The Law Commission

PART V

ACHIEVING A BALANCE: A NEW APPROACH TO CLASSIFICATION AND APPORTIONMENT

INTRODUCTION

5.1      In this Part we formulate a new scheme governing the classification of trust receipts and trust expenses as income or capital. We analyse the duty of the trustees to balance the respective interests of income and capital beneficiaries ("the duty to balance") and ask whether this obligation should be placed on a statutory footing. We argue that this balance is best achieved by the statutory conferment of a new power on trustees to allocate trust receipts and expenses between income and capital ("the power of allocation"). Where the power of allocation is available^[1] the initial classification of receipts or expenses would be subject to that power, whereas if it is not available that classification would be conclusive. We also discuss reforms to the existing equitable and statutory rules of apportionment.
5.2      The provisional proposals and consultation questions in this Part apply to private (that is, non-charitable) trusts. Charitable trusts are considered in Part VI below.

CLASSIFICATION

5.3      The prescriptive rules by which investment returns are currently defined as income or capital sometimes give rise to arbitrary and illogical results. We therefore consider that the rules of classification are in need of reform.
5.4      Ideally, any new classification rule should be of general application. We do not think, however, that it is possible to draft a general rule which gives an acceptable result in all the situations in which classification is required. An alternative approach to the classification of receipts and expenses is exemplified by the United States' Uniform Principal and Income Act 1997 ("UPIA 1997"). This lays down a series of specific statutory rules to deal with the classification of certain types of receipt and expense. We consider, however, that the adoption of the UPIA model, promulgating numerous rules to deal with every different type of investment, would make the task of trustees unacceptably onerous. We anticipate that there would be formidable difficulties in drafting these rules and that they would inevitably fail to keep pace with developments in investment practice. The default classification^[2] would become increasingly significant and the burden on trustees with a statutory power of allocation to exercise that power to restore a balance would become correspondingly heavy.
5.5      It is generally accepted that the current rules of classification work least well in relation to distributions by corporate entities to trustee-shareholders. This is where the major problems, leading to the current reference, have arisen. We therefore propose a separate new rule of classification applying solely to distributions by corporate entities to trustee-shareholders.^[3]

Corporate receipts

5.6      It could be argued that the price of legal certainty is that the application of generally sound legal principles occasionally leads to results which we intuitively consider to be unfair. However, it is difficult to accept such injustice where the underlying principles themselves have unstable juridical foundations. It is not obvious why receipts by trustee-shareholders should be classified for trust purposes in accordance with company law rules. The fact that a shareholder holds shares on trust is immaterial to the company; no notice of a trust of shares can be entered on the company's register. The concepts of share capital and trust capital each serve a very different purpose and there is no reason why they should be conflated. Furthermore, there is still significant uncertainty over how the existing rules of classification operate in certain circumstances. The current law does not, therefore, rest on principle and fails to deliver either certainty or fairness.
5.7      While the legal principles on which the classification rules are based are, in theory, relatively clear, their application to a particular set of facts can be more complex. They place a potentially onerous obligation on trustees to investigate the nature of every distribution which they receive. As companies develop new ways of rearranging capital in order to obtain commercial or tax advantages trustees may be unsure how the courts will apply existing classification rules to novel situations. To address this uncertainty they may suffer the inconvenience of making an application to court, at potentially great expense to the trust fund. Alternatively, if circumstances allow, they may decide that it is simpler to sell a lucrative shareholding in advance of a rearrangement of capital. These complexities in the operation of the current rules illustrate the need to adopt a clear and certain statutory alternative.
5.8      In those US states which have not adopted the UPIA 1997, corporate receipts are classified in accordance with common law rules; principally the "Pennsylvania rule" and the "Massachusetts rule". The "Pennsylvania rule" seeks to classify corporate receipts according to the source of each distribution. A dividend which is declared out of income which accrued to the company during the life of the trust is treated as income. Distributions of earlier profits are treated as capital. While this rule usually achieves a fair and just result between the beneficiaries, trustees are faced with the difficult and expensive task of investigating the source of each distribution. The "Massachusetts rule" (which achieves a result broadly in line with that reached under the equivalent rule of the UPIA 1997) holds that cash distributions^[4] are treated as income whereas distributions of shares are treated as capital. If the trustee-shareholder has the option to take a distribution in the form of cash or shares the distribution will be treated as income regardless of the trustee's election. US authority is fairly evenly divided between the two rules, although in recent years the Massachusetts rule has proved more popular.
5.9      We provisionally propose that a modified form of the Massachusetts rule should be adopted in England and Wales for the classification of distributions by corporate entities to trustee-shareholders. Cash distributions^[5] from corporate entities (or distributions in respect of which the trustee has the option of taking cash) should be treated as income and distributions in any other form should be classified as capital.
5.10      Consultees might find it helpful to consider how such a rule of classification would apply to the facts of some cases decided under the existing classification rules. The case of Re Sechiari concerned a direct demerger.^[6] Trustee-shareholders received British Transport stock. Under our provisionally proposed rule of classification the shares would have been received as capital. This contrasts with the decision of Romer J who held the shares to be income under the current law. In Sinclair v Lee, the trustee-shareholders received shares in Zeneca following an indirect demerger of ICI.^[7] Our proposed rule of classification would reach the same conclusion as that reached by Sir Donald Nicholls VC (i.e. that the shares were capital) without the need to draw artificial distinctions between direct and indirect demergers.
5.11      We acknowledge that this approach will not remove all complexity or every anomaly. Capital profits dividends, such as those distributed in Hill v Permanent Trustee Co of New South Wales,^[8] will still be treated as income provided that the trustee-shareholder receives (or has an option to receive) the dividend in cash. Under the proposed rule enhanced scrip dividends will be classified as income (because there is an option to take the dividend in cash). This contrasts with the result in Re Malam where an enhanced scrip dividend was treated as a distribution of capital, with the life tenant being entitled to a lien in respect of the amount of cash dividend foregone. However, we believe that the trustee's task would be made easier by a simple, clear rule of classification, the application of which would not be the catalyst for disputes. It should also be remembered that trustees would, if our proposed power of allocation were made available to them, be able to overcome any imbalance caused by the proposed rule by exercising that power to restore the balance.
5.12      The status of the classification given by the new rule will depend on whether trustees have a power to allocate the receipt in question to income or capital. If the trust contains such a power, then classification will only be on a provisional basis ("the default classification") and the receipt will not immediately accrue to the income beneficiary or to capital. Trustees can adjust this default classification by subsequently exercising their power to allocate the receipt to income or to capital, as the case may be.^[9] The default classification would only become conclusive when the trustees consciously decide to exercise (or not to exercise) the power of allocation or when, for any reason, the power of allocation ceases to be available in respect of that receipt. If trustees do not have a power of allocation the default classification indicated by this new rule would be conclusive from the start.

We provisionally propose that the existing rules for the classification of distributions by corporate entities to trustee-shareholders should be abolished.

Do consultees agree?

We provisionally propose that cash distributions to trustee-shareholders by corporate entities (excluding payments made on liquidation or on an authorised reduction of capital), or distributions which trustees could have taken in cash, should be classified as income and all other distributions from corporate entities should be classified as capital.

Do consultees agree?

Non-corporate receipts

5.13      The new approach outlined above would not be suitable for trust receipts other than distributions from corporate entities.^[10] However, the criticisms of the current rules for the classification of distributions by corporate entities to trustee-shareholders do not apply to other types of receipt. The classification of many receipts (such as rental income or interest) is simple and accords with common sense. The classification of other categories, such as timber, minerals and intellectual property rights is less clear, but does not appear to cause wide-ranging problems in practice.^[11] In addition, in the limited cases where unfairness is caused by the current rules, trustees would, if our proposed power of allocation were made available to them, be able to exercise that power to restore a proper balance.
5.14      We therefore believe that the existing rules for the classification of receipts other than distributions from corporate entities should stand. Where the statutory power of allocation is available to trustees these rules would only yield a default classification whereas if it is unavailable the classification would be conclusive from the start.^[12]
5.15      It could be argued that placing the existing rules of classification for non-corporate receipts (or modified versions of those rules) on a statutory footing could be of some benefit to trustees. We are conscious, however, of the dangers of following too closely the UPIA model with a statutory rule for every imaginable situation in which a rule of classification might be necessary.^[13] We would therefore welcome the views of consultees on whether or not difficulty is caused in practice by the existing rules of classification for non-corporate receipts not being in statutory form.

