---

Trusts (Capital and Income) Bill [HL]

This is a short but technical Bill to amend the law of England and Wales relating to capital and income in trust. Capital, for these purposes, is trust property that constitutes a pool or fund of assets, and is to be distinguished from the income earned on those assets. For those who remember their Bar or solicitor exams, the distinction has traditionally been illustrated by the homely metaphor of a tree and its fruit. The tree is the capital—for example, an office block or shares in a listed company—and the fruit is the income—for example, the rent received from renting out the offices or the dividend paid on the shares. Before turning to the substance of the Bill, I would like to say that I am very pleased to be presenting it today, although with considerable trepidation. I know that it should be my noble friend Lord McNally, who is otherwise engaged in the Chamber; he is the Minister in the Ministry of Justice who is responsible for the Law Commission and he has been a great supporter of the Bill. He is disappointed not to be able to be here, but I can assure the Committee that he will be available at later stages of the Bill. I also know that several noble Lords present today have had the advantage of attending a briefing on the Bill by Professor Elizabeth Cooke, who is the Law Commissioner responsible for the Bill, and Stephen Roberts, who is head of litigation and legal policy at the Charity Commission. I regret that I was unable to attend that session but have had the advantage of a private tutorial from Professor Cooke and Mr Roberts to prepare me for our debate today. Otherwise I would have had to rely on my lecture notes, if they still existed, from Bar exams some 35 years ago. The Government are very grateful to the Law Commission and the Charity Commission for all the help they have given in the preparation of the Bill for introduction and their continuing support for the Bill as it goes through Parliament. The Bill will implement, with minor modifications, the legislative reforms recommended by the Law Commission in its 2009 report Capital and Income in Trusts: Classification and Apportionment. These reforms owe their genesis to concerns expressed by various noble Lords, including the noble Lord, Lord Phillips of Sudbury, during debates on the Bill that became the Trustee Act 2000. This led to the publication of a Law Commission consultation paper in 2004 and the Commission’s report in 2009. The Ministry of Justice then carried out a public consultation in 2010 on the draft Bill published by the Law Commission in its report and published a response in 2011 explaining how it intended to finalise the Bill. This extended process of detailed and responsive consultation has, I believe, created a measure with a large degree of consensus, which is suitable for this special Law Commission procedure in your Lordships’ House. The overall aim of the Bill is to simplify three distinct but linked areas of trust law in England and Wales relating to capital and income. These areas are apportioning receipts between income and capital beneficiaries; classifying receipts by trustees as income or capital; and investing by charity trustees who, in deciding what investments to make, have to distinguish between investments that will produce income on the one hand and investments that will produce capital on the other. I will start with the first point addressed in the Bill, the rules of apportionment in Clause 1. They deal with apportioning trust receipts between income and capital beneficiaries. For example, a trust—let us call it the AB trust—may be established by a person making a gift of investments on trust for person A for life, with remainder to person B. This means that the trustees will pay the income arising on the investments to A until A dies, and then transfer the investments to B. Because of the different entitlements to income and capital, the trustees must distinguish between investment receipts according to their legal classification as income receipts due to A, or capital receipts which must be held ultimately for B and can be invested to produce income for A during his or her life. As noble Lords will remember, in the 19th century various cases came before the courts in which the judges had to decide how to split receipts in this way. Sensible though the decisions were in their time and circumstances, the application of some of them as general rules of trust practice is now problematic. Clause 1 therefore disapplies for new trusts the first and second parts of the rule in Howe v Earl of Dartmouth, the rule in Re Earl of Chesterfield’s Trusts and the rule in Allhusen v Whittell. This means that in the absence of express provision in a new trust, these rules will not apply and the relevant receipt will belong in its entirety to the income or capital beneficiary, depending on its classification as one or the other. This will bring new trusts into line with modern trust drafting practice, which almost always excludes these rules in the document setting out the terms of the trust. This will simplify the administration of trusts without any loss in fairness. Clause 1 also disapplies for new trusts the statutory rule requiring the apportionment of income over time imposed by the Apportionment Act 1870. The reforms effected by Clause 1 will mean that complex and time-consuming calculations, generally affecting relatively small sums of money, will be avoided. The changes in Clause 1 are restricted to new trusts so that there is no interference with the intention of settlors, who may have wished the existing law to apply. Clause 2 amends the law relating to the classification for trust law purposes of specified tax-exempt distributions by companies on demerger for all trusts. This is relevant because trustees holding shares in a company which demerges may receive a dividend in the form of a distribution of shares which represent an equivalent stake of ownership in the demerged company. The clause provides that, unless the trust specifies to the contrary, all the distributions falling within Clause 2 will be treated by the trustees for the purposes of the trust as capital. At present, rather confusingly, this is only the case on indirect demergers. The distributions to which Clause 2 applies are those that are tax-exempt under Sections 1076, 1077 and 1078 of the Corporation Tax Act 2010 and, in the future, those that are tax-exempt and are specified by an order made by statutory instrument by the Lord Chancellor. No such order is envisaged at present. In practical terms, Clause 2 will move the classification of dividends received by trustee shareholders on direct demergers from income to capital, and will secure that classification for dividends on indirect demergers, which currently rests on a decision of the High Court. As a result of the Bill, all distributions received by trustees on tax-exempt corporate demergers will be classified as capital for trust law purposes. This will remove not only the potential injustice to capital beneficiaries of seeing significant proportions of the capital holding of the trust assets converted to income by reasons beyond the control of the trustees, but also the pressure on trustees to sell investments in companies proposing demerger purely to avoid the