CAPITAL AND INCOME IN TRUSTS: CLASSIFICATION & APPORTIONMENT

Permanent Endowment

5 This concept was first defined in statute in the Charities Act 1960, and now appears in s 96(3) of the Charities Act 1993 as follows:

‘A charity shall be deemed for the purposes of this Act to have a permanent endowment unless all property held for the purposes of the charity may be expended for those purposes without distinction between capital and income, and in this Act ‘permanent endowment’ means, in relation to a charity, property held subject to a restriction on its being expended for the purposes of the charity.’

6 The only other provisions in the 1993 Act where the term ‘permanent endowment’ is mentioned are the following:
 Section 3(5)(c)(i) – all charities with permanent endowment must be registered, a provision which is due to be repealed under the draft Bill.
 Section 75(1)(a) – certain very small charities may be permitted to spend permanent endowment as income, a provision which is due to be expanded under the draft Bill.
 Section 97(1) – merely referring to the definition in s 96(3).

7 On the other hand, the concept is clearly relevant in s 26(4) (directions to charge expenditure to capital or income, and/or requiring recoupment) and in s 74(9)(a)(ii) (property of a small charity which is transferred to another charity under s 74 remains subject to existing restrictions on expenditure).

8 It should be noted that s 96(3), as interpreted by the Charity Commission, has certain special features:
 As a matter of construction, there is a presumption in favour of permanent endowment. Because of the ‘deeming’ provision there are cases where it is presumed that a charity has a permanent endowment when the donor may not have had a specific intention that capital should be preserved but has not expressly provided that it is expendable as income.
 This often results in land and buildings which are held on trust for use in specie for charitable purposes being treated as permanent endowment where the trusts contain no express power of sale and are therefore silent as to how the proceeds of any sale of the property may be applied.
 The definition is not confined to the typical case where the original gift creates a perpetual trust: a type of gift which can only be set up for charitable purposes since it is only in relation to charitable purposes that there is an exception to the Rule Against Perpetual Duration. It also applies to any case where the specific purposes for which funds may be applied differ according to whether they are capital or income. Thus a charity whose income is available for the charity’s general purposes but whose capital is confined to repairs and other works to buildings on functional property has a permanent endowment within the definition even though the capital can be fully expended and the charity may be brought to an end – e.g. where the functional land is leasehold.
 The definition therefore appears to include both ‘dispositive’ restrictions, where the subject matter of the gift itself is confined to income, and ‘purposive’ or ‘administrative’ restrictions, which are like other provisions of a charitable trust in being susceptible to change under the Commission’s power to make cy pres and administrative schemes. The Commission’s previous view was that it could not authorise the expenditure of permanent endowment in any circumstances except for the acquisition of property of a permanent nature (e.g. freehold land and buildings) or on terms of recoupment. Their current view is that it is open to them to authorise the expenditure of capital by order under s 26(4) of the 1993 Act to enable the trustees to adopt a total return policy in managing the charity’s investments.
 The CLA in an earlier paper endorsed the Commission’s previous view, which was based on the proposition that where the restriction derives from the subject matter of the original gift there is no jurisdiction to alter its terms so as to change the nature of the property which has been dedicated to charity. It does not accept that an order under s 26 is legally sufficient to enable capital to be expended where the original gift was only one of income. We would add the gloss that, where the restriction on expenditure merely confines the expenditure of capital to specified purposes which are not identical to those for which income is applicable, there is no reason in principle why a scheme should not be made to alter the relevant purposes.

9 We recommend that s 96(3) should be amended (i) so as to be of general application and not applicable solely to questions arising out of the 1993 Act, (ii) to alter the drafting so that any presumption is against the existence of permanent endowment, i.e. requiring clear words to be used in order to create a perpetual trust and (iii) removing from the definition purposive or administrative restrictions, so as to confine the concept of permanent endowment to perpetual trusts (gifts of income only).

10 In our view these amendments in themselves would clarify the position in a very helpful way, and significantly reduce the number of charities encountering administrative difficulties through the rules relating to permanent endowment.