We provisionally propose that the existing rules for the classification of trust receipts other than distributions from corporate entities should be retained.

Do consultees agree?

We invite the views of consultees on whether the existing rules for the classification of trust receipts other than distributions from corporate entities should be placed on a statutory footing.

Trust expenses

5.16      It is not possible for trust expenses to be classified on the same basis as distributions from corporate entities. In the ordinary course of events, all trust expenses will be paid in cash and so no real distinction can be drawn on the basis of the form of the expense. The classification of trust expenses should depend on the purpose for which they were incurred. The House of Lords held in Carver v Duncan that income should bear "all ordinary outgoings of a recurrent nature" whereas expenses incurred "for the benefit of the whole estate" should be attributed to capital.^[14] While there is some uncertainty in the application of this rule, we do not think that there is a sensible alternative rule for the classification of trust expenses. The rule in Carver v Duncan achieves a broadly impartial balance between the interests of competing beneficiaries. If the proposed power of allocation were available, however, the rule in Carver v Duncan would yield only a default classification.
5.17      We remain to be convinced that a statutory restatement of the rule in Carver v Duncan would reduce uncertainty in this area. We would welcome the views of consultees on whether such a restatement of the rule would be desirable and, in particular, whether its status as a common law rule causes difficulties in practice.

We provisionally propose that the law regarding the classification of trust expenses should remain unchanged. The rule laid down by the House of Lords in Carver v Duncan should continue to apply.

Do consultees agree?

We invite the views of consultees on whether the rule in Carver v Duncan should be placed on a statutory footing.

Express modification of the rules of classification by the settlor

5.18      Whatever the nature of a particular receipt or expense we believe that a settlor should continue to be able to impose his or her own rules of classification by making express provision to this effect in the terms of the trust.

We provisionally propose that the rules of classification for trust receipts and expenses should be subject to any contrary provision in the terms of the trust.

Do consultees agree?

THE DUTY TO BALANCE

5.19      The Law Reform Committee considered the duty to balance to be a "fundamental principle of equity".^[15] In Re Pauling's Settlement Trusts (No. 2) (a case involving an application for the appointment of new trustees by the court) Wilberforce J noted that new trustees would be under

… the normal duty of preserving an equitable balance, and if at any time it was shown they were inclining one way or the other, it would not be a difficult matter to bring them to account.^[16]

5.20      The duty to keep what Wilberforce J refers to as "an equitable balance" is variously known as "the duty of even-handedness", "the duty of impartiality" or "the duty to keep a fair balance". The duty broadly requires trustees of trusts in succession, when exercising any of their powers under the trust, to strike a balance, so far as is possible, between the competing interests of the income and capital beneficiaries. In other words, trustees must "be even-handed and not seek to promote the interests of one class over the other".^[17] The current rules of apportionment are underpinned by this same general equitable principle. They exist in order to achieve a balance in the limited circumstances in which they apply.
5.21      We consider that the duty to balance and its underlying equitable principle are, and should continue to be, fundamental. In this Part we provisionally propose that the current equitable apportionment rules should be replaced by a new statutory power of allocation.^[18] We consider, however, that the duty to balance should underpin any new power relating to the apportionment of capital and income.
5.22      Given the central importance of the duty to balance, it is somewhat surprising that the courts have very rarely been required to consider exactly what "balance" means. When the Court of Appeal was asked in Nestlé v National Westminster Bank plc^[19] to decide whether a particular factor (the personal circumstances of the beneficiaries) was relevant to the maintenance of balance in the context of trustee investment, "common sense" suggested to Staughton LJ that the relative financial situations of the beneficiaries could be taken into account.
5.23      As Nestlé indicates, discussions about the nature of the duty to balance usually relate to whether a particular factor is relevant to the proper exercise of a trustee power informed by that duty (in the case of Nestlé, the power of investment). Some jurisdictions, notably in the United States,^[20] take a highly prescriptive approach to the meaning of balance in given situations, listing factors which are and are not relevant. In doing so they attempt to define "balance" and so, indirectly, the duty to balance.
5.24      We recognise that a list of factors relevant to the proper meaning of "balance" might help trustees to understand what they are expected to do in particular circumstances. It would ensure that they do not have to consider the question of balance in the abstract, determining for themselves whether a particular factor is or is not relevant. We are concerned, however, that the effect of a list, even if it is explicitly non-exhaustive, might be to focus the minds of trustees on a narrow range of listed factors and to cause them to neglect other factors which might be relevant. A list could also encourage litigation by beneficiaries on the basis of the trustees' failure to take account of relevant considerations or to discount irrelevant considerations.^[21]
5.25      The listing of relevant factors, whether or not that list is exhaustive, also goes against the "common sense" approach adopted by Staughton LJ in Nestlé and, we believe, by trustees in practice. It is a feature of trust law that so long as trustees take into account all relevant considerations and ignore all irrelevant considerations, they should have a degree of flexibility in the exercise of their powers (and consequently in how they discharge their duties).^[22] The weight given to these factors is a matter for the trustees and may only be reviewed by the courts on the grounds that the trustees acted capriciously.^[23]
5.26      We consider that the scarcity of reported cases on the meaning of the duty to balance suggests that trustees are generally able to discharge the duty to balance in the circumstances in which that duty is currently relevant. We believe that trustees are able to use their common sense in finding a balance and applying the general equitable principle to the particular circumstances that face them. We are therefore of the view that there should not be a statutory list of factors relevant to a proper balance between the competing interests of income and capital beneficiaries.

We provisionally propose that there should not be a non-exhaustive statutory list of relevant factors to help trustees determine whether or not a balance has been struck between the competing interests of income and capital beneficiaries.

Do consultees agree?

If consultees do not agree, we invite their views on which factors should be included in such a list.

5.27      We invite the views of consultees on whether the existence of the duty to balance should be placed on a statutory footing. By this we merely ask whether or not the fact that trustees are under a duty to balance should be laid down in statute. The statement of the duty in statutory form would not in itself change the common law meaning of "balance" and the continuing development of the content of that duty would be left in the hands of the courts.
5.28      It could be argued that equity has adequately expressed the duty to balance in developing the rules of apportionment and in judicial guidance on the effect of the duty on the exercise by trustees of, for example, their investment powers, without the need for statutory expression of the duty.^[24] Furthermore, Parliament has never felt the need to cement other fundamental principles of equity (such as the duty to act in the best interests of the beneficiaries) in legislation. On the other hand, if legislation concerning income and capital in trusts is enacted (and reference to the duty to balance is made in that legislation), it does seem sensible for that legislation to spell out the basic duty which underlies this area of trust law.

We invite the views of consultees on whether or not a trustee's duty to balance the interests of income and capital beneficiaries should be given a statutory basis.

