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Capital Tax Review by Matthew Hutton, MA, CTA (Fellow), AIIT, TEP

Matthew Hutton MA, CTA (fellow), AIIT, TEP author of Capital Tax Review, comments on recent HMRC guidance, and its effect on future trust management expenses claims.

Context

Following the first draft of HMRC’s paper issued in September 2004 and the revised version in June 2005, a final paper has now been released (see CTR Issue 11 (Summer 2005) Item 21). It is to be applied to 2005/06 and subsequent returns of income for trustees of accumulation and discretionary trusts and for income beneficiaries of interest in possession trusts.

What follows reproduces some of the content of the guidance, especially where this has been amended from the June 2005 version.

‘2. CASE LAW ON EXPENSES – INCOME VS. CAPITAL EXPENSES

2.6 The main case on trust management expenses is Carver v Duncan, 59 TC 125. Lord Templeman explains that the issue in that case involved the consideration of two issues: the trust question of the incidence of trust expenditure as between income and capital; and the tax question of the deductibility of expenses for the purpose of calculating income chargeable to what are now the special trust rates in S686 ICTA 1988. The case did not touch on tax aspects of interest in possession trusts.

2.10 The general rule in trust law is that income 'must bear all ordinary outgoings of a recurrent nature, such as rates and taxes, and interest on charges and incumbrances' while capital 'must bear all costs, charges and expenses incurred for the benefit of the whole estate'. At this point Lord Templeman is addressing only the first issue, the trust law position. He is not saying anything about the tax position.

2.12 The fact that something is recurrent does not necessarily mean it is of an income nature. The annual premiums in Carver v Duncan were 'a recurrent charge but not an ordinary outgoing', and remained capital.

2.13 In re Bennett (1896) 1 Ch 778 affirms the trust principle that expenditure incurred for the benefit of the whole estate is a capital expense.

2.14 In sum, Carver v Duncan establishes that anything expended for the benefit of the whole estate, that is both income and capital, is to be charged to capital. There is no suggestion in case law that there is any basis for apportioning expenses that are incurred for the benefit of the whole estate into income and capital costs. This is a trust law principle affecting both accumulation/discretionary trusts and IIP trusts.

2.15 Annual fees paid to a firm of investment advisers to keep under review and to advise changes in investments comprised in the trust fund are also capital, as established in Carver v Duncan. Such fees 'are incurred for the benefit of the estate as a whole 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.' This confirms that even if income is affected, the item remains chargeable to capital because it is for the benefit of both income and capital.

2.16 Carver v Duncan also establishes that income bears the cost of 'ordinary outgoings', which are payments made 'in order to secure the income of the property'. That is, they are not made in order to distribute the income or apply it in any way, but to 'secure' it.

4. PRINCIPLES OF TMEs IN ACCUMLATION/DISCRETIONARY TRUSTS

Relief against the special trust rates

4.2 There are certain situations where items that are capital in trust law are deemed to be income for tax purposes, and are also taxable at the special trust rates. If the item is liable to tax at the special trust rates by virtue of being 'treated as income to which S686 applies', for example as in S686A(3) ICTA 1988 (company purchase of own shares) then the trustees are also entitled to relief for allowable TMEs under S686(2AA) against that deemed income. If the deemed income is liable to tax at the 'rate applicable to trusts', for example S720(5) ICTA 1988, then there is no basis for relief under S686(2AA), as there is no connection with S686 itself.

‘Applied in defraying’

4.8 The statute clearly refers to income treated as being 'applied in defraying the expenses'. The use of 'defraying' means that the amounts must actually be paid to be taken into account. It is not enough that they are incurred. So allowable TMEs are taken into account in so far as they are paid in the year for which the return is made.

‘In that year’

4.10 This phrase refers back to the start of S686 (2AA) which refers to 'income arising to trustees in any year of assessment'. So relief for allowable TMEs is given on the basis of the tax year in which they are paid.

4.11 Sometimes the trustees borrow from the trust capital to pay income expenses, or vice versa. In a year where there is not enough income and trustees borrow from capital to pay income expenses, the amount paid from income will reduce the income taxable at the special trust rates to nil. The amount taken from capital to meet the deficit will be an allowable TME for the year in which the trustees reimburse capital from income for those income expenses.

‘Properly chargeable to income’

4.12 Section 686(2AA) provides for relief for trust management expenses that are 'properly chargeable to income (or would be so chargeable but for any express provisions of the trust)' The full meaning of this is explained in Carver v Duncan 59 TC 125.

4.13 In that case, the trust deed allowed the trustees to pay certain expenses that were normally capital in trust law out of income. Lord Templeman said that although a settlor may provide that capital expenses shall be paid out of income, the settlor cannot alter the nature of those expenses.

4.14 Lord Templeman went on to examine the second 'problem' in the case, the tax problem of the deductibility of expenses for the purpose of calculating income chargeable under what is now S686.

