Flexible friend

Trusts have been an important tool in English law for several centuries and continue to ?perform useful functions today. Typically, they enable money to be set aside ?and invested by trustees to deliver benefits to others.

This will often be done to give some beneficiaries a right to receive the income generated and to give other beneficiaries a right to the capital in due course. Where there are different interests in succession like this, the law imposes on the trustees a duty to distinguish between capital and income. Therefore gains in the value of the original settlement are added to it for the benefit of future beneficiaries and income is made fully available to the current beneficiaries.

For private trusts, a number of very specific rules have been developed by the courts and, in some instances, by parliament to guide trustees and protect the often competing interests of income and capital beneficiaries. These rules were a significant safeguard for a time in which substantial sums of money were held in trust.

But more recently, with the sums of money held on trust lower than they used to be, with professional advisers usually expressly excluding those rules and with many trustees being unaware ?of the rules, it is not surprising that the Lord Chancellor referred them to the Law Commission for review.

The Law Commission’s remit was to review and report back on:

• the circumstances in which trustees may or must make apportionments between the income and capital of the trust fund

• the rights and duties of charity trustees in relation to investment returns on a charity’s permanent endowment

• the circumstances in which trustees must convert and re-invest trust property; and

• the rules that determine whether money or other property received ?by trustees is to be treated as income or capital.

Following the publication of the Law Commission report, a draft bill was introduced in the House of Lords in February 2012. On 23 October 2012, it went to the House of Commons where it passed unamended through the committee stages.

The Trusts (Capital and Income) ?Act 2013 received Royal Assent on ?31 January 2013 and will come into force on a date or dates to be set by statutory instrument.

The provisions of sections 1 to 3 of the Act are concerned principally with private trusts and with the rules that have up to now imposed specific duties on trustees to balance the interests of income and capital beneficiaries, save for the increasing number of trusts where these duties have been disapplied.

Rule change

Section 1 of the Act will free new trusts (that is, trusts coming into existence after this section is brought into force) from the following rules:

• Section 2 of the Apportionment Act 1870, under which trustees have to work out how to allocate income to beneficiaries by calculating how much was deemed to have accrued over a period rather than simply by reference to when the income arose.

• In future, income will be due to income beneficiaries as it arises during their period of entitlement.

• The first branch of the rule in Howe v Earl of Dartmouth (1802) 7 Ves Jr 137, which required trustees to dispose of any unauthorised investments held in a residuary estate if they represented a risk to the capital value of the trust fund.

• Trustees of new trusts will have a power to dispose of such assets but no obligation to do so, thereby avoiding the risk of having to sell at an unfavourable time.

• The second branch of Howe v Earl of Dartmouth, under which an income beneficiary was entitled to a specified rate of interest on unauthorised investments until they are converted, thereby protecting the interests of capital beneficiaries.

• Income beneficiaries will henceforth be entitled to actual income as it arises, even if this might on the face of it mean that the capital of the trust fund is depleted by the inclusion of a hazardous or wasting asset.

• The rule in Re Earl of Chesterfield’s Trusts (1883) 24 Ch D 643, under which an asset coming into the trustees’ possession had to be apportioned as between income ?and capital so as to compensate income beneficiaries where trustees had deferred the sale of future property (such as a reversionary interest in land) so that no income was generated.

• Under new trusts, no such compensation will have to be paid ?in these circumstances.

• The rule in Allhusen v Whittell (1867) 4 Eq 295, under which liabilities payable out of a residuary estate had to be apportioned between capital and income as if the assets were distributed at the testator’s death.

• The default position will be that liabilities will be charged to capital.

It had been proposed that further rules in Re Atkinson [1904] 2 Ch 160 (CA) and Re Bird [1901] 1 Ch 916 regarding apportionment of losses arising from insufficiently secured loan stock should be disapplied, but these have remained untouched by the Act.

Just as these rules are often disapplied by express provisions in trust instruments, it will remain possible for them to be expressly applied.

