The Law Commission

PART II

CLASSIFICATION OF TRUST RECEIPTS AND EXPENSES

INTRODUCTION

2.1      In English trust law the classification of investment returns as income or capital is rule-based. In most circumstances, the classification is straightforward and accords with common sense. The courts often draw on the metaphor of a tree and its fruit. Property which can be characterised as the "tree" is usually treated as capital whereas the "fruit" which it produces is classified as income. In simple cases the metaphor can be useful for "getting across in graphic form the basic idea of the distinction [between income and capital]".^[1] The "fruit-tree" analogy indicates that, for instance, rents received from the letting of trust property^[2] and interest received on loans of trust property^[3] are clearly income. It is equally clear that, for example, the return of the principal of a loan of trust property^[4] should be classified as capital.

RULES GOVERNING CLASSIFICATION OF CORPORATE RECEIPTS

2.2      Much of the judicial consideration of the classification of trust receipts concerns distributions by companies to trustee shareholders. In contrast to the relatively clear cases described above, the rules governing the treatment of receipts by trustees from corporate entities are complicated and, in some cases, give rise to unfairness.

The rule in Bouch v Sproule

2.3      The directors of a company which makes a profit (whether a trading profit or a capital profit^[5]) generally have two courses of action available to them. They may choose to distribute the profit to the company's shareholders in the form of a dividend. Alternatively they may elect to capitalise the profit by issuing more shares to the shareholders.^[6]
2.4      In Bouch v Sproule,^[7] the House of Lords laid down what has become the general rule for classifying receipts from companies as capital or income. The rule is that the trust classification follows company law principles. Profits which are distributed to trustee-shareholders by way of dividend are accordingly received as income. Shares allotted following capitalisation are received as capital. Lord Herschell quoted with approval the following passage from Fry LJ's judgment in the Court of Appeal:

When a testator or settlor directs or permits the subject of his disposition to remain as stocks or shares in a company which has the power either of distributing its profits as dividend or of converting them into capital, and the company validly exercises this power, such exercise of its power is binding on all persons interested under the testator or settlor in the shares, and consequently what is paid by the company as dividend goes to the tenant for life, and what is paid by the company to the shareholder as capital, or appropriated as an increase of the capital stock of the concern, enures to the benefit of all who are interested in capital.^[8]

