Carver v Duncan (Inspector of Taxes); Bosanquet v Allet (Inspector of Taxes)

[1985] 1 AC 1082

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(Judgment by: Lord Templeman)

Carver
vDuncan (Inspector of Taxes)

Court:

Judges: Lord Fraser of Tullybelton
Lord Diplock
Lord Roskill
Lord Brandon of Oak-Brook

Lord Templeman

Legislative References:
Finance Act 1973 - s 16; s 16(1); s 16(2); s 16(2)(d)
Finance Act 1970 - s 26
Income and Corporation Taxes Act 1970 - s 428(1)(a); s 455(b)
Trustee Act 1925 - s 19
Finance Act 1971 - s 32
Income and Corporation Taxes Act 1970 - s 428; s 455

Case References:
W T Ramsay Ltd v IRC - [1981] 1 All ER 865; [1982] AC 300
IRC v Burmah Oil Co Ltd - [1982] STC 30
Furniss (Inspector of Taxes) v Dawson - [1984] 1 All ER 530; [1984] AC 474
Mangin v IR Comr - [1971] 1 All ER 179; [1971] AC 739
Marx v Inland Revenue Comr - [1970] NZLR 182
Cape Brandy Syndicate v Inland Revenue Comrs - [1921] 1 KB 64
Canadian Eagle Oil Co Ltd v Regem - [1945] 2 All ER 499; [1946] AC 119
IRC v Berrill - [1982] 1 All ER 867; [1981] 1 WLR 1449
Stott v Milne - (1884) 25 Ch D 710
Macdonald v Irvine - (1878) 8 Ch D 101
Stott v Milne - (1885) 25 Ch D 710

Hearing date: 16, 17, 18 April 1985
Judgment date: 16 May 1985

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Judgment by:
Lord Templeman

My Lords, this appeal involves consideration of two problems: the trust problem of the incidence of trust expenditure as between income and capital and the tax problem of the deductibility of expenses for the purpose of calculating income chargeable to additional rate tax by s 16 of the Finance Act 1973.

Trustees are entitled to be indemnified out of the capital and income of their trust fund against all obligations incurred by the trustees in the due performance of their duties and the due exercise of their powers. The trustees must then debit each item of expenditure either against income or against capital. The general rule is that income must bear all ordinary outgoings of a recurrent nature, such as rates and taxes, and interest on charges and incumbrances. Capital must bear all costs, charges and expenses incurred for the benefit of the whole estate.

In the present appeals, the trustees of the Paul settlement paid the annual premiums on assurance policies effected by the trustees in order to obtain policy moneys corresponding to the amount of capital transfer tax payable out of the trust fund in the event of the death of the settlor before 20 November 1979. The trustees of the Devonshire settlement paid the annual premiums on endowment policies assigned to the trustees and on other endowment policies effected by the trustees. All these premiums were paid by the Paul settlement trustees and the Devonshire settlement trustees for the benefit of the whole of their respective trust funds because the capital of the trust will be augmented by the policy moneys which will be received if and when the policies mature, and the income of the trust will be increased as and when such augmentation of capital takes place, but not before that event takes place.

In Macdonald v Irvine ( 1878) 8 Ch D 101 the Court of Appeal held that premiums on life policies were a capital expense. Baggallay LJ said (at 120): '... it would hardly be equitable to compel the Plaintiff [tenant for life] to keep on foot a policy for the benefit of other persons.'

In Re Sherry [ 1913] 2 Ch 508 the trust estate included an estate pur autre vie and certain policies on the life of the cestui que vie and it was held that the premiums on the policies were a capital expense. Warrington J said (at 512):

'The life policies are reversionary interests and must be treated quite separately from the life interest of the cestui que vie. The premiums on the policies are paid for the preservation of an item of the testator's property, the benefit of which goes to capital.'

It follows that the premiums on the policies held by the Paul settlement and the Devonshire settlement trustees are capital and not income expenses.

