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You are here: BAILII >> Databases >> The Law Commission >> Capital and Income in Trusts: Classification and Apportionment (Consultation Paper) [2004] EWLC 175(1) (12 July 2004) URL: http://www.bailii.org/ew/other/EWLC/2004/175(1).html Cite as: [2004] EWLC 175(1) |
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INTRODUCTION
1.1 The Trustee Act 2000 came into force on 1 February 2001. Based on earlier work of the Law Commission,[1] it imposed a statutory duty of care on trustees in relation to the exercise of certain powers and duties, and made important reforms to the law affecting the delegation of trusteeship and the remuneration of trustees. It was particularly significant in its repeal of the Trustee Investments Act 1961 and its conferment of wide investment powers on trustees. 1.2 The Trustee Investments Act 1961 had been the subject of serious criticism for many years.[2] It was considered unduly rigid in its demand that the trust fund be divided into two parts for investment purposes in order to regulate risk-taking, and overly restrictive in its prescription of the range of permissible investments. The Act was routinely excluded in modern trust instruments so that its application was more the exception than the rule. 1.3 The 2000 Act heralded a new approach to trustee investment, abandoning the restrictive "statutory list" of authorised investments characteristic of the 1961 Act. This approach confers on trustees a "general power of investment", which means that they are now entitled to make any kind of investment they could make if they were absolutely entitled to the assets of the trust.[3] In the exercise of this power, trustees are required to have regard to the "standard investment criteria", namely the suitability to the trust of the particular investment and the need for diversification of investments (insofar as is appropriate to the circumstances of the trust).[4] The 2000 Act embraces modern portfolio investment theory in which the main concern of the investor is to balance overall growth and overall risk. 1.4 The 2000 Act regulates investment decisions regarding the retention, as well as the conversion, of existing investments. In deciding whether to retain investments trustees are required to discharge the statutory duty of care imposed by section 1 of the Act, having regard to the standard investment criteria. [5] They must also take and consider advice, unless they reasonably conclude that it is unnecessary and inappropriate to do so,[6] and discharge their duties under the general law, such as the duty of even-handedness[7] and the fiduciary duties of good faith and loyalty.[8]THE TRUSTEE ACT 2000
1.5 On the passage of the Trustee Bill, now the Trustee Act 2000, through Parliament, concerns were expressed as to whether the Act would tackle the difficulties caused in the management of trust estates by the distinction which trust law draws between income and capital. 1.6 There was particular concern over the impact of the rules preventing the expenditure of the capital of permanently endowed charitable trusts. As Lord Phillips of Sudbury explained:THE REFERENCE TO THE LAW COMMISSION
1.7 Under the current law the trustees of charitable trusts which have permanent endowments are ordinarily unable to convert any of that capital into income even when this would be to the advantage of the charity's objects. Permanently endowed charities are therefore reliant on income investment returns to fund their charitable activities. During debates in the House of Lords, Lord Dahrendorf suggested that there should be consideration of the possibility of trustees adopting "total return policies" in which the rigid distinction between capital and income receipts is abandoned in favour of attempting to achieve the maximum total return on investments.[10] This would allow trustees to make investment decisions for the overall economic benefit of the charity without regard to the legal form of the investment returns. 1.8 Replying to the above concerns, the Lord Chancellor acknowledged that the law of apportionment is in "some disarray" but proposed that this issue should be dealt with as a whole rather than piecemeal as an amendment to the Trustee Bill.[11] He gave an undertaking to refer the matter to the Law Commission for examination. The terms of the formal reference to the Law Commission are:Endowments are basically investments that can never be sold and the proceeds distributed to their charitable purposes; they must always be retained so that only the income arising from the endowment can be used for beneficial purposes. For most charities they have become a severe encumbrance.[9]
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.
1.9 The law affecting classification of trust receipts as income or capital and the rules of apportionment are of course inter-linked. Although the Trustee Act 2000 has now advanced the cause of portfolio investment theory, the current law as it appertains to classification and apportionment makes it impossible to realise all the potential benefits of that theory. Trustees are compelled to sacrifice larger economic returns which might have been achieved had there been no restrictions on the form which those returns could take. It is strongly arguable that this is not in the interests of beneficiaries or the economy as a whole.It can be seen from these terms of reference that the scope of the current project is by no means restricted to charitable trusts. Indeed, the majority of the issues under consideration are of primary importance to private (non-charitable) trusts.