2.5      The case concerned the bequest of a residuary estate to the testator's wife for life, with remainder to a third party absolutely. Part of the residuary estate consisted of shares in a company. For several years the company had transferred profits to reserve. After the testator's death the company issued partly paid up bonus shares to its shareholders of a value equivalent to that reserve. The question for the court was whether these shares should be treated as income or capital. The Court of Appeal and the House of Lords reached different conclusions on the facts as a result of divergent judicial interpretations of the roundabout route by which the bonus shares were distributed.
2.6      The company declared a dividend and a new issue of shares, giving the shareholders the option of taking the dividend in the form of cash or shares. It was thought necessary to declare a dividend because of the rule that a company may not use its own funds to pay up its shares;^[9] as shareholders have no legal right to a company's profits unless and until a dividend is declared no consideration would have passed from the shareholders to the company in respect of the issue if the shares had been issued without the prior declaration of a dividend. The Court of Appeal considered that this procedure did not disclose a clear intention to capitalise the profits. Although no rational shareholder would choose to receive the dividend in the form of cash there was in principle an option to do so. The House of Lords disagreed, concluding that this option was merely illusory and that a sufficient intention to capitalise had been manifested.
2.7      Although the application of the rule in Bouch v Sproule can be complicated, ordinarily much can be learnt from the form which the distribution takes. If a company distributes shares instead of cash to members it is likely that the shares will be received as capital. Conversely a distribution of profits in cash is likely to represent trust income. Of course, this is only a rule of thumb, and cannot be conclusive. Everything turns on the application of the clear legal principles to the precise facts of the case.
2.8      When a company capitalises its profits (whether they be trading or capital profits), the classification produced by the rule in Bouch v Sproule does at least reflect reality as far as the company is concerned. The capitalised profits remain within the company so that the sum total of the company's assets remains unchanged. As the overall number of issued shares increases so the value of each individual share decreases. In these circumstances it would be very unfair on the beneficiary interested in capital to attribute the additional allotted shares to income. It is similarly self-evident that current trading profits, distributed to shareholders as dividends, should be considered income; what the company received as income is distributed as income.
2.9      The result may be less appropriate where a company is deemed to have distributed accumulated profits to shareholders by way of dividend. The rule in Bouch v Sproule classifies these dividends as income in the hands of trustee-shareholders. This is the case even though the capital value of the company has fallen as a result of the distribution, to the detriment of beneficiaries with an interest in the trust capital. Where a trustee has purchased shares in the company after the profit has arisen, but before it is distributed, the value of the reserves is likely to have been reflected in the price paid. It can then be contended that any subsequent income distribution may unfairly favour the income beneficiary over the remainderman.
2.10      On occasion, the accumulated trading profits may represent a large proportion of the value of a company. The distribution of these profits has a potentially significant impact on the share price and can thereby drastically reduce the value of the trust's capital holding. Treating such distributions as income, payable to the income beneficiary, can operate to the serious disadvantage of those beneficiaries entitled to capital.
2.11      Where the distribution is of capital profits, rigid application of Bouch v Sproule has the potential to cause even greater unfairness. This difficulty is illustrated neatly by Re Sechiari,^[10] which is one of several cases concerning the nationalisation of the interests of Thomas Tilling & Co Ltd ("Tilling Ltd"). A testatrix had bequeathed shares in Tilling Ltd to her children for life, with remainder to her children's issue. Under the Transport Act 1947, Tilling Ltd was obliged to sell its road transport interests to the British Transport Commission in return for British Transport stock. The company distributed this stock among its shareholders as a capital profits dividend. Each shareholder received £5 of British Transport stock for each £1 of ordinary stock they held in Tilling Ltd. As a result of this distribution the value of shares in Tilling Ltd fell from £6 4s to £1 8s. Although the value of the trust capital fell by over 75 per cent the distribution was held to be income.
2.12      In Re Bates,^[11] a testator bequeathed shares in a company which owned and operated steam trawlers to his wife for life with remainder to a third party. The company sold some of its vessels for sums in excess of their balance sheet values thereby realising a capital profit. After the testator's death the company's directors resolved to distribute these profits to shareholders as cash dividends and sent a circular to shareholders explaining that the payments were made out of capital and were not in the nature of a dividend or bonus upon the shares.^[12]
2.13      Eve J held that on the facts the capital profits had not been capitalised and so remained distributable. Applying the rule in Bouch v Sproule, any payment made to shareholders from that profit was, for trust purposes, income notwithstanding that the profits themselves were of a capital (rather than trading) nature.
2.14      Companies' statements that distributions are not to be treated as dividends are therefore irrelevant to their proper classification. The court looks to the intention of the company as manifested by its actions (i.e. resolutions) rather than its words. As Lord Russell of Killowen said^[13] in Hill v Permanent Trustee Company of New South Wales Ltd,^[14] "the essence of the case" was what the company showed "not by its statements, but by its acts".^[15]
2.15      In the Hill case^[16] a corporate trustee held shares in a pastoral company. The pastoral company sold almost all of its land, livestock and other assets, and ceased to carry on business. Subsequently the company declared a dividend of these capital profits and stated that "the dividend is being paid out of profits arising from the sale of breeding stock, being assets of the company not required for resale at a profit, and that is free of income tax". Perhaps influenced by the fact that distribution had taken place immediately prior to liquidation,^[17] the Supreme Court of New South Wales held that the dividend should be treated as capital of the trust.
2.16      On appeal the Privy Council reversed this decision and held that the dividend should be treated as income of the trust estate. Lord Russell set out five principles as a fundamental restatement of the rules governing the classification of corporate receipts:

(1) A limited company when it parts with money available for distribution among its shareholders is not concerned with the fate of those moneys in the hands of any shareholder. The company does not know and does not care whether a shareholder is a trustee of his shares or not. It is of no concern to a company which is parting with money to a shareholder whether that shareholder (if he is a trustee) will hold them as a trustee for A absolutely or as trustee for A for life only.

(2) A limited company not in liquidation can make no payment by way of return of capital to its shareholders except as a step in an authorised reduction of capital. Any other payment made by it by means of which it parts with money to its shareholders must and can only be made by way of dividing profits. Whether the payment is called "dividend" or "bonus", or by any other name, it still must remain a payment on division of profits.

(3) Moneys so paid to a shareholder will (if he be a trustee) prima facie belong to the person beneficially entitled to the income of the trust estate. If such moneys or any part thereof are to be treated as part of the corpus of the trust estate there must be some provision in the trust deed which brings about that result. No statement by the company or its officers that moneys which are being paid away to shareholders out of profits are capital, or are to be treated as capital, can have any effect upon the rights of the beneficiaries under a trust instrument which comprises shares in the company.

(4) Other considerations arise when a limited company with power to increase its capital and possessing a fund of undivided profits so deals with it that no part of it leaves the possession of the company, but the whole is applied in paying up new shares which are issued and allotted proportionately to the shareholders, who would have been entitled to receive the fund had it been, in fact, divided and paid away as dividend.