Recoupment

11 The Charity Commission has over the years developed a practice of authorising the expenditure of permanent endowment for purposes which would normally have to be met from income, on terms that the capital so expended is replaced over a period of years. They clearly have power to do this under s 26(4) of the Charities Act 1993 (see above), but there is no statutory provision or case law specifying the method or approach to be adopted. In fact the Charity Commission has changed its policy over the years. In the 1960s and 1970s it used a formula which sought to make an allowance for inflation and required trustees to set up a sinking fund of which the income was not available for application until the end of a specified period. Nowadays it requires only the historical sum expended to be recouped, and enables the sums set aside annually to be contributed immediately to the charity’s income-producing endowment.

12 There also appears to have been a development of the Charity Commission’s policy relating to the type of expenditure which needs to be recouped. Whereas formerly any expenditure on ‘bricks and mortar’ (as opposed to the purchase of land on which buildings were already standing) was subject to recoupment, if the land is held as an investment the Commission are now much more sympathetic to the argument that the expenditure will enhance the value of the property, and will not therefore require recoupment. They do not normally accept this argument, however, in the more usual situation where the land on which the expenditure is undertaken is held on trust, or has been appropriated, for use for charitable purposes.

13 It is instructive to compare the position with the rules for expenditure of capital under the Settled Land Act 1925, especially since, until the Trusts of Land and Appointment of Trustees Act 1996 came into force, land belonging to a charitable trust and not held on trust for sale was deemed to be settled land.

14 Section 73 of the 1925 Act as amended sets out 19 purposes for which capital money may be applied. These include improvements authorised by the Act, which are listed in Schedule 3. Those improvements are divided between those where the replacement of capital expended by instalments of income is not required, those where replacement by instalments may be required by the Trustees of the Settlement or by the Court, and those where replacement by instalments is compulsory. It is worth noting that the rebuilding of the principal mansion house (the equivalent in terms of a private settlement to a charity’s functional property) comes within the first category, provided that the amount spent does not exceed one half of the total income of the settlement.

15 We consider that many of the financial problems encountered by charities having a permanent endowment which wish to use part of their capital on improvements to existing endowment property could be avoided if the Charity Commission took a more flexible approach to the question of what expenditure constitutes an ‘investment’ and what expenditure requires recoupment, and were prepared as a matter of course to follow the general pattern laid down for settled land in the 1925 Act. We recommend that consideration should be given to the enactment of a general principle that a charity’s permanent endowment may be expended for purposes which increase, or are intended to increase, the value of a capital asset on a long term basis. This would provide a legitimate basis for the exercise of the Commission’s discretion to seek recoupment in individual cases.

Balancing different interests
16 We agree with the Consultation Paper that, in the case of charitable trusts, there is not usually a succession of beneficiaries interested exclusively in either income or capital, though there may often be a gift over of the capital to a specified institution in a specified contingency, as in a Re Chardon  situation. The concept of striking a balance between differing (conflicting) interests does not, therefore, apply in the manner in which it applies to the classic private trust with a life tenant and remainderman. Rather, the trustees are in general concerned with, technically, only one “beneficiary”: the general public, or a section of it.

17 There is every reason, however, for charity trustees to look to future as well as current needs.  They have to assume, unless the donor specifically indicates otherwise, that, even if there is no express restriction on spending capital, the donor would want the charity’s work to be ongoing. Thus, the trustees should establish a reserves policy, so that adequate income can be retained for future needs. They may also be obliged at times to consider when it would be expedient to make capital as well as income available for present needs.

18 The ‘balance’ to be struck by charity trustees is therefore a balance between present and future needs, seen in the context of the overall circumstances - including geographical or social variations in the incidence of the relevant needs, the impact of particular events or official policies, and not a balance between income and capital entitlement. Any balancing, or consideration, of relative needs should fall within the trustees’ overall discretion in protecting the charity’s interests and pursuing its objects. We agree that charity trustees should not be under the same duty as the trustees of private trusts in relation to a duty to balance equitable interests, as such. If it is decided that the duty of private trustees to balance such interests should be put in statutory form, we consider that a statutory duty should also be imposed in relation to charitable trusts, or at least those having a permanent endowment, but that it should be expressed as a duty to have regard to both present and future needs and to other relevant considerations rather than as a duty to balance.

