Income or capital?

Trusts Discussion
1

The trustee of a trust distributes income to a life interest beneficiary and capital to the remainder beneficiaries on the life beneficiary’s death. The corpus is predominantly shares. Normally the income is about $100,00 per year. One year he receives a distribution of $1.25 mill. The company from which it comes declares it a dividend, and therefore it is prima facie income. But the “dividend” comes from the sale of a substantial asset (of a private company). The company is not being wound up, is still valuable, but now has less assets. It sounds like a return of capital, but appears in the revenue accounts, not capital accounts, of the company.
Hill v Permanent Trustee Co of New South Wales [1930] AC 720, Privy Council and the cases following it suggests dividends must be income. We have looked at cases in UK, Australia, New Zealand, Canada and Hong Kong. Does anyone know of anything elsewhere that might assist?
The trustee has, of course, made an application to the court for a direction as to how the amount should be treated in the trust, as opposed to in a tax/revenue environment.

Rebecca Treston QC
Callinan Chambers

2

An interesting question on which unfortunately I am unable to give a
definitive answer but would make some observations as this is a conundrum
that has no doubt arisen before, will arise in the future - especially if
trusts hold shares in US companies.

I note the use of the $ sign and wonder whether the transaction described
arose because what might have been considered in the UK to be a capital
transaction was instead under US tax law treated as an income dividend
payment.

Recently Johnson Controls Inc merged with Tyco and shareholders in Johnson
Controls Inc received shares in a new merged company - Johnson Controls
International PLC.

The receipt of these shares has been treated as a dividend for US tax
purposes with US withholding tax being payable! Luckily for shareholders at
the same time there was also a mandatory exchange of some shares for cash
and this cash provided funds, which would not otherwise have been
available, to pay the withholding tax on the receipt of the shares.

Furthermore I understand that shortly Adient will be demerged from Johnson
Controls International PLC and the receipt of these shares will be treated
as a taxable dividend. This time however there will be no cash receipt from
which the withholding tax can be paid. I suspect (and hope!) however that
more or less at the same time as the demerger Johnson Controls
International PLC will pay a dividend and the withholding tax on the
demerged shares will be deducted from that dividend payment.

No doubt you will have already or will be making enquiries as to ascertain
exactly why the distribution was treated as an income dividend rather a
capital payment.

It also occurs to me that it could be said that the transaction you refer
to might be contended to be akin to the enhanced scrip dividend payments
which became popular for tax reasons a few years ago and were the subject
of litigation. Then following a Law Commission report the Trusts ( Capital
and Income ) Act 2013 was enacted.

Andrew Mortimer

1 Like
3

You will find a good discussion of this issue in part II of the English Law Commission Consultation Paper 175, “Capital and Income in Trusts” http://www.lawcom.gov.uk/wp-content/uploads/2015/03/cp175_Capital_and_Income_in_Trusts_Consultation.pdf (2004). (The subsequent report (Law Com 315, 2009) contains a shorter summary discussion, so you want to look at the consultation paper rather than the final report.)

James Kessler QC
15 Old Square
Lincoln’s Inn

4

Over time, I have had to consider a number of these, arising not just from British companies but, amongst others, Swiss and US.

Currently, unless the exception identified in Sinclair v. Lee applies, the decision in Hill v. Permanent Trustee applies, so that trustees of an English Law trust are bound by the company law scenario.

Companies have devised a number of ways of “returning value” to shareholders, some of which enable trustees to receive the “return” as capital. However, many have, and in future may continue to, adopt the dividend route. Several years ago, Ladbrokes made a return to shareholders of about 60% of the share value by way of a special dividend. Income beneficiaries received a bonus at the expense of the capital beneficiaries.

Subsequent arrangements, adopted by the likes of Sainsbury, provided for shareholders to elect to receive the return in the form of different share classes, which was extremely helpful for trustees (provided that their investment manager advised them of the options in good time for a valid election to be lodged). Trustees need to be alive to such events before the date on which the register closes as, where the return of value is likely to be income, they need to consider what action might be taken to protect the value of the trust fund. This could include a sale of the holding cum distribution, and the reinvestment of the proceeds, ex distribution. In some cases, though, the total cost of the transaction (including CGT) may exceed the loss to income, in which case (and subject to relationships between the beneficiaries) it could be preferable to benefit the income beneficiary rather than the brokers and UK Exchequer.

In the case in point, which relates to a situation that has already arisen, it will be necessary to look at the company accounts, and other documents issued by the company in relation to the return of value, to ascertain if it was a return of capital or a distribution of profit. I recall that, in various US states, it is permissible to reduce the issued capital outside of a liquidation without the need for court sanction. If there is no doubt that it is income, e.g. as it is shown directly as a reduction in the P&L account, I fear the trustees are “stuck” with the principle from Hill v. Permanent Trustees.

If the trustees proceed with the application, I believe it would be helpful if the outcome (and judgment) could be shared, mindful that some of the issues the court may be asked to consider could be wider that those in other reported cases.

Paul Saunders

5

It is worth pointing out that particularly in the US, it is common for companies to buy back shares rather than declare or increase their dividend pay-out. After the transaction there will be fewer shares in issue representing the value of the same company and so all things being equal the share price will increase for all the remaining shareholders. (Assuming that the value of the company remains the same but that value is represented by fewer shares)

The process is funded from profit and so the money is clearly “income” but the remaining shareholders receive their benefit in the form of an increase in the share price which is clearly capital growth in their hands.

The distinction between capital and income is complicated as corporate actions might result in capital being distributed in a form that might be treated as income but they might equally result in what is fundamentally income being distributed in a form that is clearly capital growth in the hands of the investor.

Ian Mckeever & Co.

Consulting Actuaries

6

I suspect that if a taxpayer were receiving dividends of $100,000 p/a and making gifts out of income from it and then, on receiving a one-off dividend of $1.25m, he gave $1m of that away, claiming that was a gift out of income too, HMRC would say otherwise.

D Holliday