Exclusion of the duty to balance

5.29      We consider that settlors should in principle be free to exclude (or modify) the duty to balance, but only by doing so expressly, or by necessary implication, in the terms of the trust.^[25] We recognise that there is potential overlap here with our current trustee exemption clauses project.^[26] We do not propose to deal in this paper with the circumstances in which the duty to balance might in practice be excludable under any proposed regulation of duty exclusion clauses. Suffice to say, however, we consider that it would be excludable on the same basis as any other duty owed by trustees to the beneficiaries under the general law.
5.30      We discuss in Part III how the duty to balance can be expressly or impliedly excluded under the current law. Few problems arise under the law as it stands when the terms of the trust exclude the operation of the duty to balance either expressly or by necessary implication. Difficulties emerge, however, when the duty to balance is impliedly excluded (insofar as it relates to the original trust property) by the nature of the trust or the trust property. For instance, no implied trust for sale arises by reason of the first branch of the rule in Howe v Earl of Dartmouth over authorised investments or over specific gifts.^[27] Similarly, a power to postpone the conversion of trust property which is subject to an express trust for sale may exclude the second branch of the rule in Howe v Earl of Dartmouth, although this gives rise to difficult issues of construction.^[28]
5.31      We consider that the duty to balance should never be excluded (insofar as it applies to original trust property) solely by a power to postpone the conversion of the original trust assets. This would avoid the difficult questions of construction which arise under the current law. We also consider that a settlor should not necessarily be taken to have excluded the statutory duty to balance (insofar as it is applicable to original trust property) solely because the original trust property comprised authorised investments or because the settlor created a trust of land or an inter vivos settlement. The settlor may give specific property to be held on trust in the hope that it will maintain a balance. If, however, the original investments fail to strike a balance it is not unlikely that the settlor would expect the trustees to exercise their powers of sale and reinvestment (or, if it were available, the provisionally proposed statutory power of allocation) to rectify the imbalance. It is unrealistic to assume that the settlor has anticipated all the possible circumstances in which the original trust property might fail to achieve a balance and accepted such an outcome in those circumstances.

We provisionally propose that trustees should be subject to the duty to balance except insofar as the settlor expressly, or by necessary implication, excludes or modifies that duty in the terms of the trust.

Do consultees agree?

We provisionally propose that the duty to balance should not be impliedly excluded insofar as it relates to the original trust property because that property constitutes an authorised investment, because it was the subject of a specific gift (including any gift of realty or any gift in an inter vivos settlement) or because there is a power to postpone conversion of the original trust assets.

Do consultees agree?

Achieving a balance and moving towards total return investment

5.32      In the earlier parts of this paper we set out at length the shortcomings of the current system which allocates trust receipts on the basis of their (rule-based) classification as income or capital.^[29] We also discuss the deficiencies of the existing rules of apportionment which attempt to achieve balance between income and capital beneficiaries in specific circumstances.^[30]
5.33      In recent years, a number of overseas law reform bodies have considered the classification and apportionment of trust receipts.^[31] Their reports have emphasised the importance of the general duty of trustees to balance the competing interests of income and capital beneficiaries and have advocated the adoption of total return investment policies. In particular, the reports of the law reform bodies in four Canadian provinces^[32] have argued that the formalistic distinction between capital and income is inimical to the movement away from a list-based approach to authorised investments and towards the application to trusts of modern portfolio investment theory. The Canadian reports place significant weight on the settlor's overriding purpose of conferring financial benefits on the objects of the trust. This aim is undermined by a trust law regime which, like that in England and Wales, forces trustees to sacrifice overall economic growth in order to achieve balanced capital and income returns.
5.34      The Canadian reports recognise two vehicles through which the fruits of total return investment can be distributed by trustees for the benefit of beneficiaries; "percentage trusts" and "discretionary allocation trusts".

Percentage trusts

5.35      The percentage trust model represents a radical means of facilitating total return investment. Percentage trusts have successive interests but do not rely upon the traditional concepts of income and capital. Trustees are instead required to value the entire trust fund at fixed intervals and then pay a fixed percentage of that value to the "percentage beneficiary". The levels of capital and income in the investment returns have no role to play in defining the beneficiaries' respective entitlements. The value of each beneficiary's interest depends on the total value of the assets in the trust fund regardless of whether they take the form of income or capital on receipt.
5.36      English law does not prohibit a settlor from constituting a percentage trust by making express provision to that effect in the terms of the trust. There are, however, significant obstacles to the widespread adoption of percentage trusts in England and Wales. Aside from the fact that percentage trusts will not be suitable for all settlors or all types of trust property (e.g. the family home), general awareness of the possibility of setting up a percentage trust is low. Furthermore the drafting of percentage trusts is likely to pose problems, even to specialist practitioners, unless some sort of statutory default term were introduced.^[33]
5.37      There are also two technical difficulties. First, the rule against excessive accumulations would limit the duration of a percentage trust to 21 years. The Law Commission has recommended the abolition of this rule for private trusts^[34] but, although the Government has accepted this recommendation, no implementing legislation has yet been passed. Secondly, the current tax system for trusts is based exclusively on the traditional income/capital dichotomy. Percentage trusts represent a departure from this traditional distinction so it is difficult to see how such trusts would be taxed in the UK.
5.38      We do not intend to make any recommendations concerning percentage trusts. We would, however, be interested to hear the views of any consultees who have experience of percentage trusts.

We invite the views of consultees on the advantages and disadvantages of promoting percentage trusts within England and Wales.

Discretionary allocation trusts

5.39      An alternative model is what the Canadian law reform bodies call "discretionary allocation trusts". Discretionary allocation trusts give trustees a power to allocate receipts and expenses between the income and capital beneficiaries in order to discharge their duty to balance.
5.40      We consider that the best way of achieving total return investment in England and Wales is for the trustees of private trusts to be given a similar statutory power to allocate trust receipts and expenses between income and capital.

A new trustee power of allocation

5.41      We have already made provisional proposals for the classification of trust receipts and trust expenses as income or capital. We have outlined the duty, imposed on all trustees, to balance the respective interests of income and capital beneficiaries. We have set out the merits of "total return" investment policies which seek to maximise the overall level of investment returns irrespective of the form that those receipts might take. We now intend to consider the case for making available to trustees a statutory power to allocate trust receipts and trust expenses to income or capital insofar as is necessary to discharge the duty to balance.
5.42      In the absence of a power to allocate receipts freely between income and capital, compliance with the duty to balance inevitably restricts the trustees in their choice of investments and thereby risks compromising the total level of returns from those investments. Trustees are confined to an investment policy which they hope will deliver returns in a form which holds the necessary balance between income and capital. A power of allocation would give trustees much greater freedom to select investments, as they would no longer need to concern themselves with the likely form taken by returns, and they could instead focus on maximising the growth of the trust fund as a whole. The duty to balance could be satisfied by exercise of the power of allocation. In consequence, trustees would be able to postpone the balancing process from the time when investment policy is being formulated until after investment returns are received. This, we believe, would result in less speculative, better informed and more effective trusteeship.
5.43      We therefore provisionally propose that a statutory power of allocation should be available to trustees insofar as it is necessary to discharge the duty to balance (and for no other purpose).^[35] Trustees will be given a specified time limit during which they must decide on allocation of the particular receipt or expense to income or to capital.^[36] If they fail to make a decision within that time limit, the default classification, based on the rules we have provisionally proposed above, would become final and conclusive. We envisage that this time limit would be a set period (such as six months) after the end of the tax year within which the receipt accrues. A similar scheme would apply to trust expenses. The statutory power of allocation would therefore apply to all receipts and expenses, allowing a balance to be readily achieved outside the narrow range of situations covered by the existing apportionment rules.
5.44      Trustees would be required actively to consider whether or not to exercise the power of allocation. We envisage that the minutes of trustees' meetings should record any decision to allocate. Trustees would also need to keep detailed accounts in order to record which receipts and expenses had been allocated. It would, we think, be advisable to hold unallocated trust receipts in a separate bank account.
5.45      While delivering the undoubted advantages of total return investment the existence of a power of allocation would inevitably cause there to be a time lag between the trustees' receipt of investment returns and their distribution to beneficiaries. This delay could, we concede, be detrimental to beneficiaries who might be in financial need. In addition, the current practice, standard in relation to many smaller trusts, of mandating income to the life tenant would be endangered. We envisage that in such circumstances the trustees could alleviate the difficulties by meeting in order either to expedite distribution by exercising their power of allocation or to approve a payment on account.
5.46      It will be important that trustees with a power of allocation do not allow receipts to be distributed to the life tenant before either the trustees have consciously decided to exercise (or not to exercise) the power of allocation or the time limit for exercise of the statutory power has expired. The recoupment of sums which have been distributed to a beneficiary raises potential human rights issues, gives rise to a possible change of position or estoppel argument and could lead to a serious breakdown of the relationship between the trustees and beneficiaries. It is contemplated that trustees would only make advance payments on account if they were fairly sure that an amount equal to or exceeding those sums would be allocated to income when the time came to consider exercise of the power of allocation. If the trustees subsequently decided that the payments made on account created an imbalance between the income and capital beneficiaries it would, however, be possible for the trustees to exercise their power of allocation in respect of subsequent receipts to restore a proper balance.
5.47      We recognise that this proposed scheme would place new obligations upon trustees. We consider, however, that some additional burdens are inevitable in any shift from a rule-based to a (partly) discretion-based approach to classification of trust receipts and expenses. And while the introduction of a combined duty to balance and power of allocation would have a significant effect on trustee practice, we do not believe that it would place an excessive or unfair burden upon trustees. We contemplate that the time limit for exercising the power of allocation would not of itself require trustees who meet at least once a year to meet more regularly in order to discharge the proposed duty. If trustees fail for whatever reason to allocate a receipt within the relevant time limit, with the result that the default classification becomes binding and an imbalance results, they should be able to re-establish the necessary balance by careful exercise of the power of allocation in relation to the next receipt. For this reason, we consider that the risk of a trustee incurring personal liability for breach of trust to make good any loss resulting from wrongful exercise or non-exercise of the power of allocation is relatively low.^[37]
5.48      As we explained in Part I, the Trustee Act 2000 has imposed rigorous duties upon trustees when making investments.^[38] By removing the need to achieve balance solely through selection of appropriate forms of investment, we hope that our provisional proposals would take away a layer of difficulty from investment decisions, leaving trustees free to concentrate on balancing growth and risk. Alternatively, trustees could continue to attempt to create a balance by the selection of investments and so not be obliged to exercise the power of allocation unless actual returns failed to match predictions.