(5) The result of such a dealing is obviously wholly different from the result of paying away the profits to shareholders. In the latter case the amount of cash distributed disappears on both sides of the company's balance sheet. It is lost to the company. The fund of undistributed profits which has been divided ceases to figure among the company's liabilities; the cash necessary to provide the dividend is raised and paid away, the company's assets being reduced by that amount. In the former case the assets of the company remain undiminished, but on the liabilities side of the balance sheet (although the total number remains unchanged) the item representing undivided profits disappears, its place being taken by a corresponding increase of liability in respect of issued share capital. In other words, moneys which had been capable of division by the company as profits among its shareholders have ceased for all time to be so divisible, and can never be paid to the shareholders except upon a reduction of capital or in a winding up. The fully paid shares representing them and received by the trustees are therefore received by them as corpus and not as income.^[18]

2.17      Since Lord Russell found the rationale for the default rule in company law principles it is unsurprising that he reached the conclusion that capital profits should be treated in the same way as trading profits.^[19]

Exceptions to the rule in Bouch v Sproule

2.18      The following circumstances have been judicially recognised as exceptions to the normal application of the rule in Bouch v Sproule:

(1) A distribution will be treated as capital when the life tenant assented to the purchase of the original shares as a capital investment in the knowledge that the investment was motivated by the contemplated distribution.^[20]

(2) When a distribution is made after the testator's death but relates to a transaction completed before the testator's death, income must be treated as accruing before death.^[21] Accordingly the distribution of a dividend relating to a period which ended before the testator's death should be treated as trust capital.

(3) Where a company purports to accumulate profits as capital although it has no power to increase its capital, such profits when distributed by way of dividend are received by trustee-shareholders as capital.^[22]

Applying and extending the rule in Bouch v Sproule

2.19      The general rule has been affirmed and applied on numerous subsequent occasions in circumstances falling outside the facts of Bouch v Sproule. It is not limited to money or shares, and may apply to distributions of any assets.^[23] Particular difficulties of construction have been experienced in relation to debenture stock which is, by definition, subject to redemption on repayment of the debt at some time in the future. If the period during which redemption is postponed is short the capitalisation transaction begins to resemble the distribution of income. Despite this, the current state of the authorities is to the effect that issued debenture stock is treated as capital,^[24] even if it has already been redeemed.^[25] The rule has also been extended to cover unsecured loan stock.^[26]
2.20      A company's share premium account consists of the amount by which its issued shares are paid up in excess of their value. In Re Duff's Settlements,^[27] the Court of Appeal held that any distribution made from a company's share premium account will constitute capital in the hands of shareholders. The court held that such a distribution is tantamount to an authorised reduction of capital.^[28]

Emergence of a judicial discretion to apportion

2.21      As we have noted above,^[29] in Re Sechiari a distribution of shares was deemed to be income even though it caused a dramatic fall in the value of the trust capital. Romer J stated that the order of the court was "without prejudice to any question whether, in the circumstances, in the administration of the trust, the court has, or would exercise, any jurisdiction to apportion the dividend on equitable principles between income and capital."^[30]
2.22      In Re Kleinwort's Settlements ^[31] (the facts of which were for all material purposes identical to those of Re Sechiari) the question arose whether the court had a jurisdiction to apportion the dividend between income and capital. Vaisey J held that while there was no general rule requiring apportionment of distributed profits for the benefit of capital, the court may, in "suitable special circumstances", have jurisdiction to order apportionment.^[32] This jurisdiction was however limited to cases where there had been a breach of trust. If, for example, a trustee had acquired the shares on the initiative of the life tenant, or with the object of benefiting the life tenant, apportionment to capital might be appropriate.
2.23      Re Maclaren's Settlement Trusts ^[33] appears to support to a broader interpretation of "special circumstances":

The jurisdiction [to apportion], however, exercised in special circumstances seems to be only the exercise of a right to make a more exact distinction of income from capital. As a matter of convenience, the practice is in the ordinary case that no apportionments are made, with the result that capital sometimes gets what, on a more exact scrutiny, would prove to be income and vice versa. Where this produces a glaring error, the court will cause a more exact calculation to be made but it does not treat as income that which is capital, or as capital that which is income.^[34]

2.24      The requirement of a breach of trust to constitute "special circumstances" was re-affirmed by Re Rudd's Will Trusts.^[35] As in Re Sechiari, trustees held shares in Tilling Ltd. Despite an announcement by Tilling Ltd that they had sold off significant parts of their business the trustees failed to consider whether they should sell any part of the trust's shareholding cum dividend.^[36] It was found that the trustees had not even contemplated that the British Transport Stock might be distributable as income. The capital beneficiaries contended that this constituted a breach of trust and, as a result, that there should be an apportionment between the capital and income of the trust. Upjohn J accepted that the jurisdiction of the court to apportion dividends between capital and income was limited to cases of breach of trust.^[37] It was, however, insufficient that the trustees ought to have considered a sale or that they had misunderstood the legal implications of the company's announcement. "Special circumstances" did not exist because it had not been established that the trustees ought to have sold the stock (or part of it) cum dividend.^[38]

Problem situations

Demergers

2.25      A demerger involves the transfer by a company ("Company A") of part of its business to a new company ("Company B"). The shareholders of Company A receive shares in Company B. The mechanism of demerger can take two forms:

