DPRR/10-12/97
Trusts (Capital and Income) Bill [HL]
Memorandum by the Ministry of Justice
for the House of Lords
Delegated Powers and Regulatory Reform Committee
Introduction
This memorandum describes the purpose and content of the Trusts (Capital and Income) Bill (“the Bill”). It identifies the general content of the Bill; every provision for delegated legislation in the Bill with appropriate background information; explains the purpose of the delegated power proposed; describes why the matter is to be dealt with in delegated legislation; and explains the nature and justification for any parliamentary procedures, which apply.
Background of the Bill
The Bill will give effect to the Law Commission’s legislative recommendations in relation to the classification and apportionment of capital and income in trusts (Law Commission Report No. 315) subject to minor modifications.The Bill has been introduced into Parliament under the House of Lords procedure for uncontroversial Law Commission Bills.
The Bill makes three changes to the current law. First, it disapplies, for new trusts: (a) the statutory rule requiring the apportionment of income over time imposed by the Apportionment Act 1870, insofar as it relates to trusts; and (b) three of the rules of apportionment originating in case law, which require adjustments to be made to the entitlement to income and capital receipts in certain instances. Secondly, it alters the classification of shares received by trustees by way of investment receipts when the company in which they hold shares undergoes a demerger. Where such shares are currently classified as income, they will be classified as capital. Thirdly, it facilitates total return investment for charities with a permanent endowment; trustees will be able to make a resolution opting for new Charity Commission regulations to apply in place of the investment restrictions that currently prevent total return investment. The Bill contains delegated powers in relation to classification and total return investment. There are no delegated powers in relation to apportionment.
More detailed information about the purpose and effect of the Bill and the background to the proposals can be found in the Explanatory Notes published with the Bill.
Delegated Powers
The Bill contains three delegated powers:
- the Secretary of State mayby order specify descriptions of distributions made by bodies corporate for the purposes of clause 2 and 3 of the Bill (clause 2(3)(b));
- the Charity Commission may make regulations relating to the adoption of total return investment by charity trustees (clause 4);
- the Secretary of State may bring the Act into force by commencement order (clause 5(3)).
Clause 2(3)(a) – Power to classify certain corporate distributions as capital
Background
The Bill addresses an aspect of the trust law classification of investment receipts from companies as income or capital: the classification of dividends received by trustee shareholders which are distributions made in the course of a corporate demerger.
Such demergers can be of two kinds: direct and indirect. In each case Company A transfers part of its business to a new subsidiary company, Company B, and then declares a dividend to its shareholders. In a direct demerger the dividend is satisfied by Company A distributing the share capital of Company B to its own shareholders. In an indirect demerger the shares in Company B are transferred to a separate holding company, Company C. In consideration for this transfer, Company C satisfies Company A’s dividend by issuing its own shares to the shareholders of Company A.
Pursuant to a decision of the House of Lords,[1] shares distributed in the course of a direct demerger have to be classified as income. The result of this is that following a company reorganisation by way of a direct demerger, the trust fund’s former capital asset – the original shareholding in Company A – will be effectively split between capital and income to the extent that the value is now represented by shares in Company B. The Company B shares passing to the income beneficiary could represent a substantial percentage of the original shareholding in Company A – far in excess of normal expectations for an income return. However, exceptionally, it was later decided in the High Court that shares distributed in the course of an indirect demerger should beclassified as capital.[2] Therefore, in such a case the shares in Company C retain the classification of the original Company A shareholding; the income beneficiary does not receive a portion of that asset merely by virtue of the corporate reorganisation.
The Bill provides that where the distribution is tax-exempt under section 1076, 1077 or 1078 of the Corporation Tax Act 2010, the shares distributed in direct and indirect demergers will for the future be treated as capital for the purposes of the trust. This reform affects both private and charitable trusts, whenever created.
The delegated power
There are two categories of distributions that are defined as tax-exempt corporate distributions for the purposes of clauses 2 and 3 of the Bill. The first category is distributions that are exempt by virtue of section 1076, 1077 or 1078 of the Corporation Tax Act 2010 (clause 2(3)(a)). The second category is any other tax-exempt distribution of assets in any form made by a body corporate where the distribution is of a description specified by order made by the Secretary of State (clause 2(3)(b)).
The reason for the power
The power to make such an order provides for future developments in tax legislation that create new exempt distributions.If those exempt distributions gave rise to trust law classification problems akin to those described for corporate demergers, it could be appropriate to apply clause 2 to them. The department is not at present aware of any distributions to which the power could be applied.
Procedure
Any order made by the Secretary of State under clause 2(3)(b) must be made by statutory instrument (clause 2(3)(b))and is subject to annulment by a resolution of either House of Parliament (clause 2(6)).
This negative resolution procedure is appropriate as the power is limited to tax-exempt distributions (clause 2(4)). Such distributions can only be created by tax legislation.