We provisionally propose that a statutory power of allocation should be made available to the trustees of private trusts to enable them to discharge their duty to balance and thereby to promote total return investment policies.

Do consultees agree?

We provisionally propose that the exercise of the statutory power of allocation, where it is available, should be subject to a time limit from the date of a particular receipt or expense, after which time the default classification would become conclusive.

Do consultees agree?

We invite the views of consultees on the appropriate length of such a time limit.

We invite the views of consultees on the practical implications of our provisional proposals, particularly in relation to accounting and keeping track of individual receipts.

"Opt in" or "opt out"?^[39]

5.49      As we have stated, the duty to balance the respective interests of those entitled to income and those entitled to capital is fundamental to the trust relationship. Whether or not it is given a statutory basis, the duty to balance will remain a central component of all trusts with successive interests. Although it will be open to settlors to exclude or restrict this duty, it will otherwise apply by default.
5.50      Under the current law, the duty to balance should be discharged by the careful selection of investments, which trustees reasonably expect to deliver investment returns in a form which balances the interests of the income and capital beneficiaries. Under our provisional proposals, trustees may have a new power to allocate receipts to income or capital as a means of ensuring that the requisite balance is achieved.
5.51      It would be possible to provide that the power of allocation should be implied into all trusts with successive interests, subject only to express provision by the settlor that the power should not apply to a particular trust. This would be an "opt-out" system, in that the power of allocation would apply in the absence of contrary provision in the terms of the trust. Alternatively, it would be possible to provide that the power to allocate should not be implied. It would in that case apply only where the settlor expressly provided that the power should be exercisable by the trustees. This would be an "opt-in" system.
5.52      It may be thought that in view of our strong support for the pre-eminence of the duty to balance, we would advance the case for an opt-out system whereby statute would confer a power of allocation on all trustees of trusts with successive interests, save where a clear contrary intention is expressed. We have argued that the introduction of such a power would be highly advantageous and it follows that it should therefore apply to the largest possible number of trusts.
5.53      There are however counter-arguments. First, we can see that there may be some concerns about the scale of the administrative burden being imposed on trustees by the power of allocation. We do not ourselves consider that the burden is excessive but we cannot deny that the power would require trustees to consider whether and when to exercise it. That would place greater demands upon trustees than there are at present.
5.54      The second counter-argument is visibility. Were the power to apply on an opt-out basis, it is possible that some trustees (in particular, lay trustees) would be unaware of the availability of the power and would continue to attempt to strike a balance through the choice of suitable investments. The benefits of having the power would be lost. By contrast, if an opt-in scheme were adopted, the existence of the power of allocation would be immediately apparent from the trust instrument. Trustees might therefore be more likely to make use of it for the benefit of all the beneficiaries.
5.55      The major disadvantage of an opt-in scheme is that total return investment will be unavailable to the trustees of those trusts which fail to opt in. This group of trusts is likely to include many small trusts where the settlors have not taken proper legal advice before setting up the trust. The duty to balance derives from a fundamental principle of equity and would not be diluted in any way by the failure of the settlor (for whatever reason) to opt in to the proposed power of allocation.^[40] Trustees of trusts which have not opted in will therefore still be obliged to discharge the duty to balance but will only be able to do so through their choice of investments.

We invite the views of consultees on whether the provisionally proposed power of allocation should be available on an opt-in or opt-out basis.