(1) Direct demerger

(2) Indirect demerger

2.26      In each case the original company transfers the appropriate parts of its business to a new subsidiary company (wholly owned by it at the time of the transfer) and then declares a dividend to its shareholders. The difference between the two types of demerger lies in the way that the dividend is satisfied.

direct demergers

2.27      In a direct demerger the dividend is satisfied by Company A issuing to its shareholders the entire share capital of Company B. It is well settled that these shares are received by shareholders as income.^[39] This rule applies notwithstanding the fact that a demerger inevitably results in a fall in the value of the trust's shares in Company A. The operation of the rule in Bouch v Sproule therefore adversely affects the capital beneficiary.

indirect demergers

2.28      An indirect demerger includes a further step absent from a direct demerger; at the same time as declaring a dividend, Company A transfers all its shares in Company B to another (wholly separate) holding company ("Company C"). In consideration for this transfer of shares Company C satisfies Company A's dividend by issuing its own shares to the shareholders of Company A.
2.29      The classification of shares received by shareholders as a result of an indirect demerger was the subject of litigation in Sinclair v Lee.^[40] In that case a testatrix bequeathed shares in ICI plc ("ICI") to her husband for life with the remainder to her son. After her death, ICI resolved to demerge its bioscience activities. In preparation it consolidated its bioscience activities into a wholly owned subsidiary company. ICI proposed to transfer the shares of this subsidiary company to a newly created holding company called Zeneca Group plc ("Zeneca"). Zeneca was then to issue its own paid up shares to ICI shareholders.
2.30      Understandably the "instinctive reaction" of Sir Donald Nicholls VC, as he then was, when asked to consider the nature of the Zeneca shares in the hands of the trustees, was that the shares were received as trust capital. This result would accord with the economic realities of the situation, as after the demerger the combined values of the ICI and Zeneca shares would be approximately equal to the pre-demerger value of the ICI shares. He said:

I venture to think that no one, unversed in the arcane mysteries I shall be mentioning shortly, would have any doubt over the answer to these questions. The ICI shares form part of the capital of the fund. For the future the ICI undertaking will be divided up, with one part belonging to ICI and the other to Zeneca Group. To compensate for this loss of part of the ICI undertaking, the ICI shareholders will be receiving a corresponding number of shares in Zeneca Group. No one would imagine that the Zeneca Group shares could sensibly be regarded as income.^[41]

2.31      Sir Donald Nicholls VC conceded that the line of cases developing the rule in Bouch v Sproule ran directly against his instincts.^[42] These authorities suggested that the Zeneca shares should be treated as income but none of them dealt with the precise situation of an indirect demerger. The Vice-Chancellor therefore felt able to distinguish Bouch v Sproule and held that the Zeneca shares would be received by the trustee-shareholders as capital.
2.32      There seems no principled ground for drawing a distinction between direct demergers and indirect demergers for the application of the rule in Bouch v Sproule, especially in the light of the wide interpretation which has been given to the rule.^[43] The formalistic distinction was adopted by the Vice-Chancellor solely in order to avoid what his Lordship considered to be an "absurd" result. The clear inference from this is that the wide application of the rule in Bouch v Sproule continues to give rise to unfortunate consequences in other cases.

Scrip dividends

2.33      Scrip dividends are dividends which offer shareholders the choice of being paid in the form of cash or shares. When a company declares a conventional scrip dividend each shareholder has the option to take the dividend in cash or in additional shares of equal value. Such dividends will almost always be treated as income in the hands of the shareholder whichever option is chosen.^[44]
2.34      The situation is more complicated when the company declares an "enhanced" scrip dividend. Enhanced scrip dividends give shareholders the option of taking the distribution either in cash or in additional shares of greater value than the cash alternative. If (unusually) the shareholder opts for cash the receipt will clearly be income under the rule in Bouch v Sproule. The position is more difficult if the shareholder takes the option of receiving shares. In the majority of cases, especially where (as is common practice) the company arranges for a third party to offer to purchase the new shares at market value to enable shareholders to realise their cash value immediately, the substance of the arrangement will be such that the shares will be received as income.
2.35      However, on occasion, the courts have retreated from the strict dichotomy of the general rule and ordered an apportionment of receipts from scrip dividends between income and capital. In Re Malam ^[45] a testator bequeathed shares on trust for his widow for life and for a third party thereafter. After the testator's death, the company resolved to increase its capital by the issue of new shares. The directors were empowered to offer new shares to existing shareholders in satisfaction of a dividend. The company declared a dividend. The company would have been able to meet its obligations to shareholders in cash. In respect of half the declared dividend shareholders were offered the option of shares or cash. The trustees accepted the allotment of shares.
2.36      It was held by Stirling J that the company intended to distribute its accumulated profits as a dividend and not to capitalise them. Prima facie the rule in Bouch v Sproule would demand that such receipts be treated as income. However following the distribution there had been a sharp fall in the value of the shares as a result of the distribution of the accumulated profits. The court decided that in these circumstances the tenant for life should only be entitled to a lien in respect of the amount of cash dividend foregone. The balance was attributable to capital. Stirling J proceeded on the basis that the shares had been bought partly by the cash dividend foregone and partly by the fall in the value of the original shares.
2.37      The classification of scrip dividends is therefore uncertain. It is unclear whether the solution adopted by Stirling J will always be correct or whether it is limited to the precise facts of that case. The Re Malam decision also raises the issue of how tax will be levied in such circumstances, although the Inland Revenue have stated that they will accept all reasonable decisions by trustees.^[46] Identifying the intention of the company is not always easy since there are competing considerations. Shareholders can usually be expected to opt for the share option in an enhanced scrip situation. This suggests that the company intended to capitalise.^[47] In the past, however, enhanced scrip dividends have been declared in order to avoid the payment of advance corporation tax on cash dividends.^[48] This would point towards a distribution of income.

