Distinction between capital and income
P18 The default provisions should give trustees a power to determine what is capital and income for the purposes of distribution to allow them to invest trust assets without regard to whether the return is of an income or capital nature. Trustees would be required to act reasonably and in the best interests of the beneficiaries overall. Where there are defined classes of beneficiaries trustees should ensure a reasonable level of income is made available for the income beneficiaries. In such cases trustees would have to adopt a suitable mechanism to determine how much of the total should be distributed to the income beneficiaries.
Please give us your views on this proposal.
5.13An important aspect of the trustees’ investment obligation is the duty to be even-handed between beneficiaries. This duty, preserved by section 13F, requires trustees to act impartially between the interests of different classes of beneficiaries (where there are classes). While the duty of even-handedness retains its validity as a general principle, the way present trust law requires it to be applied is now out of keeping with the nature of the investment market and investment strategy. The problem arises most acutely where there are beneficiaries with a life interest and others (remainder beneficiaries) with a capital interest in the trust fund. The duty can be overridden by the terms of the trust and very often is. However, if it is not, the law requires income to go to the life tenants and capital appreciation to go to the remainder beneficiaries. The trustees must consequently ensure that the trust investment policy does not unfairly prejudice either income or capital beneficiaries. Trustees are not permitted to disregard the distinction between capital and income for the purposes of investing so cannot do what non-trustee investors do, which is invest for a maximum return. It is the duty of the trustee to achieve a mix of investments so that all classes of beneficiaries are catered for, and none are disadvantaged.
5.14One of the key principles of modern day portfolio investment theory is that it is artificial to distinguish between capital and income when investing. Instead modern portfolio management assesses investment options based on their overall total return regardless of whether it is correctly categorised as capital or income. However, as discussed, the default provisions in the Trustee Act do not allow trustees to disregard the distinction between capital and income when investing. This limits the ability of trustees to apply principles of modern day portfolio investment and invest for the overall maximum total return. If trustees must invest with a view to balancing the capital and income returns, both categories of beneficiaries are likely to be dissatisfied because neither will benefit from an optimal rate of return. An important issue is therefore whether the respective interests of all beneficiaries can be better protected through an emphasis on the duties of trustees without requiring trustees to maintain what has become quite an artificial distinction between capital and income.
Options for reform
5.15The options we considered were:
- retaining the status quo – a requirement that trustees select investments with regard to the legal category of the returns received; or
- introducing a new default provision that allows trustees to follow a total return investment policy.
5.16Default provisions that better supported a total return investment policy would free trustees from the requirement to select investments with regard to the legal category rather than overall return. Within the parameters of their duty of prudence, trustees would then be able to maximise the gain to the trust portfolio. The key principle here is that investment decision-making should be separated from distributional issues.
5.17There are several options for how legislation could allow a total return investment policy:
- Option A − Trustees determine what is capital and income. Trustees would be required to make a reasonable decision as to what is capital and income for the purposes of distribution. This approach relies on trustees’ duties rather than prescribing rules for trustees to follow. Trustees, guided by their duties to beneficiaries, would be required to act in the best interests of all beneficiaries. This approach would allow trustees to then make investment decisions based on total return without having to consider whether the return is income or capital appreciation. Under this option trustees might pick a fund for investment based on total overall growth and then make a reasonable determination as to what portion should be distributed as income.
- Option B − Percentage trusts. Under the percentage trust model trust assets are valued on a periodic basis and a percentage of the total value may then be distributed without regard to the distinction between capital and income. Distributions are made first from revenue and then, to the extent of any deficiency, from capital. Any revenue in excess of the percentage amount is added to capital. Overseas law reform bodies have recommended legislating for percentage trusts as an approach that permits trustees to follow a total return investment policy. The British Columbia Law Institute Committee took this approach. It was also considered by the Law Commission for England and Wales to be the model most likely to be successful in facilitating total return investment. If New Zealand adopted this approach, the default provisions could permit trustees to invest on a percentage trust where this is not prohibited by the trust deed.