Exercising the power of allocation

5.56      The power of allocation is strictly "administrative", in the sense that it is intended to facilitate the internal administration of the trust. Whether the power of allocation operates on an opt-out or opt-in basis, it will be available to trustees for one reason only; to enable them to discharge their overriding duty to balance the interests of the income and capital beneficiaries. It must be clearly distinguished from a "dispositive" power whereby trustees, having considered the various claims of beneficiaries, are entitled to make distributions out of the trust fund to particular beneficiaries at the expense of the others.
5.57      In our earlier discussion we argued that "balance" should not be defined by reference to a statutory list of relevant factors but that the meaning of "balance" should be a matter of common sense, informed by the common law.^[41] In general, we provisionally propose to apply the same approach in relation to the new statutory power of allocation. However, we believe that it is necessary to depart from that approach in one specific respect. We consider it essential that the personal circumstances of beneficiaries should not be a relevant consideration in the exercise of the statutory power of allocation.
5.58      As the power of allocation is an administrative and not a dispositive power, it would in our view be inappropriate for trustees to take account of the personal circumstances of individual beneficiaries in its exercise. In addition, we believe that the inclusion of personal circumstances as a relevant factor would risk departure from the expressed intention of the settlor, provoke legal uncertainty and increase the risk of litigation against trustees, as well as having a potentially adverse impact on the tax treatment of trusts benefiting from the power of allocation.
5.59      We anticipate the argument that permitting trustees to take account of the personal circumstances of the beneficiaries allows trustees to do "what the settlor would have wanted". We recognise that the trustees of many small trusts have or have had a long-standing friendship or familial relationship with the settlor. Even so, if the settlor has not expressed his or her wishes in the terms of the trust the trustees would have to speculate about what the settlor would want and make (possibly false) assumptions about the settlor's underlying wishes. The settlor might not have established the trust with the primary aim of providing support to the life tenant; he or she might, for example, wish to protect the capital of the trust for dynastic reasons. This latter aim is inconsistent with allowing the personal circumstances of beneficiaries to influence their relative entitlements.
5.60      Any evaluation of the beneficiaries' personal circumstances is likely to involve an element of subjectivity on the part of trustees which could lead to different trustees, or even the same trustees at different times, adopting different approaches. Although subjectivity is inherent in any discretionary power, it seems to us that we should strive to minimise inconsistency between the balance struck by different trustees (or by the same trustees at different times).
5.61      It is important to distinguish between factors to which the trustees may have regard (that is, are entitled to consider) and factors to which trustees must have regard (that is, are obliged to consider). An entitlement to take account of personal circumstances may cause uncertainty as to the legal consequences of the trustees' unwillingness or failure to have regard to such circumstances. An obligation to take personal circumstances into account would require trustees to monitor such circumstances on a regular basis, possibly in relation to a significant number of beneficiaries. This would impose a not insignificant burden. In Nestlé, Hoffmann J considered an extreme example where the life tenant was the testator's widow who had fallen upon hard times and the remainderman was young and well-off.^[42] In reality, it is more likely that the beneficiaries' needs would vary to a much lesser extent from year to year. Trustees would have to decide how to react to such short-term fluctuations.
5.62      Recognition of an entitlement, or an obligation, to take account of personal circumstances would in our view increase the potential exposure of trustees to litigation. Any exercise of the power of allocation will have an immediate and quantifiable financial impact on the beneficiaries. We believe that the inclusion of personal circumstances as a relevant consideration would increase the risk of attack by disgruntled beneficiaries on the grounds that the trustees failed to take account of relevant considerations.^[43]
5.63      A further consideration is how any legislative change flowing from our provisional proposals might affect the tax treatment of trusts. It is vital that the availability of a statutory power of allocation should not affect the tax treatment of trusts.^[44] We have had preliminary discussions with the Inland Revenue in relation to this issue. It is currently not possible to say how trusts would be taxed if our proposed power of allocation were available to trustees. We nevertheless hope that the Inland Revenue will either find themselves able to approve our proposed scheme or to co-operate in the modification of the current tax rules in order to allow it to operate in a tax neutral manner.
5.64      Under our provisionally proposed scheme the power of allocation and the default classification rules would together form part of the process of defining the nature of particular receipts and expenses. The exercise of the power should not be understood as converting income to capital or vice versa. Similarly it should not be viewed as allowing the remainderman to receive income or the life tenant to receive capital. If trustees decide to exercise their statutory power to allocate receipts to income or to capital, the default classification is displaced. The exercise of such a power in order to obtain an objective balance between the income and capital beneficiaries would therefore constitute an administrative (as opposed to dispositive) discretion. We anticipate, however, that the Revenue would be concerned if trustees were able or obliged to take account of the beneficiaries' personal circumstances in exercising the power of allocation. If trustees were able to take account of such circumstances in the exercise of that power, the power could more easily be characterised as a dispositive power.
5.65      We are therefore of the view that it would not be possible for the new statutory power of allocation to operate unless the personal circumstances of beneficiaries are irrelevant to its exercise. Our preliminary soundings of the judiciary support this position. We believe that this view is also supported by the existing equitable rules of apportionment which the power of allocation is intended to replace. The equitable rules make no reference to and take no account of the personal circumstances of beneficiaries in applying mechanical formulae to achieve a balance in specific circumstances.
5.66      Settlors who wish trustees to continue to have the flexibility to vary the balance between income and capital beneficiaries on account of personal circumstances can achieve this in a number of ways. First, it is open to the settlor not to opt in to (or, depending on which approach is taken, to opt out of) the power to allocation. In the absence of judicial developments, the approach set out in Nestlé will continue to apply to the exercise by trustees of their investment powers.^[45] Secondly, settlors may choose to include express provision in the terms of the trust to the effect that trustees may or must take into account personal circumstances when exercising a power of allocation. As noted above, the tax implications of this are uncertain. Thirdly, settlors may wish to establish a discretionary trust (or a fixed trust with a discretionary power to appoint capital or to accumulate income) in which the personal circumstances of the beneficiaries are clearly a relevant consideration for the trustees.

We provisionally propose that the personal circumstances of beneficiaries should not be a relevant factor in the exercise of the statutory power of allocation.

5.67      We recognise that this provisional proposal may appear to sit uneasily with the prevailing judicial guidance on the meaning of balance, as set out in Nestlé ("the Nestlé approach"). The judgments of both Staughton LJ, in the Court of Appeal,^[46] and Hoffmann J, at first instance, considered that trustees were entitled to take account of the personal circumstances of beneficiaries when determining whether a particular investment policy discharged the duty to balance.^[47]
5.68      This is not simply a theoretical issue. We contemplate that the power of allocation will be excludable either on an opt-in or opt-out basis. Where the power of allocation is not available (and the duty to balance must be discharged through the careful selection of investments) the meaning of "balance" will be determined by the current law.
5.69      It is possible to try to explain the difference of approach by distinguishing between the contexts in which balance is being considered. The Nestlé case concerned factors relevant when formulating an investment policy. As Hoffmann J emphasised:

… investment decisions are concerned with predictions of the future. Investments will carry current expectations … but there is always a greater or lesser risk that the outcome will deviate from those expectations.^[48]

5.70      The introduction of a power of allocation would fundamentally alter the context in which the duty to balance finds expression. The power would provide a tool for trustees to split actual returns between income and capital in whatever proportions they saw fit with precision and certainty. Like the current equitable rules of apportionment the power would apply "after the event" on actual trust receipts.
5.71      The central difference between the formulation of a balanced investment policy and the exercise of a balancing power of allocation flows from the difference in the time at which the duty to balance must be discharged. As Hoffmann J noted in Nestlé, at the pre-investment stage trustees are inevitably dealing with uncertain future outcomes. It is perhaps natural to view this attempt to balance as a "broad-brush" exercise in which the relevant factors should not be limited by the courts. In this context, it is possible to have sympathy with the view that it does not do any harm to give trustees a little more flexibility in formulating investment policy by permitting them to take account of the beneficiaries' personal circumstances. One cannot point to specific property which is being diverted from one beneficiary to another since the actual form of investment returns will remain uncertain until the investment policy is actually put into effect. In contrast, when exercising a power of allocation the fruits of the investment policy are already in the trustees' hands. The result of exercising the power of allocation is immediate and certain and it is possible to point to identifiable assets which will be diverted from one class of beneficiary to another.
5.72      The fact remains, however, that the duty underlying both the power of investment and the proposed power of allocation is the sam: the duty to balance.^[49] The consequence of making a distinction between the exercise of the power of investment and the exercise of the power of allocation is therefore that the duty to balance means different things in different contexts. It is difficult to frame a principled justification for the position where the same duty informs trustees' decisions in two different contexts but the content of that duty is significantly different in each context.
5.73      The alternative to this view is to conclude that the current law (as expressed in Nestlé) is incorrect insofar as it deems personal circumstances relevant to the meaning of "balance". The reasons behind the Nestlé approach are explored most fully by Hoffmann J at first instance. Hoffmann J felt that a duty to balance which compelled trustees to leave the personal circumstances of beneficiaries out of account when making investment decisions would be an "inhuman law".^[50] His Lordship stated that discounting personal circumstances would be "a more mechanistic process than… the law requires".^[51] His Lordship appears to share the instinctive response of many trust lawyers that it would be unconscionable or inequitable not to shift the balance of the trust fund to reflect the personal circumstances of the beneficiaries. It is said that trustees should know about and take an interest in the beneficiaries' personal circumstances and that equity should do what is "right".
5.74      This justification of the Nestlé approach is attractive and we are aware of no challenges to or any general dissatisfaction with the principle established in that case. Nor are we aware of any desire amongst practitioners to upset the status quo. However, that is not to say that the Nestlé approach is beyond criticism. The view of the duty to balance set out by Staughton LJ and Hoffmann J has never been re-considered (either by the Court of Appeal or the House of Lords), nor has it, to our knowledge, been specifically applied by the lower courts.
5.75      To some extent, the arguments against the relevance of personal circumstances in the context of the new statutory power of allocation^[52] could apply equally to the content of the duty to balance insofar as it relates to the exercise of powers of investment. We believe, however, that these concerns are of greater significance in the context of the provisionally proposed power of allocation. This is because the exercise of the power of allocation would have a much more direct and immediate impact on the relative entitlements of the beneficiaries than the original investment decisions. The causal link with the exercise of the power of allocation is much stronger.
5.76      There may, however, be more fundamental reasons why the Nestlé approach could be viewed as flawed. The effect of the Nestlé approach is to introduce a degree of flexibility into an otherwise "fixed interest" trust.^[53] We recognise that one of the main strengths of the trust is its flexibility. However, there must be limits to that flexibility. The Nestlé approach equates the ideas of administering a trust fund "impartially" with administering it "fairly" (in the sense of meritoriously). Introducing the concept of fairness makes the beneficiaries' entitlements dependent upon a much wider range of moral considerations, which otherwise have no place within a fixed interest trust. Although trustees are under a duty to act in the best interests of the beneficiaries, this duty is always limited by the terms of the trust. Ideas of "fairness" can only operate within clearly defined boundaries. It cannot, for example, be open to trustees unilaterally to alter the structure of the trust. It is also arguable that the Nestlé approach obscures the proper purpose of the duty to balance which is to strike an objective balance between income and capital. If trustees are able to take into account personal circumstances, they would have a power akin to an indirect dispositive discretion for which the settlor has (possibly for good reason) made no provision in the terms of the trust.