Criticisms of the current law

Perceived illogicality of rule in Bouch v Sproule

2.38      The operation of the rule in Bouch v Sproule appears to be illogical and capricious in many ways. Take, for example, the case of a company which declares a dividend and distributes its profits. These profits will be received by shareholders as income and, if a shareholder is a trustee, will be paid to the life tenant. If the company offers to issue new shares the life tenant could elect to apply the income received to purchase some of those shares in which case the life tenant will own them absolutely. Contrast this with the position if the company had declared a dividend and simultaneously resolved to capitalise its profits. The issued shares would be received as capital and the life tenant would have no right to them.
2.39      It should be borne in mind, however, that the convoluted process of declaring a dividend coupled with the issue of paid-up shares is, in corporate law, necessary. A company cannot purchase its own shares or issue shares by way of gift and a shareholder has no legal right to the company's assets until a dividend is declared. Unless a dividend is declared prior to paying up and issuing new share capital no valuable consideration would be transferred from the shareholders to the company. The rule in Bouch v Sproule does at least, therefore, have regard to the substance of what the directors are trying to achieve by their actions and in that sense is not illogical.

Questionable relevance of company law principles

2.40      The principles of company law are of doubtful relevance when it comes to determining whether receipts should be classified as income or capital for trust purposes. As Lord Russell noted in the Hill case,^[49] the fact that a shareholder holds shares for him- or herself or as a trustee is immaterial to the company. No notice of a trust of shares can be entered on the register of companies and so the destination of the distribution is determined by the actions of the company directors who do not know (and do not consider) whether a shareholder is a trustee. It is of no consequence to the company whether the corporate profits are treated as trust income or trust capital. It is therefore not readily apparent why the legal principles which have been developed to regulate companies should be applied without modification to trusts.^[50]
2.41      Specifically, the rule in Bouch v Sproule conflates the concepts of share capital and trust capital.^[51] There is no reason why only those profits which become share capital (following capitalisation) should be treated as trust capital. Share capital, which cannot be returned to shareholders except by way of an authorised reduction or during a winding up, exists to protect creditors and other people who deal with a limited company. Trust capital on the other hand represents the full extent of the trust property. Where trust property consists of shares the capital value of the fund will be the combined market value of all the shares which are held. The value of those shares is in turn influenced by the total worth of the underlying companies. The total value of a company is not limited to the nominal value of the issued share capital. A company will often accumulate profits which are capable of distribution to use as "working capital". If these accumulated profits are distributed as a dividend the share price of the company is likely to fall significantly with the result that the capital value of the trust fund will be diminished. Under the rule in Bouch v Sproule the distribution will nevertheless be treated as income.
2.42      Sir Donald Nicholls VC commented in Sinclair v Lee:

It is unsatisfactory to treat all accumulated profits as earmarked as income to the extent that any distribution of such profits, regardless of the amount or the circumstances, will belong to the tenant for life if made outside a winding up. Such a distribution may represent a serious erosion of the trust capital.^[52]

2.43      Similarly no distinction is drawn in company law (except for the purposes of taxation) between the distribution of current trading profits and capital profits. This is not surprising because both types of profit are available for distribution to shareholders by way of dividend. This distinction between trading profits and capital profits is, however, hugely relevant to trustees and beneficiaries. It seems appropriate to consider dividends of current trading profits to be income. This is not the case with capital profits; as these represent profits on the realisation of the company's capital assets they are more naturally considered capital.
2.44      The application of company law principles therefore fails to hold a fair balance between the life tenant and remainderman. The courts nevertheless consider themselves to have no jurisdiction to order apportionment to remedy this imbalance except in the "special circumstances" of a breach of trust.^[53]