- Option C − Discretionary allocation trust. This option would give statutory recognition to discretionary allocation trusts, while making provision for the percentage trust as the default. The default provisions would provide that if a trustee was directed by the deed to hold the trust property on a discretionary allocation trust, the trustee could allocate and apportion receipts between income and capital accounts without regard to their legal categorisation. Trustees could recover disbursements from either income or capital regardless of the account from which the disbursement was paid or to which it was allocated, and trustees could also deduct for depreciation from income and add an equivalent amount to capital to protect capital beneficiaries. This approach was recommended by the British Columbia Committee also because the percentage trust will not be suitable for discretionary trusts that give trustees a discretion whether to make distributions and, if so, how much.
5.18Submitters overwhelmingly supported provisions that facilitate a total return investment policy. We agree that this is the appropriate approach for new legislation. Submitters commented that trustees should be required to maintain a fair balance between income and capital beneficiaries and ensure that a reasonable level of income is obtained. Against this backdrop a number said trustees should be free to decide to invest on a total return basis provided this is not prohibited by the trust deed. Submitters considered that relying on the underlying duty of trustees to be impartial and make fair and equitable distribution between all classes of beneficiaries was a better approach than retaining the capital/income distinction when investing. The view of most submitters was that trustees could invest more effectively if they were not constrained by the obligation to provide an expected level of income for the benefit of an income beneficiary.
5.19Of the three options for a total return investment approach, we favour the permissive approach of option A that relies on the important duties trustees have to beneficiaries instead of specifying any particular allocation mechanism. As discussed in chapter 3, we propose to strengthen those duties and give them greater prominence in the new Act. Option A allows trustees guided by their duties to adopt the most suitable mechanism to determine how much of the total fund should be distributed to income beneficiaries. Many recent trust deeds already permit this approach. Where the trust deed allows, trustees would have the discretion to take a percentage approach. Submitters generally favoured the broad power under option A. They considered the powers should be subject to safeguards, including the duty to be impartial and to act justly and equitably, in accordance with normal business practice, and in the best interests of the beneficiaries.
5.20The few submitters who commented on the percentage trust approach (option B) considered that percentage trusts are not well understood in New Zealand and that legislation would consequently be leading the way if this approach were taken. While percentage trusts have become a feature of other jurisdictions, there has been little development or interest in the model in New Zealand so far. This is understandable because the percentage trust model is not very suitable for discretionary trusts that give trustees a discretion as to whether and how to make distributions. The New Zealand trusts landscape is distinguished by significant numbers of discretionary trusts. The percentage trust is also not particularly suitable for a trust designed primarily for capital accumulation and distribution later on.
5.21Some submitters considered that the percentage trust mechanism has merit, but for it to work there would also need to be reform to tax law to allow for the appropriate treatment of income under the percentage trust. Submitters also identified other complexities, such as asset valuation periods, with the percentage trust model that would need to be addressed before it could be specified in legislation.
5.22A few submitters commented on the discretionary allocation trust model (option C). They considered that trustees should still be subject to the obligation to act even-handedly towards beneficiaries. One submitter noted that provision for discretionary allocation trusts would be necessary if percentage trusts were to be provided for in legislation.
5.23Where trusts have income beneficiaries the traditional capital and income allocation rules stand in the way of trustees maximising the total return on investment. If trustees are able to determine what was capital and what was income for the purposes of distribution then they will be able to invest more effectively and maximise returns. The approach in option A is a flexible alternative to the current strict capital/income distinction. Trustees would have a broad discretion but would always be required to act in accordance with their underlying duties. Trustees would be required to maintain a fair balance between the interests of all beneficiaries. As is discussed in the next section, the apportionment of receipts and outgoings between capital and income should be undertaken in accordance with accepted business practice. We consider that the approach proposed below to apportionment, together with the trustee’s general duties, should be sufficient to maintain a fair balance between the interests of different classes of beneficiaries.