The Devonshire settlement trustees also paid annual fees to a firm of investment advisers to keep under review and to advise changes in investments comprised in the trust fund. This was a recurrent charge but not an ordinary outgoing and was 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.

In Re Bennett [ 1896] 1 Ch 778 capital was ordered to pay the expenses of the yearly audit and inventory of a business where capital employed in the business was a capital asset of the trust. Lindley LJ said (at 784):

'Why is this expense to be thrown upon the tenant for life? For whose benefit is it incurred? It is really for the benefit of the whole estate, though the practical effect of throwing it upon the whole estate will be that the tenant for life will lose the income of the sums expended. It has been suggested that such expenses are like annual outgoings. I do not think they are. By an "outgoing" is generally meant some payment which must be made in order to secure the income of the property.'

A L Smith LJ said (at 787):

'It is said that the case is like one of insurance, where the tenant for life pays the premiums; but the difference between the two cases is this, that in the case of insurance the payment is a voluntary one made by the tenant for life out of his own income without any obligation on his part to do so at all. Here the payment is one which the trustee, for the benefit of the tenant for life as well as of the remaindermen, may properly incur in order to see whether the 15,000l., of which the tenant for life receives the present income, and the persons entitled in remainder take the ultimate benefit, is safe or not. It is quite clear, in my judgment, that the expenses of these audits are costs, charges and expenses incurred for the benefit of the whole estate, and therefore ought to come out of capital and not out of income.'

Section 19 of the Trustee Act 1925 now provides that trustees may insure against fire at the expense of income for an amount not exceeding three-quarters of the full value of the trust property, and s 20 provides that money receivable by trustees or any beneficiary under a policy of insurance against loss or damage of trust property shall be capital moneys.

Re Bennett, which has been accepted law for nearly 90 years, affirms the trust principle that expenditure incurred for the benefit of the whole estate is a capital expense. In accordance with the authorities and in accordance with principle, the premiums paid by the Paul and Devonshire settlement trustees in respect of capital transfer tax protection and on endowment policies and the fees paid to investment advisers were capital expenses and not income expenses.

A settlor may authorise or direct his trustees to pay income expenses out of capital or to pay capital expenses out of income. In the Paul settlement the investment clause, cl 7, authorises the trustees to invest or lay out capital and accumulation of income in any property with power 'to effect acquire keep up (at the expense of capital or income as the Trustees may think fit) surrender and deal in any way with assurance policies of every kind ... ' In the exercise of this power, the trustees of the Paul settlement have paid the premiums on the capital transfer tax protection policies and on the endowment policies out of income.

In the Devonshire settlement, cl 19 provides:

'The Trustees may effect purchase or otherwise acquire a policy or policies of assurance of any kind intended to form part of the Trust Fund and pay the premiums on any policies so effected purchased or acquired (or any policy vested in them as an addition to the Trust Fund) out of income or capital of the Trust Fund or partly out of each in such manner as the Trustees at their discretion think fit ... '

In exercise of this power, the Devonshire trustees have paid the premiums on the endowment policies out of income. Clause 26(b) of the Devonshire settlement provides:

'The Trustees may at any time or times apply any income of the Trust Fund in or towards the payment or discharge of any duties taxes costs or other outgoings which but for the provisions of this clause would be payable out of or charged upon the capital of the Trust Fund.'

In exercise of this power, the Devonshire trustees have paid the annual fees of their investment advisers out of income, and for the purposes of this appeal I assume without deciding that they were entitled to do so.