Complexity and uncertainty in application to novel rearrangements of capital

2.45      Whether or not they operate fairly, the legal principles on which the rule in Bouch v Sproule is based are at least relatively clear. However, the application of the rule in Bouch v Sproule to particular novel factual situations becomes far less certain as corporate law develops new ways of rearranging capital in order to obtain commercial or tax advantages.^[54]
2.46      As a result of this uncertainty, trustees may be forced to apply to the court for directions as to the proper classification of corporate receipts in new situations.^[55] The expense of such an application, which may be considerable, will usually be borne by the trust fund to the detriment of all beneficiaries. Alternatively, trustees may seek to avoid such difficulties by selling their shareholding before the rearrangement of capital takes place. The upshot of this is that trustees may sell a potentially lucrative investment in order to maintain a fair balance between the life tenant and the remainderman.

Ignorance or disregard of the rule

2.47      Although it is not practical to measure compliance, it is questionable how often in practice trustees allocate corporate receipts in accordance with the strict rules in Bouch v Sproule. It seems likely that in many cases trustees (especially those who are not legally advised) will, as a matter of practice, allocate in accordance with common sense rather than the technical analysis set out in this Part.

RULES GOVERNING CLASSIFICATION OF NON-CORPORATE RECEIPTS

Rules relating to timber, minerals and copyright

2.48      The Scottish Law Commission, in its Discussion Paper on the Apportionment of Trust Receipts and Outgoings,^[56] considered the special rules which apply to investment returns from timber, minerals and intellectual property rights (including copyright).^[57] The general Scots law rule on timber is that it belongs to the remainderman. The life tenant is, however, entitled to take timber to meet the needs of the estate and its buildings or to take "ordinary windfalls and normal coppicing".^[58] The extent to which this exception to the general rule applies in English law is unclear.
2.49      The general rules on minerals were laid down by the House of Lords (on appeal from Scotland) in Campbell v Wardlaw.^[59] The starting point for their Lordships was that all returns from minerals should be classified as capital. Minerals are not in the nature of "fruit" because once they have been taken away from the land they are never replaced. The life tenant is, however, entitled to use minerals obtained from trust property for his own needs and those of the trust estate. The life tenant is also entitled to royalties from minerals extracted from mines which were opened before the commencement of the trust (but not those opened after the commencement of the trust). The House of Lords expressly stated that Scots law was the same as the law of England and Wales on this point.^[60] Similar principles are applied in Scotland to intellectual property rights, based on the date on which the work to which the property right relates was published.^[61]
2.50      Whilst the application of these rules is not entirely straightforward, the difficulties are of lesser significance than those relating to the classification of receipts from corporate entities. Trust funds today are much more likely to be invested in share portfolios than in forests or mines.

RULES GOVERNING CLASSIFICATION OF TRUST EXPENSES

2.51      Where a trustee holds property on trust for persons in succession it is important to determine which expenses should be met by trust income and which expenses should be charged to trust capital. The House of Lords considered the apportionment of expenses incurred in the administration of trusts in Carver v Duncan.^[62] Although that case primarily concerned the construction of section 16 of the Finance Act 1973,^[63] Lord Templeman considered the general law governing the apportionment of the costs of trust administration:

Trustees are entitled to be indemnified out of the capital and income of their trust fund against all obligations incurred by the trustees in the due performance of their duties and the due exercise of their powers. The trustees must then debit each item of expenditure either against income or against capital. The general rule is that income must bear all ordinary outgoings of a recurrent nature, such as rates and taxes, and interest on charges and incumbrances. Capital must bear all costs, charges and expenses incurred for the benefit of the whole estate.^[64]

2.52      On the facts of Carver v Duncan, Lord Templeman held that the annual premiums on insurance policies to protect the value of the trust fund were a capital expense.^[65] His Lordship also held that the annual fees of investment advisers, although they were recurrent charges, were not "ordinary outgoings" and were "incurred for the benefit of the estate as a whole". Accordingly they should also be deemed a capital expense.
2.53      This last example illustrates the difficulties in applying what seems, in principle, to be a sensible rule. In Re Bennett, Lindley LJ said: "by an 'outgoing' [i.e. an ordinary expense chargeable to income] is generally meant some payment which must be made in order to secure the income of the property."^[66] Many fees charged by trustees or their advisers will not meet this requirement, although they have "an income character in so far as [they] may be connected with an income benefit."^[67] Moreover, when a trust corporation charges an annual fee which is calculated by reference to the level of trust income it should be treated as an income expense, at least in cases where a separate capital charge is made on acceptance and/or withdrawal.^[68] Where there is no separate capital fee against which the annual fee can be contrasted the situation is less clear. The irresistible conclusion is that the annual fee reflects work done on behalf of both income and capital. Since the work is for the benefit of the whole estate, the fee should be charged to capital. There is, however, no authority on this question.
2.54      The majority of the House of Lords in Carver v Duncan (Lord Diplock dissenting) considered that the express provisions of the trust instrument regarding the apportionment of expenses were irrelevant to the question of whether certain expenses were "properly chargeable" to income under the statute in question.^[69] It is clear, however, that as a matter of general law the settlor may displace the default rule by authorising or directing the trustees to meet certain expenses, otherwise chargeable to income, out of capital or vice versa.
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Note 1    Inland Revenue Commissioners v John Lewis Properties Ltd [2002] EWCA Civ 1869 [2003] Ch 513, 546, para [89], per Dyson LJ. Although this case concerned the classification of receipts for tax purposes the principle of the “fruit-tree” analogy remains the same. Dyson LJ noted that in more complicated cases the analogy is markedly less useful and “merely begs the question: what is tree and what is fruit?”     [Back]