1.10 The principal issues for consideration in this Consultation Paper can broadly be divided into three categories:PRINCIPAL ISSUES
(1) The rules governing the classification of trust receipts as income or capital;
(2) The rules, both equitable and statutory, requiring conversion of the original trust property or apportionment between the capital and income accounts;
(3) he impact of these rules on charities, with particular reference to permanent endowments.
1.11 The significance of classification as income or capital is most clearly seen in the context of a private trust for the benefit of persons in succession. The life tenant is entitled to the income for the duration of his or her life. The beneficiary entitled in remainder, the remainderman, has no current entitlement to income, but is interested in the capital. This impacts on the trustees' duties of investment:Classification of investment returns as income or capital
1.12 Usually it will be fairly obvious whether an investment return should be classified as income, payable to the life tenant (the income beneficiary), or capital, to be held for the remainderman (the capital beneficiary). If trust property is leased out, the rent received by the trustees will clearly be income. If trust money is invested in a bank account, the interest payable on the original sum will also be income. There are, however, a number of circumstances in which receipts that would instinctively be considered capital are in fact classified as income. 1.13 Particular difficulties have been identified where the courts have sought to classify trust receipts from companies by way of distribution to their shareholders. The general rule, laid down by the House of Lords in Bouch v Sproule,[13] and developed by the Privy Council in Hill v Permanent Trustee Company of New South Wales,[14] is of uncertain extent, and where it does apply can be notoriously difficult to construe. It has been criticised judicially. In an important decision concerning the classification of trust receipts following an indirect demerger, Sir Donald Nicholls VC (as he then was) stated: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.[12]
I am mindful of the need for certainty in this area of the law. I am acutely conscious of the danger of doing more harm than good by an apparent departure from established principles so as to reach a fair conclusion in a particular case. Nevertheless, in my view an application of existing principles in their full width would produce a result in this case which would, frankly, be nothing short of absurd.[15]
1.14 In theory, rules of apportionment fairly attribute the assets and liabilities of the trust between the income and capital beneficiaries in circumstances where no proper balance would otherwise be struck. The principle behind such rules is to give effect to the duty of trustees, in the exercise of their functions, to maintain a balance, so far as it is possible, between those interested in capital and those interested in income. This important point, which is often overlooked, is central to our consideration of the subject, and will in due course form a central component in our provisional proposals. 1.15 In practice, the current law of apportionment comprises a number of rigid and technical equitable rules, most of which were judicially laid down in the eighteenth and nineteenth centuries, and which now give rise to considerable practical difficulties. They often require complex calculations to be made, yet affect very small sums of money. Consequently the rules are routinely excluded in well-drafted trust instruments or wills; they apply more often by accident than design. It is also unsatisfactory that the rules of apportionment only apply in certain specific circumstances. There are situations in which no rule applies but where justice would require apportionment between income and capital.[16] The equitable rules of apportionment are widely acknowledged to be unsatisfactory. Reform is required to ensure that the law keeps pace with modern trust practice. 1.16 Rules of apportionment can also be found in statute. By section 2 of the Apportionment Act 1870, all "rents, annuities, dividends, and other periodical payments in the nature of the income" are deemed to accrue from day to day over the period in respect of which they are made rather than being allocated to the person who is entitled to income on the date on which they become due. The income must therefore be apportioned between those entitled to the income over that period in proportion to the duration (in days) of their respective entitlements. It should be noted that this provision is of more general application than the equitable apportionment rules. It is potentially applicable whenever there is a change in the entitlement to receive income and therefore its application is not limited to trusts.[17] 1.17 In the trusts context the operation of the Apportionment Act has been described as "inconvenient" and "unfair".[18] Where a life tenant is the spouse of a testator it is unlikely to reflect the testator's intention if, for example, dividends declared in respect of a period before death are apportioned to remainder rather than income. The operation of the Act also places an onerous obligation on trustees to make complex enquiries about the precise source of and reason for the payment. The Act can produce uncertainty; it is unclear, for example, how trustees should deal with interim dividends.[19] A strict application of the Act also leads to the complexities of the rule in Re Joel [20] if there is a settlement for the maintenance of a class of minors who are contingently entitled to the fund on attaining a specified age.[21] As a result of these difficulties the operation of the Apportionment Act is, much like the equitable rules of apportionment, routinely excluded in well-drafted trust instruments and wills.Rules of apportionment