In the result, the premiums and fees which constitute capital expenses have nevertheless been lawfully paid out of income. Now, although a settlor may provide that capital expenses shall or may be paid out of income, the settlor cannot alter the nature of those expenses. The exercise of an express power or duty to pay capital expenses out of income has the effect of taking income away from the income beneficiaries and bestowing it on the capital beneficiaries, so that capital is augmented. Premiums on an endowment policy remain a capital expense although, pursuant to an express power for that purpose, the sums paid in discharge of those premiums are taken from income. If the income of a trust fund is only sufficient to pay the premiums on a ten-year endowment policy, and income is directed by the settlor to be applied in payment of those premiums, the income beneficiaries are wholly deprived of any income during the ten-year period and capital is augmented. This only means that a capital expense is paid out of income because the settlor has so provided. Similarly, a settlor cannot alter the nature of an income expense by authorising or directing the trustees to pay that expense out of capital. A direction that rates of £1,000 per annum payable in respect of a trust property settled on a tenant for life shall be paid out of capital has the effect of taking £1,000 of capital away from the capital beneficiaries and bestowing that sum on the tenant for life. This only means that an income expense is paid out of capital because the settlor has so provided.

Income tax has been judicially pronounced to be a tax on income. In arriving at the amount of income liable to income tax, Parliament may expressly provide that certain income expenses may be deducted. The legislature may go further and expressly provide that certain capital expenditure or capital allowances may be deducted for tax purposes. Fiscal legislation of that kind does not convert capital expenditure into an income expense. If the legislature provides for capital expenditure to be deducted for income tax purposes, the legislature does not increase or reduce the income of the taxpayer but reduces the amount of the income of the taxpayer which is liable to tax.

By s 32 of the Finance Act 1971 Parliament abolished earned income relief but provided that investment income should pay a higher rate of tax than earned income at an additional rate fixed in the first instance at 15%.

By s 16 of the Finance Act 1973 income tax at the additional rate prescribed by s 32 of the Finance Act 1971 was charged on the income of accumulation and discretionary settlements in the following terms, so far as relevant:

'(1) So far as income arising to trustees is income to which this section applies it shall, in addition to being chargeable to income tax at the basic rate, be chargeable at the additional rate.

(2) This section applies to income arising to trustees in any year of assessment so far as it --(a) is income which is to be accumulated or which is payable at the discretion of the trustees or any other person (whether or not the trustees have power to accumulate it); and ... (d) exceeds the income applied in defraying the expenses of the trustees in that year which are properly chargeable to income (or would be so chargeable but for any express provisions of the trust) ... '

The Paul settlement and the Devonshire settlement created accumulation and discretionary trusts. The trustees concede that s 16(2) (a) applies and that additional rate income tax is chargeable on the income of the settlements under s 16(1).

In my opinion, s 16(2) (d) 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 s 16(2) (d) 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. Section 16(2) (a) imposed additional rate tax on the income applied in augmenting capital pursuant to an express provision of the trust authorising the accumulation of income. Section 16(2) (d) cannot have been intended to exempt from additional rate tax the income applied in augmenting capital pursuant to an express provision of the trust authorising the payment of capital expenses out of income. The legislature cannot have intended to favour those pre-1973 settlements which contain power to charge capital expenditure against income and to penalise those pre-1973 settlements which contain no such power. The legislature cannot have intended to present settlors after 1973 with a method of accumulation which escapes the additional rate tax.

The argument to the contrary, persuasively advanced by counsel for the trustees, requires, in defiance of the rules of construction and for the purposes of diagnosis, the amputation of s 16(2) (d) into two limbs. Vinelott J was persuaded in his judgment that the first limb, before the words in brackets, 'taken in isolation' allows the deduction of income expenses and the deduction of capital expenses charged against income by virtue of an express provision of the trust (see [1983] STC 310 at 336). My Lords, I can find no justification for this approach, which asserts that which remains to be decided, examines the first limb as though the second limb did not exist and construes the first limb as if it simply authorised the deduction of the expenses of the trustees defrayed out of income otherwise than in breach of trust. In order to attach some meaning to the words in brackets, counsel was driven to make the suggestion on behalf of the trustees, which is summarised in the judgment of Vinelott J (at 337), that--

'the words in parentheses are necessary to cover a case which is like Stott v Milne ( 1885) 25 Ch D 710 in that expenses which ought properly to be paid out of capital are paid out of income in the first instance (there being no capital moneys available to meet them) and are payable out of capital only because there is an express provision of the trust directing the payment out of capital of expenses which the trustees would have been bound or entitled to charge to income if there had been no such express direction.'

