The International Journal
of Not-for-Profit Law

Volume 11, Issue 3, May 2009

Pesh Framjee1

1. THE DREADED TRADING

An increasing number of charities are faced the need to finance their work from earned income and as expenditure outpaces income there is a constant need to look for innovative means of income generation. On the voluntary fundraising side charities are trying to increase their slice of the fundraising cake as well as increase the size of the cake itself. However, many charities have also recognized that in addition to tapping the altruistic side of society there is potentially a large source of income that can be motivated through a mix of altruism and some personal advantage. Hence charity shops, commercial sponsorship, affinity card schemes and other sources of charity income generation that arise from earning income.

Contrary to popular misconception, many charities do have earned income streams arising from fees and sales of products and services. Indeed, earned income is a significant proportion of the income of the UK charity sector. Charities are providing products and services for a fee on a regular basis and these arrangements often leads to the dreaded “trading” with its consequent charity law and tax implications. As charities widen the range of their income generation efforts, the incidence of trading increases and income generation activities come under close scrutiny to establish what is behind the transaction.

Surprisingly, a number of charities continue be unaware of the ramifications. In the extreme, trading activities can threaten the charitable status of a charity since the generation of income per se, albeit for charitable purposes, is in itself not a charitable objective. Apart from the threat of endangering the charitable status there are also the taxation and practical “business” issues to consider.

The aim of charity trading is usually to generate income and profit and it is important to avoid having to pay tax on that profit. Charities are not automatically exempt from tax. The trading exemptions are restrictive and often difficult to fall within. What is trading?

What is trading?

What then is trading? My dictionary refers to “the practice of some occupation, business, or profession habitually carried on especially when practiced as a means to a livelihood e.g. shop keeping, commerce, buying and selling.” However our everyday understanding is considerably widened by Section 832 of the Taxes Act 1988 which states that a trade includes “every trade, manufacture, adventure or concern in the nature of trade.”  It does not cease to amaze me how unhelpful this circular definition which originates almost 200 years ago is. Consequently, the courts have on several occasions had to scrutinize activities to decide whether they fall within the definition of trade.
A Royal Commission reported in 1955 and identified six main badges of trade:

(i) the subject matter;
(ii) period of ownership;
(iii) frequency of transactions;
(iv) supplementary work;
(v) cause of sale; and
(vi) motive.

Some of the income generation activities of charities are easily recognizable as traditional charity trading – the purchase and sale of goods, Christmas cards and such. In addition, more and more charities are being enmeshed in the trading net for activities that they had thought were part of their normal fundraising effort. For example, commercial sponsorships, affinity card schemes, lotteries, conference income, etc.

What is allowed—Statutory Exemptions

Section 505 of the Income and Corporation Taxes Act 1988 (ICTA 88) gives exemption for trading profits which are used solely for charitable purposes providing:

• the trade is exercised in the course of the actual carrying out of a primary purpose of the charity;

• or the work in connection with the trade is mainly carried out by the beneficiaries of the charity.

The Charity Commissioners’ guidelines also recognize these categories of trading as acceptable and a charity in so doing will not normally endanger its charitable status. Nevertheless, it must be appreciated that when considering primary purpose trading a distinction must be made between activities which are directed to the achievement of the objectives and activities, which although they help the charity, cannot be described as carrying out or carrying out part of its charitable purposes.

For example, a church that may have charitable status with the objective of advancing religion would find that the sale of religious books qualifies as part of its primary purpose although the sale of other books would not. This is despite the fact that the profits from both types of sales are used exclusively for its charitable objects.

The sale by a charity for the handicapped of goods produced in a workshop staffed by the beneficiaries would qualify under the second alternative. As could the sale by an international aid charity of goods produced by its beneficiaries in developing countries.

Of course a prerequisite for a charity when it is considering trading is that it should have the constitutional powers to do so. Having such a power, even when it refers to non primary purpose trading, should not in itself preclude an organization from having charitable status. However, most modern governing instruments make reference to trades that are within the tax exemptions.

The question to be asked is whether the trading is on such a scale that it might dominate the organization’s original charitable purpose. If the organization’s powers allowed trading to such an extent, it would be questionable whether the organization could be said to be established for exclusively charitable purposes.