19 Where a charitable trust has permanent endowment in the sense that only the income is expendable, the nature of the trustees’ duty comes significantly closer to that of the trustees of a private trust. They have not only to consider present and future needs but, specifically, must keep the capital separate from the income and preserve it. In our view whilst this duty is not one of balancing interests it does involve the exercise of judgment in order to distinguish between meeting the needs of the objects of the charity and preserving the capital which is unavailable for expenditure as income. There is, in a sense, an obligation to balance potentially conflicting duties.

20 Despite the unrestricted power of investment conferred by the Trustee Act 2000 (as well as by the express terms of most modern charitable trusts) the trustees of a charitable trust with permanent endowment are unable to take advantage of the investment possibilities open to them. For example, investment in the types of shares or other asset classes such as hedge funds, which do not produce dividends would provide no income for distribution, however successful the investment. Where the maximum income is obtained, the capital value is likely to suffer. It also means that Trustees will tend toward a passive rather than an active management of investments, because of the effect on income of active management (see also paras 32 to 36).

21 We do believe that the permanent endowment principle is one that should be preserved and not undermined significantly by the changes that are in contemplation, because it undoubtedly attracts potential donors.

Power of allocation

22 We therefore respectfully disagree with the argument that the trustees of charitable trusts should be excluded from the statutory power of allocation proposed for private trusts . We recognise that in many cases charity trustees would be under less time pressure than the trustees of private trusts, who would often be required to take a reasonably swift decision to allocate receipts to either income or capital so as not to prejudice the cash-flow position of the life tenant. Further, as noted above, charity trustees do not have to balance the competing interests of income and capital beneficiaries. Nor do they have to identify capital and income for tax purposes. Nevertheless, the practical difficulties associated with the rules relating to permanent endowment are significant, and a power of allocation would greatly assist trustees in overcoming these, and enable them to make better use of the wider investment powers now available. As set out below , we do not consider it necessary for Parliament to follow the proposals in draft Charities Bill  to permit trustees simply to remove all the restrictions on the use of capital (where that capital does not include or consist of ‘designated land’), but neither do we feel that, in cases where charitable trusts do contain designated land, the benefits of increased flexibility should be completely denied them.

23 A power of allocation would add to the scope of the trustees’ discretion in utilising the charity’s assets in the best possible way to protect the economic interests of the charity, protect its capital value and achieve its objects in accordance with the donor’s intentions. Among other things, it would afford them the advantages of a total return approach to investment. We understand, however, that the Law Commission’s view is that the power would be an administrative power, not a dispositive power, and that the power would therefore be of relatively limited assistance to the trustees of permanent endowment charities in adopting a total return approach.

24 We strongly recommend the provision of such a power for the trustees of charitable trusts in order to enable them to carry out their duty to take into account the present and future needs of the charity in a modern investment climate. We do not consider that it should be necessary to opt in, or possible for a donor to opt out, of such a power.

Classification of receipts and expenses

25 It follows that any rules for the classification of the investments should apply only where the power of allocation is not exercised.

26 The various company law rules which are applied to company distributions to trusts either lead to artificial and anomalous distinctions, or, more often (we suspect), are simply disregarded. Greater clarity would be highly desirable, particularly in the case of permanently endowed charities. It should be recognised, however, that as matters stand, the proposed new rules of classification would on occasion make the trustees’ position even more restricted, since a distribution treated as capital would be unavailable to them for application for the charity’s objects.

27 We would accordingly recommend that the proposed new rules of classification should apply to charitable trusts on a default basis as is already proposed for private trusts , and that they should not therefore be fixed.

Proposals in draft Charities Bill

28 We have a number of comments in relation to the provisions in clause 33 of the draft Charities Bill, which deal with permanent endowment. We note that this subject is not considered in the report of the Joint Committee on the draft Bill, which was published recently. Since the Government has not yet published a real Bill, and the Joint Committee on the draft Charities Bill has made a number of suggested changes in its recent report, we would urge the Law Commission to consider the draft Charities Bill as well as the proposals for Capital and Income generally, so that the relevant provisions can be considered as a coherent whole.
 If a power of allocation were available to the trustees of charitable trusts having a permanent endowment, as we have recommended, it would apply to the endowment funds of permanently endowed charities consisting of or including ‘designated land’ (land held on trust for use for charitable purposes) as well as to those having only investments and investment property. This would be a significant improvement on the current proposals in that it would provide greater flexibility for more charities, and avoid artificial distinctions.
 It would also have the advantage that it would be exercisable only in relation to those profits which the trustees chose to allocate, not to the whole of the permanent endowment at once as is currently implied in the drafting of the substituted sections 75(4), 75A(2) and 75B(3).
 Further, it would also preserve the duty of the trustees of charitable trusts with permanent endowment to treat as capital that which, looking at the overall position, is properly to be retained, and as expendable that which is properly regarded as income, and thereby enable the charity to continue indefinitely as intended by the donor. Further, charitable trusts founded by single individuals or institutions would not be excepted from the power of allocation. We feel that this would achieve, rather more effectively than the draft bill, the objective of protecting the wishes of individual donors, and thereby encouraging them.
 Nevertheless we wish to make it clear that we are not opposed in principle to the proposition that the expenditure of permanent endowment should be permitted in more circumstances than at present, but believe that this should be carried out in a principled, rather than a haphazard, way.

