave rise to a confusing distinction between direct and indirect demergers, creating another headache for trustee shareholders who now had to investigate the mechanics of any demerger from which their trust benefited in order to see how the distribution should be treated.

The Law Commission's view was that the current law was 'illogical'¦ giving rise to inappropriate and unpredictable results'. Illogical, because the meaning of capital and income is different between trusts and companies, and inappropriate due to the imbalance of benefit between the life tenant and remaindermen.

In light of this, clause 2 of the Bill operates to treat all distributions from tax-exempt demergers as capital. Significantly, this change will apply to all trusts, including those created before the provision comes into force.

Rules of apportionment: less relevant

Trust law does not generally give trustees any flexibility in classifying the receipts from investments. The rules of apportionment developed in response to this inflexibility and encompass a number of situations where receipts or expenses have to be shared between capital and income to ensure no beneficiary takes a disproportionate benefit at the expense of another.

The rules of apportionment developed through a number of cases and are appreciated only by the most fastidious of law examiners. Collectively they are the two branches of the rule in Howe v The Earl of Dartmouth, the rules in Re Earl of Chesterfield's Trusts, Allhusen v Whittell and in Re Atkinson and Re Bird. Section 2 of the Apportionment Act contains a rule of time apportionment. This means that income beneficiaries are only entitled to the proportion of income that is deemed to have accrued during their period of entitlement.

The problem with these rules is that they were formulated decades ago and are much less relevant today. For example, the concept of 'unauthorised investments' has been rendered virtually irrelevant following the broadening of trustee investment powers in the Trustee Act 2000.

The Law Commission noted that these rules are excluded as a matter of course in professionally drafted trusts. Even where the rules apply, they are often not understood are rarely applied correctly. The calculations associated with the application of these rules are often over small sums of money and are complex and disproportionately expensive to perform. In short, the rules no longer fit.

The draft bill, by clause 1, abolishes these rules for trusts created after the Act comes into force. It is open to testators and settlors to provide expressly for their continued application but it is difficult to imagine a scenario where that is desired. In their current state the rules lead to uncertainty and the possibility of complaint from beneficiaries. Their abolition should therefore be warmly welcomed.

Charitable trusts

The rules on classification of receipts also apply to charities and can cause a problem for those set up with a permanent endowment. While the trustees can spend income produced by the trust on its charitable purposes, they cannot freely convert capital into income for expenditure. A tension is thus created between the current and future recipients of charitable assistance.

The distinction between capital and income also leads to a practical problem for charities with a permanent endowment. If only income can be spent on charitable purposes, then the trustees must invest to produce enough income to allow expenditure, while at the same time maintaining capital. Pursuing an investment policy based on total returns which focuses on the overall investment return and is generally a more flexible '“ and often more profitable '“ is not possible.

There are some ways around this at present. The Charities Act 1993 allows small charities to spend capital without Charity Commission authorisation. Larger charities can apply for authorisation if capital expenditure is desired. Charities can also apply to be specifically authorised to pursue a total return investment policy under a Charity Commission scheme (see section 26 of the Charities Act 1993).

The draft bill however, goes one step further. It smoothes the way for more charities to pursue a total return investment policy by removing the need to apply to the Charity Commission for authorisation. Under Clause 4, a charity can, by resolution, adopt the Charity Commission scheme for total return investment. The draft Bill gives the Charity Commission the power to make regulations on total return investment which charities will need to follow. Clearly this move is beneficial for charities and represents a simplification of the current process in place to allow charities with a permanent endowment to pursue total returns.

The reforms in the Trusts (Capital and Income) Bill 2012 are not in themselves revolutionary since many of their effects are already achieved either by sensible drafting or other means. However, putting what is already happening in practice on a statutory footing will remove uncertainties and ambiguities.

These long awaited reforms have finally come to fruition and will remove some of the requirements and restrictions on trustees which will make administering trusts that little bit easier and more efficient.