On the other hand incidental and insignificant trading is usually permissible by law and although any profits that do not fall within the statutory tax exemptions would be taxable there are further avenues open to the trustees. Strictly, if a charity carried out non-exempt trading activities at the same time, they could lose the exemption altogether. Within limits, HMRC used to treat the primary-purpose activity as a separate, exempt trade, but case law has said that both activities have to be treated as a single trade.

The 2006 Finance Act now specifically requires the trade to be split into two, with the primary-purpose one exempt and the non primary purpose trade being taxable. The same applies to the parallel exemption where the trade is mainly carried on by beneficiaries of the charity. Following changes to the trading exemptions found in Section 505 ICTA ‘88 HMRC have published new guidance. This explains that trading receipts should be allocated between trades that are taxable and non taxable on a reasonable basis. In their guidance HMRC have explained that it is necessary to divide the charity’s trade into a number of different statutory forms, which, for chargeable periods beginning on or after 22 March 2006, include “deemed trades.” They explain the position as follows:

All trading exercised in the course of carrying out a primary purpose of the charity (e.g. a theatre charity selling programs, a charitable school charging pupils, or a residential care charity charging residents) is referred to as “primary purpose trading.” S505 (1)(e)(i) ICTA 1988. The profits of such trades are not taxable if they are applied for charitable purposes.

Where a charity’s trade is carried out partly in the course of carrying out a primary purpose of the charity, and partly for non-primary purposes, Section 505 (1B) ICTA 1988 deems each part as a separate trade for tax purposes. The primary purpose deemed trade is not taxable. S505 (1B)(a) ICTA 1988 but the non primary purpose trade is taxable. This is discussed in more detail below.

The exemption from tax can also extend to other trading, which is not overtly primary purpose in nature but which is ancillary to the carrying out of a primary purpose. This trading can still be said to be exercised in the course of the carrying out of a primary purpose. It is therefore part of the primary purpose trade. This is discussed in greater detail below.

Beneficiary Trading encompasses trades which are non primary purpose but carried out mainly by beneficiaries (e.g. the manufacture and sale of items by residents). Where the work in connection with a charity’s trade is carried out partly by beneficiaries, the part not carried out by beneficiaries is deemed to be a separate trade, which, assuming it is non-primary purpose, will be taxable unless the small trading exemption applies

Small trades (Section 46 FA 2000)

Since April 2000 there is also a relief for small trades. The relief is from tax on profits where there is a reasonable expectation that turnover is either below:

£5,000, or the lower of

• £50,000, and
• 25% of the charity’s total incoming resources

If a charity inadvertently breaches the thresholds it will have to establish that the trading turnover and/or total incoming resources were different to its “reasonable expectation.” HMRC have explained that they will consider the circumstances to establish whether the charity had reasonable grounds to consider that it would not fall outside the exemptions. For example, this could be established by budgets and forecasts or past trends.

Extra statutory concession for fundraising events (ESC C4)

Also see separate guidance note on Fundraising events

In recognition of the fact that ICTA 88 Section 832’s unsatisfactory definition of trading would catch a number of activities that have traditionally been associated with charity fundraising, (bazaars, jumble sales, etc) HMRC published an Extra Statutory Concession, (ESC C4) This concession was similar yet different to the VAT exemption for fundraising events and therefore caused unnecessary complications and as a result of the Charity Tax Review the two have been harmonized and ESC C4 now states:

Certain events arranged by voluntary organisations or charities for the purpose of raising funds for charity may fall within the definition of “trade” in Section 832 ICTA 1988, with the result that any profits will be liable to income tax or corporation tax. Tax will not be charged on such profits provided: a. the event is of a kind which falls within the exemption from VAT under Group 12 of Schedule 9 to the VAT Act 1994 and b. the profits are transferred to charities or otherwise applied for charitable purposes.
There are however certain caveats. All the conditions of the concession must be met. This area is complicated.