Vinelott J accepted that suggestion (at 342). In my opinion the suggestion is ingenious but so far-fetched as to be incredible. Moreover, the suggestion is logically unacceptable because it postulates that Parliament in allowing deduction of expenses from income for tax purposes went out of its way to give effect to the provisions of trust deeds in relation to capital expenses covered by the first half of s 16(2) (d) but to ignore the provisions of trust deeds in relation to income expenses covered by the words in parentheses. The simple solution is that s 16(2) (d) read as a whole, and in the light of s 16(2) (a), does not produce inequality and discrimination between different trusts but requires the express provisions of all trust deeds to be ignored for the purpose of determining which kinds of expenses are deductible.

Counsel for the trustees also relied on the fact that the expression in brackets in s 16(2) (d) begins with the word 'or' rather than the word 'and' and on the meaning which he attached to the words 'but for' and to the distinction between the present indicative tense of the first part of s 16(2) (d) and the subjunctive tense of the expression in brackets. For my part, I was unable to deduce from these further operations of amputation any reason for altering the thrust of the whole of the subsection, which to my mind allows the deduction of expenses 'properly chargeable to income', ie income expenses in those settlements where the settlor has made no express provision for the payment of capital expenses out of income, and only allows in other settlements deduction of those expenses which would be properly charged to income but for an express provision in the trust directing or authorising capital expenses to be charged to income.

Finally, it was argued that ss 428 and 455 of the Income and Corporation Taxes Act 1970, reproducing provisions of the Finance Act 1938, achieved results similar to those for which the Crown contends by a slightly different form of words. Section 16 of the 1973 Act must, therefore, it is argued, produce a different result. My Lords, the Income Tax Acts are a vast patchwork begun in the nineteenth century and doomed never to be completed. It is useless to speculate why the draftsman in 1973 used words different from those employed by the draftsman in 1938. Oversight, or some difficulty, real or imagined, may have played a part. There was every reason why the 1973 draftsman should wish to obtain the same results as the 1938 draftsman and no reason why the 1973 draftsman should wish to obtain an opposite result. If the 1973 draftsman had intended to produce the opposite result, he could have made his position clear. All this is only a matter for speculation. I derive no help one way or the other from the 1938 Act.

Section 16, for reasons good or bad which do not concern the courts, imposed an additional rate of income tax on the income of accumulation and discretionary settlements remaining after the deduction of expenses 'properly chargeable to income (or would be so chargeable but for any express provisions of the trust)'. The section appears to me to allow the deduction of income expenses and to prevent the deduction of expenses which are only chargeable to income as a result of an express provision of the trust.

It is common ground that s 16 permits a deduction from the gross income of the trust of the grossed up amount of income expenses in order to arrive at the gross amount liable to additional rate tax. Section 16 applies to income 'chargeable to income tax at the basic rate' after deducting 'the income applied in defraying the expenses of the trustees'. Thus, if trustees are entitled to gross dividends of £1,000 and receive after deduction at the basic rate of 30% the net sum of £700 which they apply in discharging rates, casual repairs or other outgoings which constitute income expenses amounting to £700, the trustees may deduct £1,000 from their total gross income for the purpose of computing the amount of gross income liable to tax at the additional rate. This effect of s 16 does not assist the trustees to deduct capital expenses from gross income for the purpose of computing their liability to additional rate income tax merely because the trustees are authorised to pay those capital expenses out of income.

The Court of Appeal, reversing Vinelott J, came to the same conclusion and I would dismiss these appeals.

For the trustees the amount involved is small and for the Crown the consequences are important. The Crown has already agreed to pay the costs of the trustees up to and including the proceedings before the Court of Appeal. In the exceptional circumstances of this test case, without creating any precedent, and with acknowledgments to the fact that the Crown did not vehemently argue for its costs of the appeal to your Lordships' House, I would suggest that there should be no order for the costs of this appeal.