Clause 4 - Total return investment for charities regulations
Background
Clause 4 inserts two new sections into the Charities Act 2011. New section 104A enables the charity trustees, if a specified condition is met, to make a resolution replacing the restrictions with respect to expenditure of capital that are imposed by the terms applicable to the permanent endowment with the requirements of the regulations to be made by the Charity Commission under new section 104B. The regulations will specify the Charity Commission’s requirements in relation to the resolutions and the investment on a total return basis. The specified condition is that the charity trustees are satisfied it is in the interests of the charity for the regulations to apply in place of the restrictions.
Charities with permanent endowment are ordinarily restricted in their investment decisions, since they must keep separate income available for current use and capital held to produce future income. Because investment returns that trust law classifies as capital cannot be spent on current charitable purposes, trustees of charities with permanent endowment have to pursue an investment strategy which produces sufficient income yet maintains a balance between capital and income returns. Trustees must therefore invest with a view to the likely form of the receipt – as income or capital – in an endeavour to ensure that future investment receipts do not favour income or capital disproportionately.
By contrast, under total return investment, trustees invest with a view to optimising the overall investment return, no matter whether that takes the form of capital or income. The trustees then decide how much of that overall return should be allocated to be expended on current charitable purposes and how much should be retained to produce future returns; even if that means retaining returns classified as income. While in taking those decisions trustees have to balance the need for current expenditure and the need to maintain the long term capital value of the fund, decisions on investment are not influenced by the requirement to generate returns that take the form of income or capital, as the case may be. The usual considerations when trustees invest – in particular, the need to balance risk and return – still apply.
At present, trustees of charities with permanent endowment can only operate total return investment if they apply to the Charity Commission for an order enabling them to do so, in accordance with the Charity Commission’s scheme for total return investment set out in its Operational Guidance.[3]
The delegated powers
The new section 104B of the Charities Act 2011 (to be inserted by clause 4) gives the Charity Commission power to make regulations enabling total return investment.This power is in addition to the existing powers of the Commission to make regulations under Part 6 of the 2011 Act (see sections 63, 65 and 169).
Section 104B(1)(a) enables regulations to be made concerning resolutions under section 104A(2). Section 104A(2) enables the charity trustees to pass a resolution in respect of part or the whole of the permanent endowment fund where they consider that it ought to be freed from the applicable restrictions to enable investment without the need to maintain a balance between capital and income returns. The effect is that the relevant restrictions on capital expenditure no longer apply to the fund affected by the resolution; instead, the Charity Commission’s total return investment regulations apply (section 104A(4)). The charity trustees must be satisfied that this is in the charity’s interests in order to pass a resolution under section 104A(2): section 104A(3).
Section 104B(1)(b) enables the Charity Commission to make regulations concerning the investment of the relevant fund on a total return basis, and the expenditure from such a fund. “Relevant fund” is defined in subsection (6), and includes both the fund affected by the resolution under section 104A and all investment returns on it, both capital and income.
Section 104B(2) and (3) contains an illustrative list of requirements and restrictions that may be included in the regulations; it will be for the Charity Commission to decide on the specific provisions. For example, the Charity Commission may make regulations requiring charity trustees to notify the Commission of the making of a resolution within a specified period of it being passed or imposing restrictions on expenditure or requiring investment and allocation of investment returns in such a way as to maintain the long term capital value of the fund, so far as practicable. Nothing in this clause affects the general duties of charity trustees, for example to have regard to both present and future needs of the charity.
Section 104B(1)(c) enables the Charity Commission to make regulations about action the charity trustees need to take in respect of a part or the whole of a fund if a resolution previously made under section 104A ceases to apply to it. This power could, for example, be used to require the capital fund of the trust to be replenished in cases where there is a shortfall.
Provisions for the accumulation of income (that is, converting income to capital) may be included in the regulations made under section 104B(1)(b) and (c). Section 104B(4) states that any such provisions are not subject to section 14(3) of the Perpetuities and Accumulations Act 2009, which restricts any accumulation of income to the statutory accumulation period of 21 years.
Why the power is necessary
The powers to make regulations in section 104B are necessary so that the Charity Commission can design and provide support for a detailed total return investment scheme for charities. Although the Commission authorises total return investment on an individual basis following application by a charity, it has not yet developed regulations appropriate for all charities. Any such regulations may be detailed and are likely to require adjustment from time to time. It would therefore be inappropriate to include them within primary legislation.
To help ensure that the regulations ultimately made are suitable the Commission proposes to consult publically on its proposals for the scheme before finalising the regulations. However, drawing on its experience of the present system of authorisation following application, the Commission currently envisages that the principal features of the regulatory scheme to be implemented under the regulations will be as described in Annex A.
Procedure
Regulations made under section 104B are not subject to any Parliamentary scrutiny procedure. This follows the general approach of the Charities Act 2011 (see sections 347 – 349) and is appropriate because the conditions of total return investment are best determined by the Charity Commission in its general role as the statutory regulator of charities.