outcome of the present inconsistent classification. Demergers may be structured by companies in a variety of ways. In some cases of demerger, where Clause 2 applies to classify the distribution as capital, the company may have held off paying the usual dividends pending the demerger. The income beneficiary may then be unfairly disadvantaged because dividends that would have been income in the normal course of events have not been paid and the receipt on the demerger is classified as wholly capital. To prevent Clause 2 perpetuating this problem, Clause 3 gives the trustees power to compensate the income beneficiary from the trust capital. We do not expect that this power will be exercised often but we believe it is necessary in the interests of fairness. That brings us to Clause 4, which relates to investment by charities with a permanent endowment on a total return basis. Before describing the working of the clause, I will briefly explain the meaning of these two concepts. First, there is permanent endowment. A charity has a permanent endowment if its constitution places restrictions on the expenditure of property held for the purposes of the charity. Typically, a permanent endowment will be a capital sum donated for charitable purposes on terms that the income it generates may be used for those purposes, but the capital itself must remain untouched to create more income for the future. Secondly, there is total return basis. Total return investment involves the charity trustees selecting investments on the basis of risk and return, and then spending an appropriate proportion of the total return, irrespective of the form individual returns take, as capital or income. As a result, the trustees are not constrained in their investment choices by the need to generate income returns and can select appropriate investments in the same way as the trustees of charities that do not have permanent endowment. It may be helpful to illustrate this by way of an example. Let us assume that there is a charity set up to help homeless people, with a permanent endowment of £100,000. At present, the trustees must decide how much expenditure they think is appropriate and then set up an investment strategy to try to achieve it. For example, they might invest in a portfolio of fixed-income investments and shares that they anticipate will produce £2,000 a year. Whatever income that portfolio actually produces is expendable on the charity’s objects; the capital cannot be spent. That is the case even if the portfolio performs below expectations or some returns unexpectedly take the form of capital. In those circumstances, trustees today either face an income shortfall which could jeopardise their planned operations or have to undertake a process to enable them to spend some of their permanent endowment. Under total return investment, the charity trustees do not have to anticipate expenditure when making investments. Instead, like trustees who do not hold permanent endowment, they can invest in a portfolio which balances risk and return, ignoring the form of returns. The trustees are then able to allocate a fair proportion of the eventual total return to expenditure, whether the investment receipts in question would be classified for trust law purposes as capital or income. Total return investment is not a new concept. Charity trustees can already apply to the Charity Commission for authority to adopt it and a small number have done so. Clause 4 provides a new framework for obtaining that authorisation. Instead of making an application, charity trustees with a permanent endowment will be able to opt in to this type of investment on the terms prescribed by regulations to be made by the Charity Commission by resolution, if the trustees consider it is in the best interests of the charity to do so. This new administrative approach will reduce the costs of embarking on total return investment for both charities and the Charity Commission. The change will enable charity trustees responsible for a permanent endowment to bring themselves broadly into the same position in relation to investment decisions as charity trustees without a permanent endowment. This will allow them to invest in the same way as other trustees in accordance with their duties under the Trustee Act 2000 and the trust instrument. The detailed terms on which total return investment can be pursued will be determined by the regulations to be made by the Charity Commission. The regulations will be finalised only after the Charity Commission has carried out a consultation, which it intends to do after the Bill has been enacted. The commission has, however, made available its current draft of the proposed regulations, which is based on the terms on which authorisation is currently granted. This draft requires trustees to allocate the total return from their investments between a trust for application, which is to be spent on the charity’s objects, and a trust for investment, which is held to generate future total return. The regulations do not prescribe an amount or proportion of the total return that the charity must allocate to the trust for application as doing so would bear the risk of setting the level too low or too high depending on the prevailing economic conditions. Instead, charity trustees with a permanent endowment must exercise their duty to balance present and future interests—or, as the draft regulations put it, to exercise their powers in relation to a relevant fund, "““in such a way as not to prejudice the ability of the charity to meet the present and future needs which are designated by its trusts””." Placing reliance on the trustees in this way is the same as the approach of the law to the trustees of private trusts for interests in succession, such as the AB trust that I mentioned in an example earlier, who are required to balance present and future interests. It is, however, not for me to anticipate the final form of the Charity Commission’s regulations. It is the regulator of charities and it will decide what is most appropriate and no doubt revise the terms from time to time in the light of experience. For our present purposes the new Sections 104A and 104B of the Charities Act 2011 will provide an appropriate and efficient framework within which total return investment can be responsibly adopted by charity trustees with a permanent endowment. That concludes my brief description of the substantive provisions of the Bill. We believe that it will simplify and modernise the law of trusts in modest but important respects. It is certainly not the easiest of Bills to understand but it will bring considerable benefits to private and charitable results which will help a good number of people, including the more disadvantaged in society. The Bill illustrates the importance of having a body such as the Law Commission, which can prepare expert recommendations for the reform of law in areas which would otherwise remain rooted deep in the past, increasing the burden of the law on all who come into contact with it, and the advantages of the procedure that we have in your Lordships’ House that allows appropriate Law Commission Bills to be scrutinised, as far as possible, off the Floor of the House. This is the fourth Bill to have gone through that procedure and I therefore commend it to the Committee.