Mineral Royalties and Trusts

JONATHAN EDWARDS PhD, FCA, FTII, Cmath, MIMA of Geens, Stoke-on-Trent discusses how to resolve a conflict between trust law and the tax provisions.

A QUERY IN Readers Forum a while ago (Taxation, 11 April 2002 at pages 44 and 45) raised the rather intriguing concept of impeachment of waste as it relates to mineral royalties derived from land held in trust. Problems arise with the taxation of the mineral royalties because the treatment as to one half income, one half capital gains (section 122, Taxes Act 1988 and section 201, Taxation of Chargeable Gains Act 1992) does not always follow the treatment applicable under Trust Law.

The laws of waste

In order to appreciate what the doctrine of impeachment of waste is all about, it is necessary to consider the ways in which land could be held in trust prior to 1997 when the Trusts of Land and Appointment of Trustees Act 1996 came into effect.

Settled land

In the case of a strict settlement, or settled land, the land was actually vested in the tenant for life who had all the powers of management and sale of the land, together with the right to receive the income but not the right to the capital money arising from any sale, which was to be held by the trustees of the settlement. The fact that the tenant for life had the full powers of management could easily give rise to a conflict of interest. The concept of waste prevented such a limited owner from destroying the land to the prejudice of those in reversion or remainder. Technically, waste consisted of any act which altered the nature of the land, whether for the better or the worse, but as far as the tenant for life being made liable for any damaged caused was concerned, it was voluntary waste, or doing some action destructive of the land to the damage of the reversioners or remaindermen which was of principal importance. Clearly, the working of minerals, or the granting of a lease to another to work minerals, would have this effect and could therefore come within the concept of waste.

The general rule was that a tenant for life was liable for voluntary waste unless his interest was granted to him by an instrument exempting him from such liability. Where such exemption was granted, he was said to be 'unimpeachable of waste' and otherwise he was said to be 'impeachable of waste'. Thus he was assumed to be impeachable of waste unless the terms of the settlement made him unimpeachable.

The Settled Land Act 1925 authorised a tenant for life to grant mining leases for 100 years or less, whether the working was already open or not and whether or not he was impeachable of waste. Section 47 of the Act provided that in each case the tenant for life was entitled to three-quarters of the rent unless he was impeachable of waste, where he was only entitled to one quarter. The rest was capital money arising under the settlement and accrued to the trustees for the benefit of all those interested under the settlement. This general rule could be overridden by the terms of the settlement.

In some cases there was no tenant for life, and the trustees held the powers that would otherwise have vested in the tenant for life as 'statutory owners'. Such could arise where the beneficiary was a minor, where the trustees had discretion as to beneficiaries or where they were directed to accumulate income for future beneficiaries.

Trusts for sale

The second form of land holding in trust was under trust for sale where there was a duty upon the trustees to sell the land and convert it into money, but usually with power to postpone such sale. Prior to 1926 such trustees had no powers of leasing or mortgaging or otherwise dealing with the land except by way of sale, but the Law of Property Act 1925 gave them all the powers that a tenant for life of settled land would have under the Settled Land Act 1925. Moreover, the same directions as to money to be set aside as capital apply as in the case of settled land (section 28(1)(2), Law of Property Act 1925). Thus, in the case of mines and mineral workings, the trustees were subject to the same restrictions as to the manner in which income could be applied to the income beneficiary as applied to the tenant for life of settled land. Thus, unless the trusts provided otherwise, either one quarter or three-quarters of any rent or royalties would be set aside as capital. By so doing, the trustees would fulfil their duty not to benefit the income beneficiary at the expense of the remaindermen and vice versa. Arguably, discretionary or accumulation trusts were more likely to arise under this head, but the rules as to income and capital still applied.

From January 1997

The Trusts of Land and Appointment of Trustees Act 1996 abolished the concepts of the trust for sale and of the strict settlement for newly created trusts with effect from 1 January 1997 and replaced them with the trust of land. Existing strict settlements and trusts for sale remained as such, however. For trusts of land it would appear that the doctrine of impeachment of waste remains, and while the statutory rule of one quarter or three-quarters of the rents and royalties being capital has gone, the former statutory rule arguably provides a rule of thumb by which the trustees may balance the interests of the various beneficiaries, contrary to any specific direction or contrary intention expressed in the trust document.

Conflict with tax law

It is this division of a single source of receipts arising under the trust into income and capital parts that gives rise to the anomalous tax treatment. Fundamental to any taxation considerations is the basic concept that 'in some cases the dividing line between capital and income is not the same for the purposes of income tax as for trust administration' (per Lord Reid in Commissioners of Inland Revenue v Trustees of Joseph Reid, 30 TC 431 at page 445). Thus, what is capital in trust law may nevertheless be taxed as income so that, where three-quarters of the mineral rents and royalties are treated as capital, nevertheless one third of that amount is still treated as income in accordance with section 122, Taxes Act 1988.