4.15 He said 'In my opinion, [S686(2AA)] allows deduction of expenses properly chargeable to income, that is to say, income expenses. The words in brackets are explanatory and are placed in brackets because they are merely explanatory; they remove any possible ambiguity in the expression 'properly chargeable' by emphasising that expenses which are deductible are those which would be chargeable to income in the absence of any express provisions of the trust. The natural construction of [S686(2AA)] seems to me to authorise the deduction of income applied in defraying income expenses but not income applied in defraying capital expenses. This construction is consistent with trust law, consistent with income tax law and consistent also with common sense.'

4.16 So for S686(2AA) purposes, we ignore the provisions of the trust deed. If under the particular terms of the deed, the trustees pay some expenses that are capital in general trust law out of income, they are not allowable for Section 686(2AA) purposes.

9. TRUST MANAGEMENT EXPENSES – GUIDE TO SPECIFIC ITEMS

Accountancy and audit costs

Cost of having trust accounts prepared

9.5 Where accountancy costs have already been allowed against trading income they will not come into consideration as TMEs. The trust can have relief for a particular expense only once.

9.6 Where there is no trade, as in most trusts, case law principles determine the allowance of TMEs (as set out in the Explanatory Note above). It can be argued that, since well-drawn trust accounts include balance sheets and capital accounts, they are to the benefit of the trust fund as a whole so that the cost of having them prepared should fall on capital. However, the nature of trust accounts is such that it is reasonable to accept that the costs of accounting for the trust's income should be treated as a distinct expense, and as such payable out of income.

9.7 In each trust therefore, a part of the costs of having trust accounts prepared will be properly chargeable to income, on the basis of a just and reasonable apportionment. Such an apportionment is best made by the person who prepares the accounts.

Cost of having trust accounts audited

9.9 In circumstances other than those envisaged by Section 22(4) Trustee Act 1925 Trustees may be empowered by the trust instrument to undertake audits. If the audit is undertaken pursuant to a power in the trust instrument the incidence of the expense of it is governed by general principles. Although an audit is undertaken for the good of the trust as a whole, some of the expenses of such an audit are allowable as TMEs on the basis of just and reasonable apportionment. Such an apportionment is best made by the person who carries out the audit.

Cost of preparing trust tax return

9.10 The expense of having a trust tax return prepared is more likely to be income than capital, because the trust returns income each year, but does not always make a chargeable disposal for CGT purposes. If only income is returned in one year all of the costs are allowable TMEs. If both income and capital gains are returned the allowable TMEs are those that relate to income, apportioned on a just and reasonable basis. This is most easily done by excluding the costs of preparing the capital gains part of the return.

Cost of obtaining tax advice

9.11 Where the tax advice relates to capital gains tax or IHT, the costs are not properly payable out of income, as they cannot be said to relate to income in any way. These costs are not allowable TMEs.

9.12 Tax advice is an allowable TME only where it relates directly to the preparation of income tax returns (see above).

Bank charges and interest

9.13 Whether charges on a bank account or overdraft are payable out of income or capital depends on what those charges secure. If they secure a facility that is for the better administration of the trust fund as a whole, such charges should be treated as an expense of capital. So for example charges on a current account, whether or not it incidentally bears interest, or to keep open an overdraft facility that may or may not be taken up, are capital and so the charges are not TMEs properly chargeable to income. They are therefore not allowable TMEs.

9.14 Whether interest on a bank loan or overdraft is allowable depends on the actual use of the funds advanced by the bank to the trustees. See 'Interest' below at 9.21-9.23.

Distributing income – cost of

9.16 The incidental costs of making distributions such as the cost of posting a cheque to a beneficiary are not properly chargeable to income because they are not concerned (solely or otherwise) with the securing the trust income (see above at 2.16). These costs are therefore not allowable TMEs.

Interest

9.21 Interest may have been incurred in the course of a trade or rental business and already allowed as a deduction against trading or rental income. As a separate matter, some interest may be incurred as a trust management expense.

9.22 In certain instances interest can be an allowable TME, where it is paid to secure the income of the trust. As explained above in 2.11, by 'outgoing' is generally meant some payment which must be made in order to secure the income of the property. Where the funds are used so that what the payment of interest secures is purely for the benefit of the income fund, for example where interest is paid on a loan taken out in order to purchase an income-bearing asset for the trust, the interest should be regarded as an expense of income. Otherwise, interest is not properly chargeable to income and is therefore not an allowable TME. For example, if a loan is taken out or overdraft arranged to pay for general administration, or to buy a non-income generating asset for the trust, that is not an expense paid to secure the income of the trust, and the interest is not allowable.