We invite the views of consultees on whether or not the Nestlé approach (that personal circumstances of the beneficiaries are a relevant factor in discharging the duty to balance through the formulation of investment policy) is correct.

If consultees believe the Nestlé approach to be incorrect, we provisionally propose that the duty to balance should be statutorily redefined to exclude the personal circumstances of beneficiaries as a relevant factor. Do consultees agree?

5.77      Finally, we appreciate that this analysis of the factors relevant to the duty to balance and the exercise of the power of allocation is not exhaustive. We would welcome the input of consultees on any further points relating to factors which should be relevant (or irrelevant) to the duty to balance or to the exercise of the statutory power of allocation.

We invite any further views of consultees on factors which should be relevant (or irrelevant) to the duty to balance or to the exercise of the statutory power of allocation.

Judicial control of the statutory power of allocation

5.78      The Law Reform Committee thought that beneficiaries should be able to apply for a court order to ensure that trustees complied with their duty to balance.^[54] The beneficiary would bear the burden of showing "substantial prejudice". An order would only be made in an exceptional case after consideration of the administration of the trust as a whole.
5.79      The extent of the judicial control of trustees' discretionary powers is a controversial issue which is arguably in need of general reconsideration. We consider that it is inappropriate to deal with the trustee's statutory power of allocation separately from other powers.^[55]
5.80      A beneficiary would ordinarily be able to seek redress for breach of trust if a trustee fails to discharge his duty to balance. The Law Reform Committee recommended that no action for breach of trust should lie against trustees who have acted in good faith in exercising (or failing to exercise) their proposed statutory power. It is not clear why the Committee considered that the action for breach of trust should be replaced by judicial control of the new trustee power. Trustees with our proposed power of allocation would presumably be given a fairly wide margin of appreciation before their failure to maintain a balance could be said to constitute a breach of trust. As discussed above,^[56] the common law concept of "balance" is rooted in vague notions of common sense. Trustees may also protect themselves by seeking prior directions from the court or by obtaining the agreement of all the beneficiaries to a proposed course of action.^[57] A trustee who acts reasonably and in good faith can also seek to invoke the court's discretion to excuse a breach of trust under section 61 of the Trustee Act 1925. We accept, however, that these routes may be more attractive in theory than in practice.^[58]
5.81      We believe that the real protection for trustees lies in the continuing availability of the power of allocation. A court finding a breach of trust would in the majority of cases simply require the trustees to exercise that power of allocation to restore a balance.^[59] We also foresee that in practice most disputes between beneficiaries and trustees would be resolved without resort to the courts (or to any formal sort of dispute resolution). Most beneficiaries would be satisfied if trustees agree to rectify any imbalance by the exercise of their power of allocation in respect of future receipts or expenses. This is consistent with the policy of the Civil Procedure Rules to encourage the resolution of disputes out of court and to avoid litigation.
5.82      Although we would not anticipate a significant amount of litigation concerning the exercise (or non-exercise) of our proposed power of allocation we consider that there may be advantages in adopting a protocol to assist trustees and beneficiaries in the resolution of disputes out of court. We would welcome the views of consultees on the practical utility of such a protocol in these particular circumstances.

We provisionally propose that the exercise (or non-exercise) of the statutory power of allocation should be subject to review by the courts on the same basis as any other discretionary power conferred upon trustees.

Do consultees agree?

We provisionally propose that, in principle, an action for breach of trust should lie against trustees who fail to discharge their duty to balance.

Do consultees agree?

We invite the views of consultees on whether a special protocol concerning the resolution of disputes over the exercise of the proposed power of allocation would be of assistance to trustees and beneficiaries.

THE EQUITABLE RULES OF APPORTIONMENT

5.83      The equitable rules of apportionment are intended to give effect to equity's general principle of impartiality. The arbitrary formalism of the current rules sometimes runs counter to this principle, although the rules largely achieve a defensible result in the specific circumstances to which they apply. They neglect, however, the sometimes pressing need for apportionment between the interests of capital and income beneficiaries in those situations which are not covered by the existing rules.
5.84      A number of specific criticisms of the rigid and technical equitable rules is set out in Part III.^[60] For these reasons, some of the equitable rules of apportionment have already been abolished by legislation in other common law jurisdictions. The second branch of the rule in Howe v Earl of Dartmouth has been abrogated (in the absence of contrary intention) in Western Australia^[61] and in New Zealand.^[62] The rule in Allhusen v Whittell has been abolished in a number of Australian states,^[63] in the Canadian provinces of Ontario,^[64] British Columbia^[65] and Manitoba^[66] and in New Zealand.^[67]
5.85      Aside from the many criticisms of the equitable rules, we consider that the availability of a statutory power of allocation would render them unnecessary. This power would allow trustees to maintain a balance between the income and capital beneficiaries by allocating receipts or expenses between income and capital, including (where appropriate) the situations covered by the existing equitable rules of apportionment.

We provisionally propose that all the existing equitable rules of apportionment should be abrogated.

Do consultees agree?

THE APPORTIONMENT ACT 1870

5.86      The rule set out in section 2 of the 1870 Act has long been criticised as being inconvenient and unfair.^[68]
5.87      We recognise that the 1870 Act does not apply exclusively to trusts. We do not, therefore, consider it appropriate to recommend its repeal. We do consider, however, that section 2 of the 1870 Act should not apply to trusts unless the settlor expresses a contrary intention in the terms of the trust. Periodic payments of income should be paid to the beneficiary who is entitled to income at the time when the payment becomes due.

We provisionally propose that the statutory apportionment rule contained in section 2 of the Apportionment Act 1870 should not apply to trusts except insofar as the terms of the trust (expressly or by necessary implication) express a contrary intention.

Do consultees agree?

5.88      Where available, the proposed statutory power of allocation would be sufficient to maintain a balance between the income and capital beneficiaries when a receipt arises in respect of a period which started before but ended after the creation of the trust. The abrogation of the statutory apportionment rule contained in section 2 of the 1870 Act would be of little consequence. This relies, however, on the statutory power being available and the receipt becoming due whilst the life interest is still subsisting. On termination of the life interest the remainderman becomes absolutely entitled to the trust property and (since there are no competing interests between which to hold a balance) the proposed statutory power of allocation would no longer be available. The same problem arises when one life interest follows the termination of another life interest. In this latter case there is the added difficulty that the "competing interests" in question are both entitlements to income. The proposed statutory power of allocation between income and capital would not, in any event, be of assistance. There may, however, be circumstances in which the trustees consider that apportionment is necessary to maintain a balance between the beneficiaries and to reflect the substance of the receipt in question. We propose, therefore, that trustees should have a power to apportion receipts in circumstances which are currently covered by section 2 of the 1870 Act when, and in the manner in which, they, in their absolute discretion, deem it just and expedient.

We provisionally propose that when trustees receive a payment of income in respect of a period during which two (or more) individuals (or classes of individuals) were entitled to income, they should have a statutory power to apportion when, and in the manner in which, they, in their absolute discretion, deem it just and expedient.

Do consultees agree?

TRUSTS FOR SALE

Express and statutory trusts for sale

5.89      A settlor may expressly impose a duty on trustees to convert trust personalty and reinvest the proceeds.^[69] This is an important aspect of the settlor's freedom to give property to trustees on such terms as he or she thinks fit. Similarly a statutory trust for sale reflects the will of Parliament that trust property should be converted and the proceeds reinvested.