1.18 Issues involving apportionment arise in quite different circumstances where charities are concerned. Private trusts in succession benefit identified individuals (or classes) with distinct interests; usually a life tenant entitled to income and a remainderman interested in capital. Charitable trusts on the other hand always further the same charitable purpose. The same individuals may benefit from a charitable trust now and in the future; the "beneficiary" of a charitable trust is the public at large. The main tension is therefore between supporting the current charitable purposes of the trust and ensuring that sufficient value remains in the trust to allow it to further its charitable purposes in the future. Whether a charitable trust can fulfil its purposes by expending capital and income or income alone depends on the terms of the trust. Some trusts have expendable capital endowments which can be dissipated in furtherance of the charitable purposes. Many, however, have a permanent endowment which cannot be distributed. In these circumstances the classification of returns as income or capital is of crucial importance.Impact on charities
1.19 The rules of apportionment have been critically examined in the 23rd Report of the Law Reform Committee,[22] the Trust Law Committee's 1999 Consultation Paper[23] and the Scottish Law Commission's Discussion Paper in 2003.[24] All three law reform bodies recommended the abolition and replacement of the rules. The rules of classification of trust receipts as income or capital have also been considered at length by the Trust Law Committee and the Scottish Law Commission, and again recommendations for reform have been made. 1.20 Following receipt of this reference by the Law Commission, there have been significant developments in relation to charity law reform. Total return investment policies have been the subject of operational guidance from the Charity Commission, and in response to a consultation process initiated by the Strategy Unit of the Cabinet Office a draft Charities Bill has been published.LAW REFORM INITIATIVES TO DATE
1.21 We consider that the case for some reform of the current law is overwhelming, and we are provisionally proposing a new approach to the classification and apportionment of income and capital in trusts. In overview we propose to:SUMMARY OF OUR PROVISIONAL PROPOSALS
(1) Replace, in the absence of contrary provision in the terms of the trust, the rules for classification of corporate receipts by trustee-shareholders as income or capital with a simpler alternative based on the form of receipts. The rules of classification for other receipts and expenses will remain unaltered.
(2) Make available a new power for trustees to allocate investment returns and trust expenses as income or capital insofar as is necessary to maintain a balance between income and capital ("the power of allocation").
(3) Abrogate all existing equitable rules of apportionment.
(4) Replace the provisions of the Apportionment Act 1870 (only insofar as they relate to trusts) with a discretion to apportion periodic payments which accrue from day to day when it is just and expedient to do so (unless contrary intention is shown in the terms of the trust).
(5) Abolish the implied trust for sale of unauthorised hazardous or wasting assets under the first branch of the rule in Howe v Earl of Dartmouth. Express and statutory trusts for sale would be unaffected.
(6) Clarify the mechanism by which trustees of permanently endowed charities may invest on a "total return" basis.[25]
1.22 This Paper sets out the reasoning behind our provisional proposals. In Part II we state the current law concerning classification of trust receipts, and in Part III we state the current law of apportionment. In each case, we make criticisms of the existing law. In Part IV we briefly summarise the views and recommendations of the law reform bodies which have already considered the case for reform of the law in the United Kingdom. In Part V we explain the reforms which we are provisionally proposing, setting out the details of a new approach to classification and apportionment. In Part VI we give specific consideration to the problems facing charities. 1.23 The provisional proposals, and those issues on which we invite the views of consultees, are brought together in Part VII of the Paper for convenience.THIS CONSULTATION PAPER
1.24 We do not consider that the provisional proposals for reform described in this Paper would contravene any rights contained in the European Convention on Human Rights. We would, however, be interested to hear the views of consultees on this issue.HUMAN RIGHTS
We would welcome the views of consultees on the human rights implications of the provisional proposals described in this Paper.
1.25 Current Government practice is to consider the impact of changes to regulatory structures on businesses, particularly small businesses, charities and other voluntary organisations by means of a regulatory impact assessment. While the Law Commission does not provide its own regulatory impact assessments, it does seek to collect information and views which may be of assistance to Government in this regard. 1.26 Any legislative regulation of the areas of law discussed in this Paper is likely to confer benefits and to impose costs on businesses, organisations and individuals. We believe that the expected benefits to beneficiaries are likely to outweigh the potential administrative costs of the new scheme. We do, however, invite the views of consultees on, in particular, the likely impact of our proposals on small trusts. We do not foresee a significant amount of litigation flowing from the introduction of our provisional proposals.[26]REGULATORY IMPACT
We would welcome any information or views from consultees about the regulatory impact of our provisional proposals.