Corporate receipts

Section 2 will change the treatment of corporate receipts arising on demergers, removing the rule in Bouch v Sproule (1887) LR 12 App Cas 385, which requires shares issued on a direct demerger (that is, where shareholders receive shares in the subsidiary) to be treated as income, and removing the rule in Sinclair v Lee [1993] Ch 497, which provided that shares issues on an indirect demerger (that is, where shareholders receive shares in a third holding company) shall represent capital.

Once in force, section 2 will provide that all tax-exempt corporate distributions are treated as capital. This will apply to existing as well as new trusts, to charitable as well as private trusts, and will be subject to any contrary intention in the trust instrument.

Capital funds

Section 3 will permit trustees to pay funds out of capital to income beneficiaries if the rule in section 2 would otherwise lose income, for example if profits have been rolled up into the shares that are issued on demerger. Under trust law, payments under this section will be capital in ?the beneficiaries’ hands.

Total return

Section 4 introduces new rules for “total return” investment by the trustees of charitable trusts. Many charities are established as trusts and, among these there are many thousands established on terms that are intended to preserve the long-term capital value of the trust assets by limiting the trustees’ power to spend any part of the capital.

Charities that have this form of endowment are in effect performing a balancing act between the current beneficiaries (whose interests will be best served by maximising the income) and future beneficiaries (whose interests will be best served by maximising capital growth). In this respect, the trustees have similar duties to the trustees of private trusts.

As the rules governing the investment of charity funds have become progressively more relaxed (most notably with the introduction of the general power of investment in the Trustee Act 2000) it became clear that the rules on classification and allocation of investment returns were hampering the efforts of charity trustees to maximise their investment returns.

This was because their choice of investments was being dictated in part by the need to select investments that would deliver the right balance of income and capital growth so that current beneficiaries would have the benefit of as much income as possible without depleting the capital. The overall effect was, for some charities, a reduction in the overall yield compared with what might otherwise have been achieved.

Following the Trustee Act 2000, ?the Charity Commission published guidance setting out the terms on which they would be willing to use their existing powers under the Charities Act to authorise trustees of endowed charities to adopt a total return ?approach to investment.

This approach overcomes the problem by allowing trustees to put all investment return into a single pool and to use their own judgment to determine how much of this should be expended as if it was income and how much reinvested as capital. The commission’s authority would be subject in each case to directions as to how the trustees must exercise their discretion and how they must report their use of the total ?return approach.

Statutory power

Section 4 inserts sections 104A and 104B into the Charities Act 2011 to give the trustees of endowed charities a statutory power to adopt a total return approach to investment without the need to seek the Charity Commission’s sanction.

Trustees will be able to use this power by passing a resolution to the effect that the endowment they hold (or a part of it) should be invested without the need to maintain a balance between capital and income returns, and should therefore be freed from the restrictions in the original trusts as to the expenditure of capital.

Where trustees have passed such a resolution, the original restrictions will be replaced by regulations made by the commission under section 104B. Those regulations will be subject to consultation by the commission, which is expected to be issued in the next few months and are expected to include the directions that accompany the orders that the commission has been making since 2001, covering the following matters:

• what procedures have to be followed for passing resolutions under section 104A, for varying or revoking them and for notifying the commission when they have been passed

• under what circumstances a resolution might cease to be ?effective and what the trustees ?must do in such a case

• how the trustees must seek to preserve the long-term capital value of the endowment and how they may accumulate income

• what advice trustees must take ?when investing funds and allocating returns; and

• how charity trustees must report to the commission on the investment ?of, and expenditure from, any ?fund in respect of which they ?have passed a resolution.

It is also possible that the draft regulations will offer additional ?flexibility in the treatment of capital ?and income by charity trustees.

In practice, this provides an opportunity for the endowed charities ?on the commission’s register to adopt ?a more flexible approach to managing their investments without the cost, ?both for the charities and for the commission, of having to seek an ?order first.