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Matthew Hutton MA, CTA (fellow), AIIT, TEP comments on the recent Special Commissioners' decision in The Peter Clay Discretionary Trust v HMRC.

Context

HMRC’s guidance on trust management expenses published on 2 February 2006 said at para 9.34 about trustees’ fees: ‘The irresistible conclusion is that the annual fee reflects work on behalf of both income and capital.  Since the work done is for the benefit of the whole estate the fee should be charged to capital …’ in the words of the Law Commission Paper, and so concluding that on general principles trustees’ fees are properly payable out of capital. 

Para 9.42 of HMRC’s guidance conceded that the whole issue was likely to be the subject of litigation in the near future. 

The trustees of The Peter Clay Discretionary Trust v HMRC: the facts

There was an agreed statement of facts and issues as follows:

The case arose out of a dispute between HMRC and the trustees of a UK resident discretionary trust, made by Peter Robert Clay on 5.12.95 and known as the Peter Clay Discretionary Trust, as to the amount properly deductible for income tax purposes under TA 1988 s686(2AA) as being expenses properly chargeable to the income of the trust.  The dispute arose in respect of the year of assessment ending 5.4.01, but the resolution of the dispute is likely to have a bearing on the position for subsequent years.  

In essence the dispute raises the question of whether it is proper for trustees as a matter of the general law (that is to say disregarding, in accordance with the relevant statutory provisions in this behalf, any express provision in their trust) to charge part of certain annual expenses to the income of their trust, on the footing that that is the proper application of the general rules as top the incidence of trustee expenses; the ambit of the dispute includes specifically the following categories of expense namely (i) trustees’ fees (ii) investment management fees (iii) bank charges (iv) custodian fees and (v) professional fees for accountancy and administration. 

As part of the argument, HMRC have sought to say that trustee remuneration is in any event not an expense of the trust; in the alternative HMRC said that remuneration is an expense incurred for the benefit of the beneficiaries of the trust as a whole and so must be charged in its entirety to capital.  The Appellants said that that cannot be correct, as a matter of looking at fees which are charged for services which relate to various different types of activity, some designed exclusively for the purpose of producing the proper income from the trust and others designed for general purposes or with express regard to capital.  They said on authority that it is clear that some part of the trustees’ fees must properly be regarded as ordinary and recurrent expenses of the trust which should be charged to income and that here too, as in the case of the investment managers’ fees and bank charges, a proportion of these fees is plainly incurred as a result of the receipt of income and is chargeable to income accordingly.  They said the proportion they have claimed is reasonable on the facts of the case. 

The decision: SpC (Adrian Shipwright and Dr John Avery Jones)

It is surprising that there is no authority about attribution of a single expense.  The Special Commissioners agreed with Mr McCall that the underlying general principle is to achieve fairness between beneficiaries entitled to income and capital.  As Trustee Act 1925 s22(4) illustrates, the expenses of an audit can be attributed between income and capital, presumably on the basis that different work is performed on the income and expenditure account than on the balance sheet. 

Therefore the approach preferred is that one should attribute between income and capital unless the expense really is a capital expense where the interest of the income beneficiary is merely the consequential loss of income on the capital that goes to pay the expense.  Examples of this in Carver v Duncan are the insurance premiums, whether on an endowment policy which is essentially an investment, or a term policy, which protects the capital in the event of the settlor’s death, and the investment managers’ fee, described by Lord Templeman at p.1120-1 ‘to keep under review and to advise changes in investments comprised in the trust fund’ … ‘because the advice of the investment advisers will affect the future value of the capital of the trust fund and the future level of income arising from that capital’. 

The Special Commissioners’ views on each type of expense were as follows:

(1) The accountancy fees relate in part to the separate work on checking and recording the income and that part is properly attributed to income.

(2) The custodian fees relate in large part to the collection of income on foreign investments. The Special Commissioners considered that an attribution should be made between income and capital.

(3) Mr Stockwell’s fee based on the time spent can be attributed in part to income in exactly the same way as if a bank trustee had charged separate income and capital fees, as in In re Roberts Will Trusts. The Special Commissioners did not consider that the fixed fee paid to the non-executive trustees should be attributed partly to income. The distinction is that the fee of the non-executive trustees does not vary according to the amount of work attributed to income, as does Mr Stockwell’s fee, and it should therefore properly be treated as expenses incurred for the benefit of the whole estate which should be charged to capital.

(4) The bank charges relate in part to the ordinary receipts and payments the majority in number of which are likely to be of an income nature, while another account relates to an overdraft on capital account. The Special Commissioners considered that part of the charges for the former account should be attributed to income.

(5) The work of the investment managers is wider than that described by Lord Templeman in Carver v Duncan as being ‘to keep under review and to advise changes in investments comprised in the trust fund’, reflecting the evidence from both witnesses about the change in the nature of the role of investment managers in the 1990s. The Special Commissioners did not therefore consider that the position is conclusively determined by Carver v Duncan. However, the work is predominantly attributable to capital, particularly when, as here, the Custodian does the bulk of the work relating to the income.
 
The only part seriously contended for attribution to income is the investment of accumulated income. If the accumulation were for a particular child then it would be proper to attribute the cost of investment of those accumulations to that fund, as opposed to the capital generally. Here since accumulations of income can be paid as income of a future year they are held on different trusts from the original capital and it would be proper to charge the fund with its investment rather than the whole capital. But the real question is whether because one is dealing with income until the accumulation takes place this is to be attributed to income. In the Special Commissioners’ view accumulation of income takes one beyond the point at which the expenses are ‘properly chargeable to income’. The trustees will have resolved to accumulate the income, at which point it become capital and the expenses of investing it are capital. The position might well be different if the trustees are temporarily investing income while deciding whether to accumulate it.

Timing

One would expect a correlation between the timing of the income and expenses which is best achieved if the expenses are computed on an accruals basis and set against the income of the year in which the income accrues. If expenses are computed on a cash basis it will often happen that they are set against income of a subsequent year from that in which they are incurred, which loses the correlation and may have the effect of reducing the income of different beneficiaries, or the nature of the trusts may have changed. The Special Commissioners did not consider that subs (2AA) is trying to be prescriptive about the timing of the expenditure since the timing of the income against which the expenditure is set depends on the nature of the income. While the Special Commissioners considered that an accruals basis achieves a better result in terms of fairness between income and capital beneficiaries and is more suitable to larger trusts such as the one in this appeal, they did not consider that a cash basis, which may be easier to operate in practice for smaller trusts, is wrong.

(The Trustees of The Peter Clay Discretionary Trust v HMRC 27.2.07, report supplied to me by Simon Jennings of Rawlinson & Hunter)

Comment

As noted in the second paragraph under Context above, HMRC had been anticipating a legal challenge – and here is a strong judgment in favour of the taxpayer.  The case will undoubtedly go further however, though it is good news at this early stage.

More Information

The above article has been taken from Matthew Hutton’s Capital Tax Review, a quarterly update for professional advisers of private clients. For more information, visit http://www.taxationweb.co.uk/books/capital_tax_review.php

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