Law report: New shares to be treated as capital: Sinclair v Lee and another - Chancery Division (Sir Donald Nicholls, Vice-Chancellor), 30 April 1993.

Shares in Zeneca Group plc, allotted and issued directly to shareholders of Imperial Chemical Industries by way of a dividend declared by ICI as part of a company demerger, should be treated in the hands of trustee shareholders as capital belonging to remaindermen rather than income to be distributed to life tenants.

Sir Donald Nicholls, Vice-Chancellor, so ruled on an originating summons by Neil Sinclair, a trustee of the trusts of the will of Dora Lee, deceased. In the will she left a holding of ICI shares to her husband, William Lee, for life, with remainder to her son, Michael David Lee, absolutely.

ICI was now dividing itself in two: henceforth Zeneca Group plc would belong to the same shareholders and in the same proportions as ICI. A shareholder with 1,000 ICI shares would end up with 1,000 ICI shares and 1,000 Zeneca Group shares. The new shares would be issued by the Zeneca Group as fully paid-up in consideration for the transfer by ICI of shares in its wholly-owned subsidiary Zeneca Ltd. The new shares were being allotted and issued directly to ICI shareholders in satisfaction of a dividend of an amount exceeding the shares' nominal value.

Simon Taube (Berwin Leighton) for the trustee; Peter Horsfield QC (Berwin Leighton) for the remainderman; Christopher McCall QC (Berwin Leighton) for the life tenant; Robert Walker QC (Treasury Solicitor) as amicus curiae.

SIR DONALD NICHOLLS V-C said no one unversed in the arcane mysteries of the law would doubt that the new shares should be treated as capital. The problem arose because they were being allotted by the company mechanism of a dividend, and there was a long line of cases holding that dividends paid on shares forming part of a trust fund should be treated as income: see, particularly, Hill v Permanent Trustee Company of New South Wales Ltd (1930) AC 720.

Here, the following facts were to be noted.

The transfer by ICI of shares in Zeneca Ltd to Zeneca Group, and the allotment of Zeneca Group shares to ICI shareholders, were part of a single indivisible transaction. The demerger agreement was conditional on the passing of the demerger resolution. ICI itself would never become entitled to receive any property in exchange for the Zeneca Ltd shares.

The commercial purpose of this tripartite transaction was not for ICI to part with some of its assets to its shareholders, but to replace a single head company with two head companies. ICI shareholders would have the same proportionate interest in the two new trading entities as they had in the old large one.

This division would take place on terms whereby the capital of the companies would be increased, and the reserves distributable as profits decreased, in a manner analogous to the issue of bonus shares.

ICI shareholders would be no nearer the underlying assets than before. But ICI, the company declaring the dividend, parted with assets of value: its shares in Zeneca Ltd. In that respect the transaction was not a classic capitalisation case, in which the company retained its assets intact and issued shares of its own in exchange for hitherto distributable profits.

Nor was this a classic case of distribution by a dividend 'in specie'. ICI owned, and parted with, shares in Zeneca Ltd; but these did not reach ICI shareholders, who received shares in Zeneca Group to which ICI was never entitled.

Thus the transaction was something of a hybrid, having features both of a capitalisation and of a distribution of a dividend in specie. But to regard it as a distribution of profits, akin to payment of a dividend in specie and hence income, would be to exalt company form over commercial substance to an extent that was unacceptable. The principles enunciated in Hill's case were only guidelines, which the court should not apply too slavishly.

This was a company reconstruction, with two capital assets (shares in ICI and Zeneca Group) in the trustees' hands replacing one existing capital asset (ICI shares). The new shares in Zeneca Group should, therefore, be held by Mrs Lee's trustees as capital of the fund.