Individual authorisations by the Charity Commission

29 As indicated above , we do not accept that the current practice of the Charity Commission in giving authority for the spending of capital of a permanently endowed charity by way of an order under Section 26 Charities Act 1993 has any legal justification. Although the Charity Commission is often helpful and innovative in the manner in which it assists charities, and this is to be welcomed, the policies it adopts must be consistent with the law. If a donor has made a gift of income in perpetuity we do not believe that the Charity Commission has power to change the nature of that gift by enabling the capital from which that income is derived to be applied as income.

30 We also consider that, in practice, the Charity Commission’s current practice is dangerous. It is clearly unworkable where the value of the investments decreases and in addition there are several other respects in which it operates in an arbitrary way, which may appear reasonable at the time of the order but may lead to unforeseen or unintended consequences. We consider our recommendations regarding the power of allocation and, in addition or in the alternative, the use of the percentage model on a voluntary basis (see below), to be far preferable to the continuation of the Commission’s practice. If, however, our recommendations were not accepted, and if (contrary to our recommendation) the system of individual authorisations by the Charity Commission were to continue, it would have, in the CLA’s view, to be given a proper statutory basis.

Investing on a total return basis – an alternative approach

31 The following comments relate to an alternative approach to total return, which is touched upon in the Consultation Paper but not closely examined. They assume greater importance if the power of allocation is to be administrative in character, not dispositive (see para 23 above).

32 As practitioners in the field of charity law, we are well aware that, with developments in investment management during the last decade, many charities now wish to manage their investments on a total return basis. This creates a problem for charities which have a permanent endowment. To what extent should the restrictions inherent in the concept of permanent endowment as a gift of income in perpetuity be relaxed in order that the trustees of such charities may adopt an investment policy which is not constrained by the current (or indeed proposed) classification of capital (or more accurately capital profits) and income? Charities with an expendable endowment  can spend capital or income without restraint, regardless of whether the total return is positive or negative.

33 The investment powers under the Trustee Act 2000 already allow trustees to select investments on a total return (or ‘absolute return’) basis as that concept is understood within Modern Investment Theory, but that Act does nothing to enable a capital return in the hands of the trustees of a charitable trust with permanent endowment to be treated as income. We are not therefore talking about “a power to invest on a total return basis”, but rather about how the rules on permanent endowment might be relaxed to enable trustees to apply the resources of charities in a way which, on the one hand, achieves overall economic growth  and, on the other, enables them to promote the objects on a reasonably consistent basis, without fundamentally undermining the principle underlying a gift of permanent endowment.

34 Though we are not investment experts, we believe that it is widely understood that investment is a long term process and, whilst in the medium to long term economic returns on investments should produce positive capital returns, any risk analysis recognises that there will be periods of volatility and declining asset values, which may be sustained for comparatively long periods. This is readily illustrated by investment performance over the last few years, which have seen a significant decline in asset values and (as importantly) a decline in income returns at the same time. The summary of the consolidated figures in “Top 3000 Charities” for 2004 graphically illustrates the point. The total annual investment income of the charity universe, from which the figures are derived, has declined from £2,189m in 2001 to £1,963m in 2003. The total investment income in that three-year period was £6,195m. In the same period, the total investment losses were £8,773m: a total negative return of £2,578m. The impact of such negative returns can easily be seen by reference to the Charity Commission’s own illustration in their guidance note OG 83 C4.