We provisionally propose that where a settlor expressly creates or statute imposes a trust for sale (without a power to postpone sale), trustees should continue to be under a duty to convert the trust property and reinvest the proceeds.

Do consultees agree?

Implied trusts for sale

5.90      In specific circumstances the current duty to balance gives rise to an implied trust for sale of unauthorised investments under the first branch of the rule in Howe v Earl of Dartmouth.^[70]
5.91      We consider that, in the limited range of circumstances in which the rule operates, there are better ways of discharging the duty to balance than a prescriptive duty to sell trust property. Such a duty is incompatible with our aim of increasing trustees' flexibility in the making of investment decisions. We prefer a position where the trustees may choose to exercise their general power to sell investments which fail to maintain a balance between beneficiaries but may also elect to retain successful investments and, where it is available, discharge their duty to balance by making use of the proposed statutory power of allocation.

We provisionally propose that the first branch of the rule in Howe v Earl of Dartmouth should be abrogated.

Do consultees agree?

SCOPE OF THE PROVISIONAL PROPOSALS

5.92      We consider that the scheme outlined above should apply to all private (i.e. non-charitable) trusts (including discretionary trusts) which are governed by the law of England and Wales and in which the interests in income and capital are divided.

We provisionally propose that the scheme set out in this Part should be made applicable to all private trusts which are governed by the law of England and Wales and in which there is a division of the capital and income interests.

Do consultees agree?

We invite the views of consultees on whether there are any specific types or categories of private trust to which the provisional proposals in this Part should not apply (or to which they should apply in modified form).

TRANSITIONAL PROVISIONS

5.93      We invite the views of consultees on whether our provisional proposals should apply to trusts created before the proposals come into force. The arguments in this context depend to a large extent on whether an opt-in or opt-out power of allocation is preferred.^[71]
5.94      Even if the statutory power of allocation is available on an opt-out basis we do not believe that to apply our proposed scheme to existing trusts would necessarily be unfair to beneficiaries. It can be argued that our provisional proposals only give substantial effect (albeit in a new way) to the duty to balance which already applies to trusts by default. The proposals would not apply to pre-existing trusts in which the existing duty to balance has been excluded. On this analysis beneficiaries would have no legitimate complaint as our proposals merely give the trustees the tools to discharge a duty which they were already under and to which the beneficiaries' interests were always subject. The beneficiaries are getting nothing more nor less than that to which they are entitled.
5.95      There is, however, a counter-argument to this analysis. The settlor of an existing trust will not have had the statutory power of allocation in mind when deciding upon the terms of the trust and so it would be wrong to interpret his or her failure to make contrary provision as a tacit approval of the scheme we have provisionally proposed. The current duty to balance is relatively easily discharged by the trustees making informed investment decisions (although there is no guarantee that the investments chosen will actually maintain a balance). Once investment decisions have been made and the returns received the duty to balance has no significant role to play. The current equitable and statutory apportionment rules are based on the same principle as the duty to balance, but operate automatically according to a prescribed formula. Whereas trustees currently have no general discretionary power to allocate actual investment returns between income and capital, our provisional proposals would make such a power available to trustees. This radically changes the context in which the duty to balance operates and accords much greater significance to the duty.
5.96      We recognise that our proposals may be said to impose novel and potentially onerous obligations upon trustees which they would not have contemplated when they chose to accept the trusteeship. Particular problems might arise in the context of some commercial trusts where the scope of the trustees' duties are strictly limited.^[72] It is equally true, however, that trustees who are not prepared to take on the new obligations could retire or resign.

We invite the views of consultees on whether our provisional proposals should apply to trusts created before the proposals come into force if the proposed statutory power of allocation applies on an opt-out basis.

5.97      If the power of allocation is only to be available on an opt-in basis the beneficiaries of pre-existing trusts will be largely unaffected if our provisional proposals are applied to such trusts. No settlor could be said to have opted in to a statutory power of allocation which was not in existence when the trust was created.
5.98      We do, however, anticipate that the trustees of some pre-existing trusts might wish to invest on a total return basis. We therefore invite the views of consultees on whether the trustees of pre-existing trusts should be able, either unilaterally or with the sanction of the court, to opt in to the statutory power of allocation, and adopt a total return approach to investment, when this is in the best interests of the beneficiaries as a whole and is not inconsistent with the terms of the trust.

We invite the views of consultees on whether or not the trustees of pre-existing trusts should be able to opt in to the statutory power of allocation.

We invite the views of consultees on whether or not the trustees of pre-existing trusts, if they are able to opt in to the statutory power of allocation in order to adopt a total return investment policy, should be required to seek the approval of the court before adopting such policies.

5.99      As our provisional proposals may require trustees to adjust their accounting practices we consider that any new statutory scheme should come into effect on the first day of the tax year following the enactment of any implementing legislation.

We provisionally propose that any legislative reform based on our provisional proposals should take effect on the first day of the tax year following the enactment of any implementing legislation.

Do consultees agree?

TAX IMPLICATIONS OF THE PROVISIONAL PROPOSALS

5.100      Our provisional proposals for a new scheme for classification and apportionment must fit within the system of taxation for trusts. The changes to trust law that we provisionally propose should be tax-neutral, neither increasing the revenue and capital tax burdens on trusts and beneficiaries nor offering tax savings or tax planning opportunities.
5.101      We have held initial discussions with the Inland Revenue about the tax implications of our provisional proposals and will continue to work with them to find a workable and fair tax treatment for trusts subject to any new apportionment and classification regime. This will need to fit within the modernised system of trust taxation on which the Inland Revenue is currently consulting. We would be grateful to receive consultees' input on any aspect of trust taxation or individual taxation raised by our provisional proposals.

We would welcome comments of any nature on the tax implications of the provisional proposals in this Paper.

Note 1    The availability of this power would depend on whether an “opt-in” or “opt-out” scheme is favoured.    [Back]

Note 2    Insofar as there is no specific rule in the UPIA 1997 to deal with a particular receipt or expense it is classified as capital (UPIA 1997, s 103(a)(4)).    [Back]

Note 3    Our proposed new rule of classification is only intended to apply to distributions by corporate entities to trustees in their capacity as shareholders of the issuing company (not, for instance, where the payment is made to the trustees in satisfaction of an existing debt).     [Back]

Note 4    A payment made on liquidation or on an authorised reduction of capital does not constitute a distribution and is classified as capital.    [Back]

Note 5    We provisionally propose that a payment made on liquidation or otherwise on an authorised reduction of capital should fall outside the definition of distribution and should continue to be classified as capital.    [Back]

Note 6    See further above, paras 2.11, 2.27.    [Back]

Note 7    See further above, paras 2.28 – 2.32.    [Back]

Note 8    See further above, paras 2.15 – 2.17.    [Back]

Note 9    See below, paras 5.41 – 5.82 for discussion of how we contemplate that the proposed statutory power of allocation (when available) would operate.    [Back]

Note 10    For example, the proposed new rule would classify a cash repayment of the principal of a loan by a corporate entity to a trustee as income. We do not believe that it is satisfactory to allow the rule to create such significant anomalies, notwithstanding the potential availability of a power of allocation to vary the default classification.    [Back]

Note 11    This is perhaps indicated by the dearth of reported English cases in these areas.    [Back]

Note 12    See above, para 5.12.    [Back]

Note 13    See above, para 5.4.    [Back]

Note 14    [1985] AC 1082, 1120, per Lord Templeman. See further above, paras 2.51 – 2.54.    [Back]

Note 15    The Powers and Duties of Trustees (1982) 23rd Report of the Law Reform Committee, Cmnd 8733, para 3.26.    [Back]

Note 16    [1963] Ch 576, 586.    [Back]

Note 17    Discussion Paper on Trust Receipts and Outgoings (2003) Scot Law Com No 124, para 2.34.    [Back]

Note 18    See below, paras 5.83 – 5.85.    [Back]