Note 2    Sinclair v Lee [1993] Ch 497, 506, per Sir Donald Nicholls VC.    [Back]

Note 3    Re Atkinson [1904] 2 Ch 160, 165, per Vaughan Williams LJ.    [Back]

Note 4    Ibid.    [Back]

Note 5    A trading profit is the excess of a company’s trading receipts over its costs. A capital profit is realised where a company sells an asset in excess of its balance sheet value. Both sorts of profit are available for distribution to shareholders; there is no distinction in company law between divisible profits of different kinds. The only important line to draw is between capital (which can only be distributed in a winding up or by way of an authorised reduction of capital) and undistributed divisible profits.    [Back]

Note 6    Thus increasing the issued share capital of the company by the amount of profit capitalised.    [Back]

Note 7    (1885) 12 App Cas 385.    [Back]

Note 8    Ibid, 397398.    [Back]

Note 9    The phrase “pay up” refers to the purchase of shares in a company. The purchaser of fully paid up shares has contributed the full nominal amount of those shares (i.e. the value of those shares as recorded in the company’s Memorandum of Association). In the case of partly paid up shares the shareholder has contributed less than this amount and a call may be made for the sums required to fully pay up his or her shareholding.    [Back]

Note 10    [1950] 1 All ER 417 (Romer J).    [Back]

Note 11    [1928] Ch 682 (Eve J).    [Back]

Note 12    The company’s express intention in making this statement was to protect the shareholders from liability for income tax.    [Back]

Note 13    Referring to the decision of the House of Lords inBouch v Sproule.    [Back]

Note 14    [1930] AC 720 (PC).    [Back]

Note 15    Ibid, 732.    [Back]

Note 16    Although Hill is a decision of the Privy Council it is now viewed as the leading case on the classification for trust purposes of receipts from corporate entities. It was applied by the Court of Appeal in Re Doughty [1947] Ch 263.    [Back]

Note 17    If the distribution had taken place on liquidation then it would have constituted capital: see now Companies Act 1985, s 263(2)(d) and Sinclair v Lee [1993] Ch 497, 507, per Sir Donald Nicholls VC.    [Back]

Note 18    [1930] AC 720, 730–732.    [Back]

Note 19    The rule in Bouch v Sproule has been applied to capital profits dividends on several other occasions: Re Doughty [1947] Ch 263 (CA); Re Harrison’s Will Trusts [1949] Ch 678 (Roxburgh J); Re Sechiari [1950] 1 All ER 417 (Romer J); Re Kleinwort’s Settlements [1951] Ch 860 (Vaisey J).    [Back]

Note 20    Re Maclaren’s Settlement Trusts [1951] 2 All ER 414 (Harman J).    [Back]

Note 21    Re Winder’s Will Trust [1951] Ch 916 (Romer J). The same principle applies mutatis mutandis to inter vivos trusts.    [Back]

Note 22    Irving v Houston (1803) 4 Paton Sc App 521 (HL), distinguished in Bouch v Sproule on the basis that the company in the earlier case (the Bank of Scotland) had no power to increase its capital.     [Back]

Note 23    Re Outen’s Will Trusts [1963] Ch 291, 314, per Plowman J.    [Back]

Note 24    Commissioners of Inland Revenue v Fisher’s Executors [1926] AC 395 (HL).    [Back]

Note 25    Commissioner of Income-Tax, Bengal v Mercantile Bank of India Ltd [1936] AC 478 (PC).    [Back]

Note 26    Re Outen’s Will Trusts [1963] Ch 291 (Plowman J). The probability of redemption of the stock was held to be irrelevant provided that capitalisation had taken place.    [Back]

Note 27    [1951] Ch 923 (CA).    [Back]

Note 28    Ibid, 929, per Jenkins LJ.    [Back]

Note 29    See above, para 2.11.    [Back]

Note 30    Ibid, 419.    [Back]

Note 31    [1951] Ch 860 (Vaisey J).    [Back]

Note 32    Ibid, 863.    [Back]

Note 33    [1951] 2 All ER 414 (Harman J). This was another case in the litigation arising out of the nationalisation of Tilling Ltd.    [Back]

