Background and Summary Capital and income in trusts
5.The Act gives effect, subject to minor modifications, to the recommendations made in the Law Commission’s Report Capital and Income in Trusts: Classification and Apportionment (Law Com No. 315). It makes changes to technical rules of trust law which apply to trustees who have to distinguish between capital and income in managing the property of a private trust or a charity.
6.In this context, capital is trust property that constitutes a pool or fund of assets, and is to be distinguished from the income earned on those assets. The metaphor of a tree and its fruit is illustrative: the “tree” is the capital (such as an office block), and the “fruit” is the income (such as the rent received from renting out the offices). Trustees who manage capital assets and receive income are likely to have to invest to preserve the value of the capital and to produce the required income. In dealing with returns on investment, they may have to distinguish between beneficiaries entitled to receive income and beneficiaries entitled to receive capital. Trustees’ powers and duties in relation to investment are governed not only by the terms of the trust itself, but also by the general law: in particular, by the Trustee Act 2000. Under the 2000 Act, trustees are given a general power of investment, but this is subject to duties such as the requirement to exercise reasonable care and skill, and to have regard to standard investment criteria.
7.Under the trust, one class of beneficiaries may be entitled to capital, and another to income. For example, a private trust (the AB Trust) may be established by a person making a gift of investments on trust “for A for life, with remainder to B”. The trustees will pay the income arising on the investments to A until A dies, and then transfer the investments to B. A is termed the “life tenant”, and B the “remainderman”; such a trust, which shares property and income over time, is termed a trust “for interests in succession”.
8.Because of the different entitlements to income and capital, the trustees must distinguish between investment receipts according to their legal classification as income receipts due to A, or capital receipts which must be held for B and can be invested to produce income. They may also need to apply rules of apportionment between capital and income, which can affect the beneficiaries’ entitlements; for example, by requiring the trustees to apply some of a capital receipt as though it were income (see paragraphs 11 and 12 below).
9.Similar issues arise in relation to charities with a permanent endowment. A permanent endowment is a protected fund which is subject to restrictions on what may be spent on the charity’s purposes. This means that in order to achieve a balance between the charity’s current and future purposes, the trustees must select their investments according to the likely form of the return as income or capital; capital receipts must generally be added to and held as part of the permanent endowment fund, and only income receipts can be spent. If that balance is not actually reflected in the returns received, the trustees cannot take a view over the whole return and reallocate capital and income returns – they are constrained by the form the returns actually take. Therefore, they cannot follow the approach to investment taken by many other trustees, who are able to invest with a view to the overall return; selecting investments on the basis of achieving an appropriate balance between risk and return in accordance with the general law governing trustees’ investment duties.
10.The Act makes three changes to the current law.
	It disapplies, for new trusts:the statutory rule requiring the apportionment of income over time imposed by the Apportionment Act 1870, insofar as it relates to trusts; andthree 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.
	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.
	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.