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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(4) (12 July 2004) URL: http://www.bailii.org/ew/other/EWLC/2004/175(4).html Cite as: [2004] EWLC 175(4) |
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PREVIOUS PROPOSALS FOR REFORM
4.1 In Parts II and III we set out at length our criticisms of the current law affecting the classification of trust receipts and the equitable and statutory rules of apportionment. It appears to us that the case for reform is overwhelming. In Part V we will set out provisional proposals for a new statutory scheme. 4.2 Before doing so, however, we should outline briefly the proposals for reform which have been previously made by law reform bodies in the UK. It will become clear that in formulating our own proposals, we have been considerably influenced by the work which has already been carried out.INTRODUCTION
4.3 As we mentioned in Part I, there have been three major studies of these areas of the law in recent years. The equitable and statutory rules of apportionment were considered by the Law Reform Committee in its Report on the Powers and Duties of Trustees published in 1982.[1] The Trust Law Committee, under the Chairmanship of Sir John Vinelott, published a Consultation Paper on Capital and Income of Trusts in 1999, considering both the rules for classification of investment returns and the equitable and statutory rules of apportionment.[2] In September 2003 the Scottish Law Commission published a Discussion Paper on the Apportionment of Trust Receipts and Outgoings as part of its Sixth Programme of Law Reform.[3] Again, this Paper covered both issues of classification and apportionment.PREVIOUS PROPOSALS
The 23rd report of the Law Reform Committee (1982)
4.4 The Law Reform Committee recommended that section 6(1) of the Trustee Investments Act 1961 be amended,[4] so that trustees would be required to consider "the need to hold an even hand between beneficiaries with different interests" when making investments. 4.5 Three points should be made regarding this recommendation. First, the subsequent decision in Nestlé v National Westminster Bank considered, albeit somewhat briefly, the existing scope of the trustees' duty of even-handedness.[5] Secondly, the enactment of the Trustee Act 2000 has comprehensively altered the landscape of trustee investment. The "list approach" to authorised investments set out in the Trustee Investments Act 1961 has now been abandoned in favour of the conferment on trustees of liberal and wide-ranging investment powers, subject to a statutory duty of reasonable care.[6] Thirdly it may be unduly restrictive to require trustees to consider the need to maintain a fair balance between the beneficiaries when making investments if they have a power to remove imbalances which arise on receipt of investment returns.[7] The imposition of such a duty is an obstacle to the adoption of a total return approach to investment.[8] 4.6 The Law Reform Committee acknowledged criticism of the existing equitable rules of apportionment whilst recognising that "each of [the equitable rules of apportionment], taken in isolation, produces a perfectly just result for the special situation with which it is adapted to deal".[9] It considered the trustees' duty of even-handedness between all the beneficiaries (on which the rules are based) to be a "fundamental principle of equity". 4.7 The Committee rejected the suggestion that the existing rules should be left in place because, in practice, they are usually excluded or (if applicable) are "honoured more in the breach than in the observance".[10] It concluded that the need to maintain a fair balance between the interests of all beneficiaries meant it was not practical simply to abolish the existing rules of apportionment.[11] There will always be circumstances when fairness demands an adjustment to be made between capital and income. 4.8 The Committee dismissed the idea of applying the existing rules only when expressly included by the settlor.[12] It considered that express inclusion would in practice be unlikely, leading to possible unfairness when apportionment would have been appropriate. Even if the rules were expressly included the existing problems of complexity and technicality would remain. 4.9 The Law Reform Committee accordingly recommended that the existing technical rules of apportionment should be replaced by a general discretionary power for trustees to adjust the capital and income accounts of the trust. Trustees could exercise this power in order to restore or maintain a fair balance between all the beneficiaries. In deciding whether and how to exercise this power trustees should take account of the trust investments as a whole. Apportionment should no longer be restricted to the specific circumstances covered by the equitable rules of apportionment. 4.10 The recommendations of the Law Reform Committee have been substantially enacted in the Bahamas. Section 89 of the Bahamian Trustee Act 1998 provides:Duty of "even-handedness"
(1) The rules of equitable apportionment known as the Rule in Howe v. Earl of Dartmouth, the Rule in Re Earl of Chesterfield's Trusts and the Rule in Allhusen v. Whittell are abolished in all their branches.
(2) Whenever trustees in their discretion determine that property held by them for successive interests is not (when considered as a whole) so invested as to maintain a fair balance between beneficiaries interested in current income and other beneficiaries or that a particular receipt disturbs that balance, the trustees shall apportion income receipts to capital of the trust property or estate or apportion capital receipts to income of the trust property or estate so far (if at all) as they in their discretion consider necessary in order to restore such balance.
(3) On the application of a beneficiary (whether or not under a disability) aggrieved by any act or failure to act by trustees under subsection (2) the Court may give such directions as the Court may think fit for the purpose of redressing such grievance.[13]
(4) A trustee who has acted in good faith shall not be personally liable for the costs of any other party to any such application and the costs of such a trustee of such an application shall be provided for out of the trust property or its income.
(5) Subsections (2), (3) and (4) shall apply if and so far only as a contrary intention is not expressed in the trust instrument and shall have effect subject to that instrument.
4.11 The Law Reform Committee noted that the operation of section 2 of the Apportionment Act 1870 is not confined to trusts in succession. The Committee consequently concluded that recommending the repeal of the 1870 Act was "outside [their] terms of reference".[14] The Committee considered the application of the 1870 Act "on any death when a trust or settlement arises as the result of the death".[15] It recommended that the 1870 Act should be inapplicable in such circumstances unless a contrary intention is expressed in the trust instrument. The Committee also concluded that there would only be a few cases in which "significant hardship" would be caused by failure to apportion following a change in the beneficial entitlement to income. It therefore recommended that the 1870 Act should be amended so that income belongs exclusively (subject to contrary provision in the trust instrument) to the person entitled to income on the date that the sum becomes due.Statutory rules of apportionment
Trust Law Committee consultation paper (1999)
4.12 The Trust Law Committee's analysis of classification focused on the problems encountered with corporate receipts identified in litigation arising from a demerger of ICI.[16] Its Consultation Paper discussed three possible approaches to the classification of trust receipts from companies:Classification of corporate receipts as income or capital
(1) Treat a "reasonable return" on trust capital as income.[17]
(2) Allow the life tenant to take the trading profits of the company earned for the duration of his or her life interest.[18]
(3) Leave the existing rules of classification in place subject to a discretion for the trustees to reallocate income to capital and vice versa.[19]
4.13 In Sinclair v Lee, Sir Donald Nicholls VC had broached the possibility of allowing the life tenant a "reasonable return" on the invested trust capital as an alternative to the current rules.[20] The Trust Law Committee considered three possible methods of giving legislative effect to such a reform. First, it would be possible to enact a specified percentage rate which would constitute a "reasonable return". The Committee argued, however, that a fixed level of "reasonable return" would, like the "fair equivalent" under the second branch of the rule in Howe v Earl of Dartmouth and Re Chesterfield's Trusts,[21] easily become out of date with changing economic circumstances. It would also be insufficiently flexible to take account of the specific circumstances of a particular case. 4.14 Secondly, the Trust Law Committee suggested that it might be possible to achieve a "reasonable return" on invested trust capital by imposing a statutory duty on trustees to maintain the value of the trust capital. The life tenant would receive as income any investment returns over and above the level required to maintain the value of the capital investment fund. This would, of course, demand precise ascertainment of the initial capital value of the fund which would then have to be increased over time to take account of the effect of inflation. Both these requirements might involve complex calculations. It is also not entirely clear why the entire risk of a diminution in the value of trust capital should be imposed on the life tenant. 4.15 Thirdly, the concept of a "reasonable return" could be adopted in general terms without further elaboration. This would give trustees a significant amount of flexibility to take account of the circumstances of the trust as a whole. It would amount, in effect, to a broad discretion to classify trust investment returns in order to achieve a fair balance between the interests of all the beneficiaries. The danger would be increased uncertainty, and the possibility of litigation contesting the exercise of discretion by trustees. In the meantime it would be difficult to determine where the beneficial interests in the property lay.reasonable return on trust capital
4.16 The Vice-Chancellor's alternative suggestion in Sinclair v Lee was that all the trading profits of the company earned during the lifetime of the trust's shareholding should be received as income.[22] The Trust Law Committee argued that this would impose on trustees the disproportionately onerous task of examining the company's accounts in order to determine how to deal with any extraordinary distribution. Moreover it might be difficult to draw a clear and satisfactory distinction between trading profits and capital profits when, for example, a company elects to distribute some of its accumulated reserves and it is impossible to determine to which profits the distribution is attributable.trading profits during lifetime of trust
4.17 The preferred approach of the Trust Law Committee was to leave the rule in Bouch v Sproule intact, but to give trustees a discretion to re-allocate income to capital and vice versa. The exercise of this power would be informed by the trustees' duty to maintain a fair balance between the beneficiaries entitled to income and those who are interested in capital.discretion to reallocate income to capital and vice versa
4.18 The Trust Law Committee proposed that all of the equitable rules of apportionment be abolished. Its Consultation Paper discussed the possibility of not replacing the rules. As the rules of apportionment are routinely excluded in all well-drafted wills and settlements it might be concluded that they are not necessary to maintain a fair balance between the beneficiaries or to give effect to the settlor's or testator's wishes. The Committee rejected this approach in favour of conferring a general discretion on trustees to apportion receipts and expenses in order to discharge their duty to maintain a fair balance between the beneficiaries. In this respect, the Committee supported the earlier recommendations of the Law Reform Committee. It also adopted the recommendations of the Law Reform Committee concerning the 1870 Act.Equitable and statutory rules of apportionment
4.19 Although Scots trust law does not rest on the same basis as English trust law,[23] in this area of trust law the same problems arise as are outlined in Parts II and III of this Paper. 4.20 The Scottish Law Commission acknowledged that difficulties of classification arise in a wide range of contexts. The Discussion Paper considered the rules of classification in conjunction with the equitable rules of apportionment. The Commission also made proposals for the reform of the 1870 Act.Scottish Law Commission Discussion Paper (2003)
4.21 The Scottish Law Commission considered four possible options for reform:Classification of trust receipts and the equitable apportionment rules
(1) Enact legislative replacements for the existing rules of classification and apportionment.
(2) Enact a legislative replacement for the rule in Bouch v Sproule.
(3) Create a general judicial power to alter a classification or apportionment produced by the existing rules.
(4) Give trustees a general power to allocate receipts and outgoings between income and capital.
4.22 The Scottish Law Commission considered changing the existing rules by legislation but concluded that this would be unsatisfactory.[24] No legislative scheme of apportionment rules could exhaustively cover all situations in which apportionment might be appropriate. Notwithstanding the limitations of such an approach a huge amount of work would be involved in the preparation of such a statute.complete legislative replacement of existing rules
4.23 The possibility of limiting reform to the enactment of a legislative replacement for the rule in Bouch v Sproule was also rejected by the Scottish Law Commission.[25] In particular the Commission considered the suggestion of the Trust Law Committee, echoing that of Sir Donald Nicholls VC in Sinclair v Lee, to allow the life tenant a "reasonable return" on invested capital. The Commission also noted that the problems of classification of trust receipts were not best addressed by the adoption of new fixed and technical rules. Such rules quickly become out of date as the economic environment changes. Moreover the structure of transactions may change to take account of, for example, annual changes in taxation law. The fixed rules may not cater adequately for these new transactions.legislative replacement for rule in bouch v sproule
4.24 The Scottish Law Commission was not convinced that a judicial power to order the classification or apportionment of trust property would be a satisfactory approach.[26] It would of course encourage a great deal of expensive and time-consuming litigation by disgruntled beneficiaries. Apportionment decisions are highly dependent on specific factual scenarios and are therefore better dealt with by trustees on a day-to-day basis.judicial power of classification and apportionment
4.25 The scheme proposed by the Scottish Law Commission is in many ways similar to that which has been proposed by both the Law Reform Committee and the Trust Law Committee. The Commission proposed that the existing technical rules of apportionment should be abolished and replaced with a general discretionary power for trustees to allocate receipts and outgoings between income and capital in order to maintain a fair balance between income and capital.[27] The power would be to "decide what is capital and what is income and the proportion in which expenses are charged to income and capital respectively".[28] 4.26 The power would automatically be applicable in the absence of contrary provision in the trust instrument.[29] The existing rules of classification would continue to apply as a "background" to the trustees' discretionary power. The power would only be available if the trustees considered that the classification of trust receipts or outgoings under the existing rules was uncertain or unfair. The power would also have to be exercised in the light of the duty of even-handedness.trustee power of classification and apportionment
4.27 We agree with much of what was recommended by the Law Reform Committee, Trust Law Committee and Scottish Law Commission and our provisional proposals draw heavily on the three previous papers. We do, however, differ in certain material respects. 4.28 First, although the Law Reform Committee recognised the significance of the duty to balance we think it must form the central feature of the new apportionment regime. 4.29 Second, we wish to go further than the Law Reform Committee in the scope of the proposed statutory power. We feel that the investment climate for trustees has been so fundamentally altered by the changes introduced by the Trustee Act 2000 and the development of modern portfolio investment theory that a power merely to rectify accidental imbalances is insufficient. 4.30 Finally, we consider that the current rules of classification of corporate receipts (stemming from the principle in Bouch v Sproule) are so unsatisfactory that they cannot be allowed to stand. We therefore suggest a possible replacement. 4.31 We hope that our provisional proposals blend the strengths of previous recommendations into a workable new scheme. Details of the scheme we propose are set out in the next Part.BUILDING A NEW SCHEME OF CLASSIFICATION AND APPORTIONMENT
Note 1 The Powers and Duties of Trustees (1982) 23rd Report of the Law Reform Committee, Cmnd 8733 (“LRC”). [Back] Note 2 Capital and Income of Trusts (1999) Trust Law Committee Consultation Paper (“TLC”). [Back] Note 3 Apportionment of Trust Receipts and Outgoings (2003) Scottish Law Com Discussion Paper No 124 (“SLC”). [Back] Note 4 LRC, paras 3.22 and para 3.36. See further TLC, para 6.4. [Back] Note 5 [1993] 1 WLR 1260. We discuss this important issue below, paras 5.19 – 5.26, 5.56 – 5.76. [Back] Note 6 See further above, paras 1.1 1.4. [Back] Note 7 See below, paras 5.41 – 5.66, for discussion of the provisionally proposed power of allocation. [Back] Note 8 The statutory trustee power envisaged by the Law Reform Committee would only be available to correct accidental imbalances. The trustees would not be able to invest with the aim of maximising economic return safe in the knowledge that they could discharge their duty of even-handedness by exercising the statutory power to restore a balance at a later date. [Back] Note 10 Ibid, para 3.32. [Back] Note 11 Ibid, para 3.33. [Back] Note 12 Ibid, para 3.34. [Back] Note 13 See below, paras 5.78 – 5.82, for discussion of the judicial control of our provisionally proposed power of allocation. [Back] Note 14 LRC, para 3.37. We also consider that the repeal of the 1870 Act lies outside our terms of reference: see below, paras 5.86 – 5.88. [Back] Note 15 Ibid, para 3.40. [Back] Note 16 See Sinclair v Lee [1993] Ch 497. [Back] Note 18 Ibid, para 6.10. [Back] Note 19 Ibid, para 6.11. [Back] Note 20 [1993] Ch 497, 508. [Back] Note 21 See above, para 3.21. [Back] Note 22 [1993] Ch 497, 508. [Back] Note 23 In Scotland there is a unified notion of property. Under Scots law a trustee has absolute and undivided ownership of the trust property and the beneficiary has a personal right to require due administration of the trust. There is no separation of legal and beneficial ownership. [Back] Note 24 SLC, para 2.30. [Back] Note 25 Ibid, para 2.31. [Back] Note 26 Ibid, para 2.32. [Back] Note 27 Ibid, para 2.33et seq. [Back] Note 28 Ibid, para 2.33. [Back] Note 29 The SLC (at para 2.33) expressly rejected a recommendation of the Ontario Law Reform Committee that settlors should have to “opt in” to a similar regime. [Back]
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