Note 34    [1951] 2 All ER 414, 420, per Harman J.    [Back]

Note 35    [1952] 1 All ER 254 (Upjohn J).    [Back]

Note 36    “Sale cum dividend” means a sale before an expected dividend has been declared. The price of shares sold at this time is generally higher to reflect the value of the contemplated dividend.    [Back]

Note 37    Following Re Kleinwort’s Settlement Trusts [1951] Ch 860 (Vaisey J).    [Back]

Note 38    [1952] 1 All ER 254, 260, per Upjohn J.    [Back]

Note 39    Re Sechiari [1950] 1 All ER 417 (Romer J).    [Back]

Note 40    [1993] Ch 497 (Sir Donald Nicholls VC).    [Back]

Note 41    Ibid, 504.    [Back]

Note 42    Ibid, 505. The line of cases referred to includes Hill v Permanent Trustee Company of New South Wales [1930] AC 720 (PC) and Re Doughty [1947] Ch 263 (CA).    [Back]

Note 43    See above, paras 2.19 – 2.20.    [Back]

Note 44    The dividend will be classified in accordance with the general rule inBouch v Sproule.    [Back]

Note 45    [1894] 3 Ch 578 (Stirling J).    [Back]

Note 46    Statement of Practice 4/94, para 6.    [Back]

Note 47    On the basis that the terms of the offer make it so unrealistic that any shareholder would take the cash option, this option is in fact illusory. This was the view that the House of Lords took in Bouch v Sproule (although technically that distribution did not take the form of an enhanced scrip dividend since only partly paid-up shares were available).    [Back]

Note 48    Advance corporation tax has now been abolished but it was stated in “Capital and Income of Trusts” (1999) Trust Law Committee Consultation Paper, para 2.3 that this change “will not make the position any clearer. It and other tax changes may well breed new ways of making distributions to shareholders that will throw up new questions about whether they are capital or income of a trust, to which the existing principles will not prove strong or clear enough to give any certain answers.”    [Back]

Note 49    [1930] AC 720 (PC).    [Back]

Note 50    Lord Russell dismissed this concern summarily on the grounds that a testator or settlor could displace the default rule by careful drafting of the trust instrument to display a contrary intention. In the absence of such an intention the testator or settlor is presumed to have intended corporate receipts to be treated in accordance with the general rule (see, for example, the discussion in Sinclair v Lee [1993] Ch 497, 514, per Sir Donald Nicholls VC).    [Back]

Note 51    Sinclair v Lee [1993] Ch 497, 511, per Sir Donald Nicholls VC.    [Back]

Note 52    [1993] Ch 497, 508, per Sir Donald Nicholls VC.    [Back]

Note 53    See above, paras 2.21 – 2.24.    [Back]

Note 54    The decision in Sinclair v Lee was based on a narrow ground of distinction with previously decided cases. It is difficult to say whether this distinction will be available for new kinds of capital rearrangement. It is also unclear whether the courts will be prepared to follow the lead of Sir Donald Nicholls VC (as he then was) to destabilise the rule in Bouch v Sproule more generally.     [Back]

Note 55    As inSinclair v Lee.    [Back]

Note 56    (2003) Scot Law Com Discussion Paper No 124.    [Back]

Note 57    Ibid, paras 2.8 – 2.10.    [Back]

Note 58    Ibid, para 2.9.    [Back]

Note 59    (1883) 8 App Cas 641.    [Back]

Note 60    Ibid, 644, per Lord Blackburn LC.    [Back]

Note 61    Simpson (Davidson’s Trustees) v Ogilvie (1910) 1 SLT 45 (Second Division). It is unclear whether this states the law in England and Wales as well but, as it applies the principle in Campbell v Wardlaw by analogy, it seems likely that it does.    [Back]

Note 62    [1985] AC 1082.    [Back]

Note 63    Since repealed by the Income and Corporation Taxes Act (“ICTA”) 1988, s 844(4) and Schedule 31 and replaced by s 686 of that Act.    [Back]

Note 64    [1985] AC 1082, 1120.    [Back]

Note 65    Ibid, following Macdonald v Irvine (1878) 8 Ch D 101 (CA) and Re Sherry [1913] 2 Ch 508 (Warrington J).    [Back]

Note 66    [1896] 1 Ch 778; approved by Lord Templeman in Carver v Duncan [1985] AC 1082, 1121.    [Back]

Note 67    Capital and Income of Trusts (1999) Trust Law Committee Consultation Paper, para 4.1.    [Back]

Note 68    Re Hulton [1936] Ch 536 (Clauson J); Re Roberts’ Will Trusts [1937] Ch 274 (Crossman J); Re Godwin [1938] Ch 341 (Farwell J).    [Back]

Note 69    Carver v Duncan [1985] AC 1082, 1121, per Lord Templeman.    [Back]

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