Distinction between capital and income
R15 The new Trusts Act should provide that:
(1) To facilitate total return investment and allow trustees to invest trust funds without regard to whether the return on investment is technically of an income or capital nature, trustees should have discretion to determine whether a return is to be treated as income or capital for the purposes of distribution.
(2) Trustees should be required to exercise their discretion on how a return is to be treated in a manner that is consistent with their duties as trustees and fairly and reasonably takes into account the interests of all beneficiaries.
(3) Trustees should ensure that a reasonable level of income is made available for income beneficiaries in situations where there are defined classes of beneficiaries. Note
The discretion of trustees to decide what is to be treated as income or capital is for the purposes of trust law and does not in any way alter or override the definitions and application of the revenue statutes, for the purposes of taxation.
The duty of impartiality and modern portfolio investment theory
7.17A key principle 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. The default provisions in the Trustee Act do not allow trustees to disregard the distinction between capital and income when investing. Trustees have a duty, preserved by section 13F, to act impartially between the interests of different beneficiaries (and classes of beneficiaries where there are classes). This default duty can be, and often is, overridden by the terms of the trust. However, when it is not, it limits the ability of trustees to apply principles of modern day portfolio management and invest for the overall maximum total return.
7.18Problems mostly arise where there are beneficiaries with a life interest and others (remainder beneficiaries) with a capital interest in the trust fund. If the duty of impartiality has not been overridden, then 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.
7.19Where 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. To address this issue we recommend a new default provision which frees trustees from the requirement to select investments with regard to the legal category rather than overall return. The recommended approach will better support trustees adopting a total return investment policy. Within the parameters of their duties, 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.
7.20The Commission considered several options, including recommending the percentage trust model, as law reform bodies in some other jurisdictions have done. Under the percentage trust a percentage of the total value of the trust assets is distributed annually in place of income. However, while submitters overwhelmingly supported reform facilitating total return investment, there was little interest in or understanding of the percentage trust approach. Some said that it is not well understood in New Zealand and legislation would be ahead of practice. An important consideration that steered us away from percentage trusts was that it is unsuitable for trusts that give trustees a discretion as to whether and how to make distributions. The New Zealand trust landscape is distinguished by significant numbers of such discretionary trusts so we found the percentage trust model unsuitable as a default provision.
7.21Instead the Commission has recommended that trustees be able to determine what is capital and income for the purposes of distribution. Trustees would be required to make such determinations in a manner that is consistent with their duties as trustees and fairly and reasonably takes into account the interests of all beneficiaries. This approach relies on trustees’ mandatory duties rather than on prescribing rules for trustees to follow. Trustees, guided by their duties to beneficiaries, would have discretion to adopt a suitable mechanism to determine how much of the fund should be returned to income beneficiaries (where this is applicable) but would be required to do this in a manner that is in the overall interests of all beneficiaries.
7.22Many recent trust deeds already permit this approach because it allows an investment strategy aimed at the best total return without concern over whether the return is technically income or capital appreciation. The view of most submitters was that trustees could invest more effectively if they were not constrained by distinctions between income and capital growth.
7.23The discretion of trustees to decide what is to be treated as income or capital for purposes of trust law does not necessarily alter income tax obligations.