The regulations are to be made in such manner as the Charity Commission determine. They are not required to be made by statutory instrument. However, under section 347 of the Charities Act 2011 any regulations of the Commission may make different provision for different cases or descriptions of case or different purposes or areas, and contain such supplemental, incidental, consequential, transitory or transitional provision or savings as the Commission considers appropriate. This is appropriate given the technical content of the regulations and the role of the Commission as statutory regulator of charities. The Commission must, however, publish the regulations in such way as it thinks fit (new section 104B(5). This also corresponds with the general practice of the Commission.
Clause 5(3) - Commencement
The delegated power
Clause 5(3) enables the Secretary of State to bring the provisions of the Bill (other than clauses 5 and 6 which come into force on the day the Act is passed) into force on such day or days as he may appoint by order. The order may make such provision as the Secretary of State considers necessary or expedient for transitory, transitional or saving purposes in connection with the coming into force of any provision of the Bill.
Why the power is necessary and procedure
The clause 5(3) power is a standard power exercisable by statutory instrument and is not subject to any resolution procedure. It will enable adequate time for those affected to make the necessary preparations. It may be the case that the provisions of the different clauses, particularly clause 4, are brought into force at different times.
Territorial Extent
The Bill extends to England and Wales only. The Bill does not deal with provisions within the legislative competence of the National Assembly for Wales and does not affect the functions of Welsh Government Ministers.
Ministry of Justice
February 2012
Annex A The draft regulations
Charities Act 2011
The Charities (Total Return) Regulations 20xx
Made xx xxxxxx
Coming into force xxxxxxxxxxxxxx
In exercise of the powers conferred on it by section 104B of the Charities Act 2011 the Charity Commission for England and Wales makes the following regulations:
Part 1 – General Provisions
- These regulations may be cited as the Charities (Total Return) Regulations 20xx and come into force on xxxxxxxx.
- In these regulations:
“the 2011 Act” means the Charities Act 2011;
“expendable endowment” means a capital fund which the trustees may convert into income;
“investment return” means the return from investments which represent the assets given to the charity on a trust for investment and includes:
- any interest receivable; plus
- any net rent and other income or gains derived from the use or exploitation of assets; plus
- any dividends; plus
- all forms of capital gain resulting on, or from, the disposal, redemption, or revaluation of investment assets (including the issue or repayment of share or loan capital); less
- any capital losses resulting on or from the disposal, redemption, or revaluation of investment assets;
“negative total return” means that the total return represents a reduction in the value of the relevant fund;
“relevant fund” has the same meaning as in section 104B(6) of the 2011 Act;
“relevant percentage” is the percentage equivalent to the rise in the retail price index or in the consumer price index for the financial year in which the allocation is made;
“relevant value” is the value of the trust for investment having deducted from that value the amount of any unapplied total return included within it;
“total return” means the whole of the investment return received by a charity, regardless of when it has arisen;
“total return approach to investment” means an approach to investment which gives trustees flexibility in the way they allocate the total return arising from the trust for investment between the trust for application and the trust for investment;
“trust for application” means a trust that attaches to charity property which the trustees have to apply for the purposes of the charity within a reasonable period of receipt;
“trust for investment” means a trust that is created when a gift to a charity is made on the condition that it should not be applied directly for the purposes of the charity, but instead should be invested to produce a return. This return is then to be applied for the purposes of the charity;
“unapplied total return” means that part of the total return which has not been allocated to either the trust for application or the trust for investment.
Part II – Adoption of a total return approach to investment
3.(1) These regulations apply where the trustees of a charity with an available endowment fund (as defined in section 104A(5) of the 2011 Act) make a resolution under section 104A(2) of the 2011 Act.
(2) The trustees shall identify and record, at the time when a resolution under section 104A(2) is made, which part of the existing assets of the charity represents its unapplied total return.
(3) The trustees may decide, at any time, and from time to time, subject to these regulations but otherwise at their discretion, what part of the unapplied total return should be held on the trust for application and, subject to regulation 5, what part of the unapplied total return should be accumulated as part of the trust for investment.
(4) The unapplied total return which is not allocated to the trust for application nor accumulated in the trust for investment shall be dealt with in the same way as the trust for investment until it is so allocated or accumulated.
- The trustees may, in exercising their powers in respect of a relevant fund, allocate part of the relevant fund not exceeding 10% of the total value of the relevant fund (deducting the amount of any unapplied total return) to the trust for application subject to its recoupment on a pound for pound basis over a period to be reasonably determined by the trustees. When exercising this power trustees should have regard to the duty set out in regulation 6 (2) below.
- The trustees may, as part of the exercise of their powers in respect of a relevant fund accumulate in the trust for investment an amount from the investment return which does not exceed the relevant percentage of the relevant value.
- The trustees shall comply with the following directions as to matters connected with, or arising out of, the exercise of their powers in relation to a relevant fund:
(1) When using those powers, and when discharging the duties set out in regulation 3 (2) and (4) above and 6 (2) and (3) below, each of the trustees has a duty to exercise such care and skill as is reasonable in the circumstances, having regard in particular: