Mitchell v Hart [1914] HCA 72; (1914) 19 CLR 33 (26 November 1914)

Mitchell Defendant, Appellant; and Hart and others Defendants and Plaintiffs, Respondents.

Knox K.C. (with him E. Milner Stephen), for the respondent Edith Maria Hart, representing the beneficiaries interested in the income of the estate.

The question for determination in this case is whether certain shares in Tooth & Co. Ltd., which were allotted to and accepted by the trustees of the testator's will, are under the circumstances to be regarded, as between the persons entitled to the income of the testator's estate and those entitled in remainder, as an accretion to capital or as income. The learned Judge, following a previous decision of another Judge of the Supreme Court (unreported), has held, in effect, that they are an accretion to capital, but that the persons entitled to the income of the estate are entitled to a charge upon them for a sum which, although in form a dividend upon existing shares, was never actually paid as such but was accepted by the Company in full payment for the shares, which were of much greater value.

The transactions in question are of a kind not unfamiliar. The Company, having accumulated large funds of surplus profits after payment of ordinary dividends, proposed to distribute those funds amongst their shareholders, the operation taking in each case the form of an issue of new shares accompanied by a distribution by way of bonus of an amount exactly equal to the amount payable in respect of the new shares. The question is whether the amount of the bonus is to be regarded as income or as an accretion to capital.

The principle to be applied in answering that question is declared by the case of Bouch v. Sproule[1], by which we are bound. The principle is that regard is to be had to the intention of the Company as evidenced by the substance and not the form of the transaction. If the substance of the transaction is that the Company determine to convert the undivided profits into paid up capital upon newly created shares, then those shares are capital. If, on the other hand, the substance of the transaction is that the Company determine to make a distribution of profits, accompanied by an option to the shareholders either to accept their proportion of the fund in cash or to apply it in the purchase of new shares in the Company, the amount so distributed may be regarded as income, whether it is actually paid and repaid or not. In In re Evans[2] Neville J. thus expressed the principle:—"What was the nature of the scheme? Was the scheme intended by the Company to result in the transfer of the amount or part of the amount standing to the credit of the reserve fund to the payment of new capital to be distributed amongst shareholders, or was it merely an ordinary distribution of dividends out of the reserve fund, leaving it a matter of pure choice, with regard to which the Company expressed no desire at all, as to how it should be applied?"

In the present case the schemes (for there were two separate transactions) were in each case expressed in the form of four resolutions. By the first the capital of the Company was increased by £100,000, in 100,000 new shares of £1 each. By the second it was resolved that the new shares should be offered to the shareholders at par in the proportion of one new share for every nine shares (in the second case every ten shares) held by them, on the footing that the full amount should be paid on acceptance of the offer within a time to be limited by the directors for acceptance. By the third resolution it was resolved that the sum of £100,000, being portion of the amount standing to the credit of the Company's reserves, should be distributed amongst the shareholders by way of bonus in proportion to the number of their shares, and that each shareholder might direct in writing that the amount of bonus should be used in payment for the new shares. By the fourth resolution the directors were authorized to dispose of new shares so offered and not accepted to such persons and upon such terms as they might think most advantageous, and that the premiums received for the sale of such shares should be divided pro ratâ amongst the shareholders who did not accept the new shares.

It appears, therefore, that the only substantial option left to the shareholders was, in each case, not how their proportion of an ordinary distribution of funds by way of dividend should be applied, but whether their proportion of new capital, which was to be created at all events, irrespective of any option on their part, in the form of fully paid up shares, should be taken by them in the form of shares or in the form of money representing their proportion of the proceeds realized by a sale of the new shares not taken by shareholders in specie. It is common ground that the value of the new shares would exceed the nominal amount of the bonus or dividend.

Under these circumstances it appears to me that the substance of each transaction was not a distribution of a dividend or bonus, but a creation of additional capital, or, in the words of Lord Herschell[3], "to convert the undivided profits into paid-up capital upon newly-created shares." The real and substantial option was, as I have said, not to take or refuse to take a dividend quâ dividend, but to take new shares in specie or to take a sum substantially representing their value.

In whichever way it was exercised, the shareholder was to get substantially the same benefit, the only difference being that in one case the new shares would be disposed of for his benefit, and in the other taken by himself in specie.

If the contrary view is accepted I have some difficulty in seeing any ground for dividing the benefit between the tenant for life and remaindermen. The benefit, whatever it was, was either a payment of income or a creation of capital by way of accretion, and must, I think, belong to one or the other. It is true that in In re Northage[4] North J. saw his way to divide it, but the facts of that case were very different from the present.

I will only add that I am much impressed by what I venture respectfully to call the strong common sense of Lord Eldon's remark in Irving v. Houston[5] that "If ... a person who buys bank stock ... gives the life interest of his estate to anyone it can scarcely be his meaning that the life-renter should run away with a bonus that may have been accumulating as capital for half a century."

The question is, after all, one of construction of the will. In my judgment the benefit which accrued to the trustees under the schemes in question was not income in the sense in which that term was used by the testator.

In my opinion the appeal should be allowed, and the order should be varied by omitting the declarations that the tenants for life are entitled to a charge on the shares and that the amount of the charge should be raised by a sale of a sufficient number of them.

The point decided in Bouch v. Sproule[6] is thus stated in Lindley on Companies, 6th ed., p. 742:—"If acompany can lawfully increase its capital, and it does so by capitalizing and distributing its accumulated profits, then what is distributed in respect of shares held for life must be treated as capital, whether what is distributed is cash or new shares."

But it is essential that the distribution of the profits must be so as to increase the capital, and that by force of the act of the company itself, leaving no room for discretion in the matter by the recipient of the profits as to their ultimate destination.

It is clear that the process of converting profits into capital in the necessary sense, cannot be effected without distribution as a step in the process, because, as was pointed out by Lord Herschell in Bouch v. Sproule[7], the company "cannot be considered as having intended to convert, or having converted, any part of its profits into capital when it has made no such increase," that is, increase of capital stock. The profits to become capital must be paid for capital stock. And, before being so paid, they must in law be the property of the applicant for that stock. The next postulate is that when profits are distributed they belong absolutely to the recipient, and cannot be clogged with a condition binding in law to return them or apply them to the payment of shares. In the strict legal sense there is always an option to retain the profits and refuse to take the shares which the company desires to be taken and paid for by means of the profits. But the question is one of business and hard fact, and it is the substance of the transaction which governs the relations of tenant for life and remainderman.

The company may so frame its resolve to issue new shares, and to distribute the profits, as to bind the two into one transaction from a practical standpoint. But, to accomplish this, the bonus or dividend must be so offered that the ordinary instincts of human self-interest of a reasonably prudent man will naturally and instantly direct the money back into the coffers of the company in exchange for the new shares contemporaneously offered, notwithstanding that these are legally refusable by the shareholder. If the distribution is made in such terms, and in such surrounding circumstances, that the ordinary promptings of human nature would lead to the one act accompanying the other, they may be regarded as indispensable and inseparable parts of one transaction, and the benefit offered by the company is simply the net difference between the actual value of the shares and the price asked, including in that the money distributed for the purpose of paying the price in whole or in part.

If that is the position, the tenant for life cannot assert that the dividend has been received by the trustees for him. In truth it has not. It has not been received by the trustees at all for incorporation in the estate, but they are mere conduit-pipes to receive and pass it on for a given purpose.

When these considerations are applied to the present case, it is obvious that the Company have stopped short of irrevocably linking the distribution of profits with their return. They have not supplied the want of a legal compulsion with a practical one. They have afforded a ready and facile means of paying for the shares, and have thereby made the acceptance of the new shares more probable. But they have not put any pressure whatever upon the shareholders to take the new shares. On the contrary, they have said in effect: "Notwithstanding the facilities we afford you to take the new issue, if you do not choose to take them you shall not be penalized. You shall still have, besides the share of profits, your share of whatever premiums we obtain from outside contributions."

That stops short of the practical compulsion necessary to weld the two branches of the transaction together; it leaves a full and free option from a business standpoint; and as neither law nor self-interest can be said to compel the repayment of the profits distributed, they have not been capitalized and remain income.

In view of the facts, we think the decretal order of Harvey J. should stand as made, including the declarations respecting the charge upon the shares for the amount of the bonuses.

Appeal dismissed. Costs of all parties as between solicitor and client to be paid out of the fund.

[1] 12 App. Cas., 385.

[2] (1913) 1 Ch., 23, at p. 32.

[3] 12 App. Cas., 385, at p. 399.

[4] 64 L.T., 625.

[5] 4 Paton, Sc. App., 521.

[6] 12 App. Cas., 385.

[7] 12 App. Cas., 385, at p. 398.

High Court of Australia

Mitchell v Hart [1914] HCA 72; (1914) 19 CLR 33 (26 November 1914)

HIGH COURT OF AUSTRALIA