Note that for trusts this has now been enshrined in law – Section 529 of the Income Taxes Act 2007 states:

Exemption for profits from fund-raising events
(1) The profits of a trade carried on by a charitable trust are not taken into account in calculating total income so far as they arise from a VAT-exempt event.
(2) Subsection (1) applies so far as the profits are applied to the purposes of the charitable trust only.
(3) An event is a VAT-exempt event if the supply of goods and services by the charitable trust in connection with the event would be exempt from value added tax under Group 12 of Schedule 9 to the Value Added Tax Act 1994 (c. 23) (fund-raising events by charities and other qualifying bodies).

Trades that are partly primary purpose

Charities also carry out trading which is not part of the primary purpose of the charity but which is typically undertaken to raise funds to be applied for charitable purposes (e.g. sales of promotional items or commercial sponsorships). Where a charity’s trade is carried out partly in the course of carrying out a primary purpose of the charity, and partly for non-primary purposes, Section 505 (1B) ICTA 1988 deems each part as a separate trade for tax purposes. The charity’s non-primary purpose deemed trade is not exempt from tax, unless the work is carried out mainly or partly by beneficiaries – or the small trading exemption applies (see above).

HMRC has explained that this would apply in cases where the trade might deal in a range of goods or services only some of which are within, or ancillary to, a primary purpose. Or the trade might deal with some customers who cannot properly be regarded as beneficiaries of the charity. Examples of such trading cited in the HMRC guidance include:

• a shop in an art gallery or museum which sells a range of goods, some of which are related to a primary purpose of the charity (i.e. education and the preservation of property for the public benefit e.g. direct reproductions of exhibits and catalogues), and some of which are not (e.g. promotional pens, mugs, tea towels, stamps, etc.)

• the letting of serviced accommodation for students in term-time (primary purpose), and for tourists out of term (non primary purpose), by a school or college

• the sale of food and drink in a theatre restaurant or bar both to members of the audience (beneficiaries of the charity) and the general public (non-beneficiaries).

Ancillary Income and Part Exempt Trades

As highlighted above HMRC have also extended the exemption from tax to other trades, which in themselves are not primary purpose but which are ancillary to the carrying out of a primary purpose. They have cited the example of “the sale of food and drink in a cafeteria to visitors to exhibits by an art Trust or museum.” Such trades will qualify as primary purpose trades.

HMRC have also recognized that in some cases a primary purpose trading activity may include an element of some non-exempt trading.

HMRC will establish whether the non-exempt activity can be assessed as a separate trade. In the example of the shop, if there was a separate shop selling the souvenirs it would probably be assessed as a separate trade.
In the past HMRC adopted a rule of thumb and if the trade was seen to be part of a single trade and the turnover of the non-exempt part amounts to less than ten per cent of the total trade the Revenue will usually permit it to be disregarded as de minimis so long as it is not large (defined as £50,000). If it is not treated as de minimis HMRC explained that they may seek to tax the whole trade. This guidance has now been superseded and HMRC explains:

The exemption from tax can also extend to other trading, which is not overtly primary purpose in nature but which is ancillary to the carrying out of a primary purpose. This trading can still be said to be exercised in the course of the carrying out of a primary purpose. It is therefore part of the primary purpose trade. Any impression that it is a separate category is incorrect.

Examples of trading which qualifies as primary purpose because it is ancillary to the carrying out of a primary purpose are:

• the sale of relevant goods or provision of services, for the benefit of students by a school or college (text books, for example)
• the provision of a crèche for the children of students by a school or college in return for payment
• the sale of food and drink in a cafeteria to visitors to exhibits by an art gallery or museum
• the sale of food and drink in a restaurant or bar to members of the audience by a theatre
• the sale of confectionery, toiletries and flowers to patients and their visitors by a hospital.

Public benefit

When considering the issue of what trading is allowable there is need to consider the issue of the public benefit test as enshrined in the Charities Act 2006. The Act has for the first time set out in legislation charitable objectives and established the over arching requirement to demonstrate that the activities provide public benefit.

For the first time the law requires charities which advance education, religion or relieve poverty to demonstrate explicitly they deliver public benefit.

The Charity Commission has emphasized that there is a particular focus on fee charging and this is of relevance when considering the issue of trading. The Charity Commission has stated that charities which charge relatively high fees must demonstrate accessibility to those facilities or services.