Note 19    Nestlé v National Westminster Bank plc [1993] 1 WLR 1260 (CA); [2000] WTLR 795 (Hoffmann J).    [Back]

Note 20    Section 104(b) of the UPIA 1997 sets out a non-exhaustive list of factors to be considered by trustees in exercising their discretion to apportion.    [Back]

Note 21    Re Hastings-Bass [1975] Ch 25.    [Back]

Note 22    Ibid.    [Back]

Note 23    Edge v Pensions Ombudsman [2000] Ch 602, 627630, per Chadwick LJ.    [Back]

Note 24    Nestlé v National Westminster Bank plc [1993] 1 WLR 1260 (CA); [2000] WTLR 795 (Hoffmann J).    [Back]

Note 25    If the settlor modifies or excludes the statutory duty to balance, the proposed statutory power of allocation would not be available. A settlor who adopts a modified version of the statutory duty to balance may incorporate an express power of allocation in the terms of the trust but does so at the risk of unfavourable tax treatment: see below, paras 5.63 – 5.64, for discussion of the potential tax treatment of the power of allocation. Inland Revenue approval will be sought for our proposed scheme in its entirety and not for any modified forms which a settlor might choose to adopt.    [Back]

Note 26    The mischief of so-called “duty exclusion clauses” was considered in Trustee Exemption Clauses (2003) Law Com Consultation Paper No 171, paras 4.89 – 4.97.    [Back]

Note 27    As no implied trust for sale arises over specific gifts, the rule has no application to realty or to inter vivos settlements, the court assuming that such gifts were intended to be enjoyedin specie. See above, paras 3.7, 3.9 – 3.14.    [Back]

Note 28    See above, para 3.28.    [Back]

Note 29    See above, paras 2.38 – 2.47.    [Back]

Note 30    See above, paras 3.36 – 3.43, 3.53, 3.63.    [Back]

Note 31    Notably in Australia - Report on Trustees’ Powers of Investment (1984) Law Reform Committee of Western Australia Report No 34(V); Bahamas - Trustee Act 1998 enacts the recommendations of the English Law Reform Committee; Canada - see references below, n 32; United States – Uniform Management of Institutional Funds Act 1972, UPIA 1997.    [Back]

Note 32    Ontario (Report on the Law of Trusts (1984)), Manitoba (Trustee Investments: The Modern Portfolio Theory (1999)), British Columbia (Total Return Investing by Trustees (2001)) and Saskatchewan (Proposals for Reform of the Trustees Act (2002)).    [Back]

Note 33    For example, something akin to section 33 of the Trustee Act 1925 (which allows settlors to invoke a protective trust by using the phrase “… on protective trusts”).    [Back]

Note 34    The Rules Against Perpetuities and Excessive Accumulations (1998) Law Com No 251.    [Back]

Note 35    This provisional proposal broadly follows the previous proposals in this area by the Law Reform Committee, the Trust Law Committee and the Scottish Law Commission (see above, Part IV). It also reflects the general approach adopted in other jurisdictions such as the Bahamas and the United States and recommended in several Canadian provinces. We consider below, see paras 5.49 – 5.55, whether the statutory power of allocation should be made available on an opt-in or opt-out basis.    [Back]

Note 36    A time limit is necessary to ensure that receipts are classified, and so available for distribution, within a reasonable period.    [Back]

Note 37    See below, paras 5.78 – 5.82.    [Back]

Note 38    See above, paras 1.1 – 1.4.    [Back]

Note 39    The “opt-in” or “opt-out” nature of the proposed power of allocation has implications for pre-existing trusts: see below, paras 5.93 – 5.99.    [Back]

Note 40    Failure to opt in to the new power would not be sufficient to exclude or modify the duty to balance. See above, paras 5.29 – 5.31, for discussion of the circumstances in which the duty to balance would be excluded or modified.    [Back]

Note 41    See above, paras 5.19 – 5.26.    [Back]

Note 42    [2000] WTLR 795, 803.    [Back]

Note 43    Re Hastings-Bass [1975] Ch 25.    [Back]

Note 44    For example, by making them subject to the income and inheritance tax regimes applicable to discretionary trusts.    [Back]

Note 45    But see below, paras 5.67 – 5.76, where we invite views as to the correctness of the Nestle approach in the context of trustee investment.     [Back]

Note 46    The other members of the Court of Appeal panel (Dillon and Leggatt LJJ) expressed no opinion on relevance of personal circumstances to the duty to balance.    [Back]

Note 47    “The trustees have in my judgement a wide discretion. They are for example entitled to take into account the income needs of the tenant for life or the fact that the tenant for life was a person known to the settlor and a primary object of the trust whereas the remainderman is a remoter relative or a stranger. Of course, these cannot be allowed to become the overriding considerations but the concept of fairness between classes of beneficiaries does not require them to be excluded.” ([2000] WTLR 795, 803, per Hoffmann J).    [Back]

Note 48    [2000] WTLR 795, 803.    [Back]

Note 49    InNestlé, Staughton LJ ([1993] 1 WLR 1260, 1279) did not limits his comments regarding personal circumstances to the duties of trustees in selecting investments. It is clear that his Lordship was discussing the content of a more general duty to preserve an “equitable balance”. See also, Re Pauling’s Settlement Trusts (No. 2) [1963] Ch 576, 586, per Wilberforce J (cited with approval by Staughton LJ in Nestlé at 1279).    [Back]

Note 50    [2000] WTLR 795, 803.    [Back]

Note 51    Ibid.    [Back]

Note 52    As considered above, paras 5.56 – 5.66.    [Back]

Note 53    Although we recognise that there is a danger of drawing too sharp a line between so-called “fixed” and “discretionary” trusts, it is useful to consider the paradigmatic fixed interest trust by way of simple illustration.    [Back]

Note 54    The Powers and Duties of Trustees (1982) 23rd Report of the Law Reform Committee, Cmnd 8733, para 3.37.    [Back]

Note 55    We agree with the views of the Scottish Law Commission on this question: see Discussion Paper on Apportionment of Trust Receipts and Outgoings (2003) Scot Law Com No 124, para 2.40.    [Back]

Note 56    See above, paras 5.19 – 5.26.    [Back]

Note 57    Assuming, of course, that all the beneficiaries are sui juris and together absolutely entitled to the trust property.    [Back]

Note 58    See Trustee Exemption Clauses (2003) Law Com Consultation Paper No 171, paras 4.63 – 4.66, for discussion of the inadequacy of section 61 of the Trustee Act 1925 as the basis of exculpatory relief.    [Back]

Note 59    This will not be possible when the life tenant has died.    [Back]

Note 60    See above, paras 3.36 – 3.43, 3.53, 3.63.    [Back]

Note 61    Trustee Act 1962, s 105.    [Back]

Note 62    Trustee Act 1956, s 85.    [Back]

Note 63    Wills, Probate and Administration Act 1898, s 46D (New South Wales); Trustee Act, s 74 (Victoria); Trusts Act 1973, s 78 (Queensland); Trustees Act 1962, s 84 (Western Australia).    [Back]

Note 64    Trustee Act RSO 1980, c 512, s 49(1)(a).    [Back]

Note 65    Trustee Act RSBC 1979, c 414, s 101(1)(a).    [Back]

Note 66    Trustee Act RSM 1970, c T160, s 34.    [Back]

Note 67    Trustee Act 1956, s 84.    [Back]

Note 68    See above, paras 3.81 – 3.87.    [Back]

Note 69    This is not the case for realty; section 4 of the Trusts of Land and Appointment of Trustees Act 1996 provides that an express trust for sale of realty automatically includes, despite any express provision to the contrary, a power to postpone sale of the land.    [Back]

Note 70    See above, paras 3.6 – 3.14.    [Back]

Note 71    See above, paras 5.49 – 5.55.    [Back]

Note 72    The extent to which duty exclusion or extended power clauses should be given effect was considered in Trustee Exemption Clauses (2003) Consultation Paper No 171, paras 4.89 – 4.97.    [Back]

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