35 Any relaxation of the permanent endowment principle must recognise the volatility and risk of the investment process and allow charity trustees to maintain a spending pattern, which is consistent and sustainable. It is arguable that it should not be directly related to investment returns and their inherent volatility, which could result in trustees being forced to suspend distribution for a relatively longer period. It is not difficult to envisage a situation where only a couple of years of negative returns could extinguish any “unapplied total return” brought forward or could take a similar period to restore a positive “unapplied total return” (see Charity Commission Operational Guidance OG 83). A power of allocation would not deal with this problem because it applies only to profits (unless used in a somewhat artificial way).

36 Charitable trusts have two characteristics, which distinguish them in a fundamental way from private trusts. First, they are of potentially perpetual duration, and this is actually a requirement in the case of those which are permanently endowed in the sense that the gift was of income only. This provides an investment timescale of unique length. Secondly, charities must be in a general sense for the public benefit  and in that context it seems wholly undesirable that a charity should be unable for purely technical reasons to apply its resources towards its objects because of the arbitrary, and relatively short term, under-performance of investment markets (as can occur under the CC total return model).

37 We believe that the percentage trust model  is one that could be adopted for charities with permanent endowment. The technical difficulties  are of limited significance to charities and their beneficiaries, given that charities are not taxpayers. Subject to the recommendations we make above on the more detailed application of the permanent endowment principle , we believe that the concept has merit in the encouragement of substantial charitable giving  and should not be undermined significantly by the proposed permissive power. It is a relatively simple model and avoids a requirement to make what may be seen to be arbitrary and possibly artificial decisions on allocation of incoming resources and expenditure, already closely defined in the Charities SORP.

38 We consider that the concept of permanent endowment as a “gift of income in perpetuity”  should be respected, but could sensibly be supplemented by a power permitting charity trustees to apply up to a certain percentage (say 5%) of the charity’s total assets (ie income after administrative expenses supplemented by capital) towards its charitable objects, regardless of the strict capital and income classification. We would not recommend the American model under which the expenditure of a fixed percentage, set by the State, is compulsory but would see it as a much more voluntary arrangement which could be tailored to individual cases. Thus the relevant percentage of overall increase would not have to be applied as if it were income but could be retained, in whole or in part, as capital. This would enable trustees to meet the charity’s present and future objectives in a planned and reasonably predictable manner, importantly permitting them to enter into commitments over a number of years. If the income yield were higher than the percentage, the Trustees might be permitted either to apply the net income available or to add it to capital, enabling the Trustees to maintain a rational relationship between expendable funds and retained assets.

39 We recommend that, if the Law Commission decides in favour of the power to adopt a percentage model, it should be based on a form of statutory default provision as postulated in para 5.36; that the provision specifies a default percentage that should apply, subject to amendment by statutory instrument, based on the asset value at the previous balance sheet date; and that Trustees are permitted to opt into the use of that power (and indeed to opt out) at any time, subject to a requirement to report the decision to the Charity Commission and to duties of disclosure in the statutory report and accounts.

Summary

40 To summarise, our responses to the specific questions about charities listed on the last page of the Consultation Paper are as follows:

7.40 Not agreed. See above, paragraphs 16 to 21.
7.41 Not agreed. See above, paragraphs 22 to 24. This is our principal recommendation.
7.42 This depends on whether there is to be a statutory duty for private trusts See above, paragraph 18.
7.43 Not agreed. We consider that any rules should apply on a default basis only. See above, paragraphs 25 to 27.
7.44 Agreed, but we consider that, especially if the power of allocation is to be available on and administrative rather than a dispositive basis, serious consideration should be given to the percentage trust model as an option for charities with a permanent endowment. See above, paragraphs 31 to 39.
7.45 Agreed, but we consider the present practice to be flawed, both legally and practically, and would greatly prefer that the practice is discontinued. See above, paragraphs 29 to 30.

41 We would also stress the need, in our view, to reform the definition of ‘permanent endowment’ in the Charities Act 1993, and to clarify (and moderate) the rules relating to recoupment of capital.

42 For what it is worth, we entirely agree that the rules of apportionment do not, and should not, apply to charities.

43 If we can be of any further assistance to the Law Commission we would be happy to discuss the proposals with them.

Signed Francesca Quint
(for the Charity Law Association)