9.23 Allowable interest includes:

• interest on a loan or overdraft to purchase an income-producing asset, such as shares

• interest on a loan or overdraft taken by trustees for acquiring property that is occupied by a beneficiary

Legal costs

9.29 The trust law text book Underhill & Hayton, Law relating to trusts and trustees says at page 535 'all costs incident to the administration and protection of the trust property, including legal proceedings, are borne by corpus, unless they relate exclusively to the tenant for life. The corpus must bear all costs, charges and expenses incurred for the benefit of the whole estate.'

9.30 At page 544, it says about 'general costs incident to administration', 'Legal expenses or investment advice incident to the administration of a trust almost exclusively fall on capital, unless the settlor has expressly provided for them, for they are for the benefit of all persons interested.'

9.31 So legal costs are not allowable TMEs, unless they relate exclusively to the IIP beneficiary.

Running costs

9.40 Where - typically in larger trusts, such as those established by a business for the benefit of its current and former employees - the method of administration of the trust involves maintaining an office, the attendant expenses are not properly chargeable to income. Such expenses include salaries of personnel, expenses of accommodation, cleaning, and maintenance of equipment and premises. These are the expenses of the operation of the trust as a whole, and so properly chargeable to capital. The fact that such charges may be recurrent does not affect that fact that they are incurred for the benefit of the trust as a whole and hence capital. Furthermore such costs cannot be said to be made solely to secure the trust's income. They are therefore not allowable TMEs.

Travel and subsistence costs

9.41 The incidence of travel and subsistence costs properly incurred by trustees depends on their purpose. Usual principles apply so that the matter turns on whether those expenses were incurred solely for the benefit of/in the course of securing the income of the trust. So, for example, expenses incurred in having meetings to decide which beneficiaries should be given income are not incurred for the benefit of/in the course of securing the income of the trust. They are incurred in the course of the distributive process. They do not result in an increase or maintenance of the income fund - or any part of trust funds. In fact they diminish trust funds. Therefore they are not properly chargeable to income, and are not allowable TMEs. In the vast majority of cases travel and subsistence expenses incurred by trustees will properly fall on capital.

Trustees’ fees

9.42 The position on trustees' fees is widely disputed. The issue of trustees' fees is likely to be the subject of litigation between HMRC and other interested parties in the near future. HMRC's current position is as set out in paras. 9.43 - 9.44. Trust representatives' position is as set out in para. 9.45.

Trusts administered by the Public Trustee

9.43 The following position does not apply to cases administered by the Public Trustee. There is specific statute on the Public Trustee's remuneration. The current fees order is the Public Trustee (Fees) Order SI 1999 No. 855. That provides that all fees are payable out of capital except those specified in the Order. Only those costs specifically chargeable to income by statute are allowable TMEs.

All other trusts

9.44 Trustees' fees represent payment for work done by the trustee in carrying out the terms of the trust as a whole. Corporate trustees' brochures suggest that these fees are in fact charged to capital. The Law Commission paper 175, Capital and income in Trusts: classification and apportionment at para. 2.53 says about trustees' fees 'The irresistible conclusion is that the annual fee reflects work done 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…' On general principles, therefore, trustees' fees are properly payable out of capital.

9.45 Trust representatives have put forward the following arguments. Trustees' fees are annual recurrent expenses. The annual fee reflects work done on behalf of both income and capital. There is a case for apportioning the fees partly to income.

(HMRC Guidance January 2006 2.2.06)

Comment

This published HMRC guidance will have very dramatic effects on the level of expenses typically claimed and not queried in the past which will be accepted by HMRC for 2005/06. The most contentious issue, that is a complete disallowance of trustee management fees is I understand to be the subject of an appeal to the Special Commissioners.

Otherwise, HMRC’s general position, based upon an analysis of Carver v Duncan, is that where, as in most cases, expenses albeit recurrent are incurred for the benefit of the trust as a whole they are not deductible. The only limited exceptions which HMRC will allow is in the case of preparing and auditing trust accounts and preparing the trust tax return. Otherwise (eg see 9.12) an expense of obtaining tax advice will be allowable only where directly related to income tax returns. And there is a quite extraordinary position on bank charges and interest (see 9.14 and 9.21 – 9.23).

Presumably, in a case where part of the trustees’ fees can be demonstrably referred to a solely income purpose, as accepted by HMRC, rendering a separate bill for that revenue expense should ensure deductibility? The apportionments referred to at paras 9.7, 9.9 and 9.10 above do not of themselves envisage separate bills, though that would be the most convenient course of action. Arguing the other way, in relation to 9.12 on the cost of obtaining tax advice, presumably the advice referable to the capital gains page of the SA return is not deductible – and so should be separated out, in case it taints the deductibility of the whole fee! This issue can be expected to run and run ..

Matthew Hutton MA, CTA (fellow), AIIT, TEP
March 2006

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.

About the Author

Matthew Hutton is a non-practising solicitor (admitted 1979), who has specialised in tax for over 25 years. Having run his own consultancy (latterly through Matthew Hutton Ltd) until 30th September 2000, he now devotes his professional time to writing and lecturing.

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