A second fundamental principle concerns the person or persons who can be taxed in respect of particular receipts. As far as income tax is concerned, mineral royalties are taxed under Schedule D (sections 55 and 119(1), Taxes Act 1988). Under the general provisions relating to Schedule D, income tax is chargeable on the persons receiving or entitled to the income (section 59, Taxes Act 1988). Thus, with an in possession trust where there is an income beneficiary, while the trustees are assessable in the first instance, the income beneficiary is also chargeable and, in particular, if he is liable to higher rate tax. However, because he is not entitled to receive any part of the receipts which in trust law are capital, he cannot be taxed on any such capital as is treated as income for tax purposes. The corresponding point as regards discretionary trustees is now recognised by the Revenue in its Interpretation RI163 providing that section 686, Taxes Act 1988 does not apply to such part.

Resolving the conflict

In the light of all this, how then do trustees approach the question of their tax liability? This would comprise a three stage process:

(1) Does the trust instrument provide that the whole, or some specified portion, of the rents and royalties are to be treated as income? If this is the case, then the one quarter, three-quarters rule has no application.

(2) Does the trust instrument provide that the tenant for life or income beneficiary is unimpeachable of waste? If so, subject to (1) above, three-quarters of any rents and royalties fall to be treated as income in the hands of the beneficiary and the rest is capital. Otherwise, again subject to (1), the income beneficiary or tenant for life is impeachable of waste and only one quarter of the receipts are income.

(3) Apply the statutory provisions of section 122, Taxes Act 1988 and section 201, Taxation of Chargeable Gains Act 1992 in accordance with the result of (1)or (2) above.

There would therefore appear to be four combinations of trust/tax treatment (ignoring the deduction against income for one half of management expenses provided for by sections 121 and 122, Taxes Act 1988).

Trust income taxed as income: In the case of in possession trusts, trust income which is also taxable as income would be charged to income tax at basic rate in the hands of the trustees (if received by them) with the income beneficiary liable to the excess if a higher rate taxpayer, or directly at the beneficiary's marginal rate if received direct. In the case of discretionary or accumulation trusts, the trustees would be taxed at trust rate and any such tax would go into the tax pool to frank distributions.

Trust capital taxed as capital gain: Trust capital gains would accrue to the trustees and be charged to capital gains tax at the rate equivalent to the trust rate. Note that in the case of settled land, section 69(3), Taxation of Chargeable Gains Act 1992 splits responsibility between the tenant for life and the trustees by constituting them a single body of trustees for capital gains tax purposes.

Trust capital taxed as income: That which is capital for trust purposes but which is liable to income tax again would accrue to the trustees and, in accordance with section 59, Taxes Act 1988 (in possession trusts) or RI163 (discretionary and accumulation trusts) can be taxed only at basic rate on the trustees with no charge falling on any income beneficiary.

Trust income taxed as capital gain: The most difficult category is for trust income which is not taxable as income, but instead is a capital gain. the position here is not wholly free from doubt.

Prima facie the trustees of interest in possession trusts would appear to be chargeable to capital gains tax. However, it is at least arguable that the income beneficiary is absolutely entitled to this part subject to any rights of the trustees to resort to the receipts for the payments of outgoings. This would appear to bring such part within section 60(1), Taxation of Chargeable Gains Act 1992 (bare trusts), with the result that it would be the beneficiary, to the exclusion of the trustees, who is chargeable to capital gains tax, and at his marginal rate.

If there is no person absolutely entitled to the money as against the trustees, section 60(1) cannot apply. The trustees are therefore chargeable to capital gains tax at the rate equivalent to the trust rate. However, what is the status of such trust income when it is distributed? If it constitutes 'for all purposes of the Income Tax Acts income of the person to whom [the distribution] is made' (section 687(1)(a), Taxes Act 1988), then it is deemed to be a net payment after deduction of income tax at the trust rate, which income tax is assessable on the trustees subject to its being franked by the tax pool. Herein lies the problem identified by the first of the replies to the original query, because there is no provision for capital gains tax assessed on the trustees to fall into the tax pool and the trust rate deduction from the distribution represents a further charge.

If, on the other hand, the effect of section 201, Taxation of Chargeable Gains Act 1992 (mineral leases: one half capital treatment) is to convert income to capital for tax purposes, then does this treatment flow through to the subsequent distribution? This would seem not to be the case since the source of the payment to the beneficiary is the trustees exercise of discretion and not the original source as such and the aforesaid section appears to apply only to the person entitled to receive the royalties.

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