1.27 We would like to take this opportunity to thank the members of the Trust Law Committee, in particular Sir John Vinelott, Mr John Dilger, Professor David Hayton, Mr Michael Jacobs and Mr Geoffrey Shindler, for their assistance and advice. We are very grateful to Mrs Francesca Quint of 11 Old Square and Mr James Dutton of the Charity Commission with whom we have discussed the impact of the current law and our provisional proposals on charities. We are particularly indebted to the Honourable Mr Justice Etherton for soliciting the views of the judges of the Chancery Division, on the initiative of the Right Honourable Sir Andrew Morritt VC, on the outline of the scheme provisionally proposed in Part V of this Paper. They should not, however, necessarily be taken to agree with the provisional proposals outlined in this Paper and any errors which remain are our own.ACKNOWLEDGEMENTS
Note 1 See, in particular, Trustees’ Powers and Duties (1999) Law Com No 260; Scot Law Com No 172. [Back] Note 2 Trustees’ Powers and Duties (1999) Law Com No 260, Scot Law Com No 172; paras 2.16 2.18. [Back] Note 3 Trustee Act 2000, s 3. Investment in land is excluded from the scope of the general power, although trustees do have statutory power to acquire freehold or leasehold land in the UK: Trustee Act 2000, s 8. The investment power is itself subject to restriction or exclusion in the trust instrument or by any enactment or any provision of subordinate legislation: Trustee Act 2000, s 6(1)(b). [Back] Note 4 Trustee Act 2000, s 4. [Back] Note 5 The statutory duty of care is to “exercise such care and skill as is reasonable in the circumstances”. The extent to which this and other duties of trustees should be capable of exclusion or restriction is the subject another consultation paper of the Law Commission: see Trustee Exemption Clauses (2003) Law Com No 171. [Back] Note 6 Trustee Act 2000, s 5. [Back] Note 7 See below, paras 5.19 – 5.26. [Back] Note 8 See, for example, Boardman v Phipps [1967] 2 AC 46 (HL). [Back] Note 9 Hansard (HL) 14 April 2000, vol 612, col 389. [Back] Note 10 For discussion of “total return policies” see below, paras 5.32 – 5.40 and paras 6.39 – 6.61. [Back] Note 11 Hansard (HL) 14 April 2000, vol 612, col 389. [Back] Note 12 Re Whiteley (1886) 33 Ch D 347, 350, per Cotton LJ. [Back] Note 13 (1885) 12 App Cas 385. [Back] Note 15 Sinclair v Lee [1993] Ch 497, 515. [Back] Note 16 Some of these circumstances are considered below (paras 3.64 – 3.74) alongside the equitable rules of apportionment. [Back] Note 17 It is, for example, relevant to the calculation of an employee’s accrued holiday pay on termination of employment: Thames Water Utilities Ltd v Reynolds [1996] IRLR 186. [Back] Note 18 The Powers and Duties of Trustees (1982) 23rd Report of the Law Reform Committee, Cmnd 8733, para 3.39. [Back] Note 19 Interim dividends are declared in respect of a period which has not come to an end, whereas final dividends only arise when the period has been finally concluded. [Back] Note 20 [1967] Ch 14 (Goff J). [Back] Note 21 The implications of the rule in Re Joel are considered below, paras 3.79, 3.85 – 3.87. [Back] Note 22 The Powers and Duties of Trustees (1982) 23rd Report of the Law Reform Committee, Cmnd 8733. [Back] Note 23 Capital and Income of Trusts (1999) Trust Law Committee Consultation Paper. [Back] Note 24 Apportionment of Trust Receipts and Outgoings (2003) Scot Law Com Discussion Paper No 124. [Back] Note 25 Following the Government’s recent review of charity law we consider that the question of whether charity trustees should be permitted to distribute a permanent endowment as if it were income lies outside the scope of the project. See below, paras 6.31 – 6.34. [Back] Note 26 See below, paras 5.78 – 5.82. [Back]
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