It will not normally be possible to demonstrate public benefit through indirect benefits alone, such as savings in public expenditure through the provision of a service like education or health. They have explained that they think that all charities should give an account each year of the public benefit they provide.

For fee-charging charities where public benefit is not immediately obvious given the high level of fees charged, one suggestion we will explore is to expect those charities also to assess and report the value of the tangible benefits they bring, alongside the value of the tax breaks they receive.

The Charity Commission has explained that “there are two essential elements of the public benefit requirement: 1. Benefit – to be charitable the pursuit of an organization’s purposes must be capable of producing a benefit which can be demonstrated and which is recognized by law as beneficial; and 2. Public – that benefit is provided for or available to the public or a sufficient section of the public.”
They go on to explain that this can be broken down further into four principles which show whether an organization provides benefit to the public.

1. There must be an identifiable benefit.
2. Benefit must be to the public, or a section of the public.
3. People on low incomes must be able to benefit.
4. Any private benefit must be incidental.

Other useful guidance

The Charity Commission has published guidance which is available form the publications section on its website – See CC35.

HMRC’s detailed guidance for charities can be found on the charities section of the HMRC web site. In addition, in June 2007 HMRC published detailed guidance on trading for Higher Education Institutions.

This guidance was prepared for the British Universities Finance Directors’ Group (BUFDG) and focuses on universities but the principles would apply to all charities. This guidance includes a flow chart for considering a university’s trading activities. This has been reproduced at Appendix 1 with HMRC permission.

2. SPECIFIC ACTIVITIES

In this section I have attempted to briefly look at the more common trading activities carried out by charities

Sale of donated goods

When one thinks of charity trading it is the traditional charity shop selling donated goods that come to mind. Neither the Charity Commissioners nor HMRC treat the sale of donated goods as trading. The sale of donated goods is treated by them as the mere conversion of donated gifts into cash. As a result donated goods can be sold by a charity without fear of endangering charitable or tax status.

HMRC has explained that this applies even if the donated items are sorted, cleaned and given minor repairs. However, they have warned that if the goods are significantly altered or processed so that they are sold in a different state from that in which they were donated, the sale proceeds may be regarded as trading income. For example, if a charity makes donated fabric into clothes for sale, this will amount to a trade.

The VAT rules take an even more favorable view and offer the best possible VAT situation. The sale of donated goods is zero rated. This applies to charities as well as any “taxable person” who has covenanted by deed to give all the profits of the supply of donated goods to a charity. Consequently, it is possible to reclaim all the input VAT associated with the supply without having to charge any output VAT.

There are schemes gaining popularity whereby the charity sells goods on behalf of the donor who then Gift Aids the proceeds to the charity. HMRC has agreed to specific rules that need to be followed but it is relevant to note that this is not the sale of donated goods and any commission paid by the owner for the goods will be trading income. In addition, since the amount of zero rated sales will inevitably decrease there may be an impact on VAT recovery and a possible impact on rates (See Section 7).

Corporate sponsorship

Also see separate guidance note on corporate partnerships and donations

Many charities are now targeting the marketing budget of corporate donors, instead of seeking pure charitable donations. What starts as a means of profitable fundraising can have fairly disastrous tax implications if the arrangements are not properly structured and planned.

Typical examples are commercial sponsorship and joint ventures. In these cases it is important to see whether the charity, in return for the sponsorship, is offering free publicity. There is no problem with the mere acknowledgement of a donation. On the other hand if the “gratitude” offers free publicity for the corporate organization (e.g., by prominent use of their logo or strap line) then it is quite likely that it will be construed that the charity is supplying an advertising service. This is within the realms of the dreaded “trading” and the making of “taxable supplies,” with implications both in terms of corporation tax and VAT.

It is vital when looking a transaction of this sort to establish the exact substance of the transaction and see whether it is a true donation or commercial transaction, with the charity supplying advertising and publicity services. In essence, if the payments are made in exchange for something, such as advertising of the sponsor, the payment is often no longer treated as a pure donation. For example, a charity may publicize and acknowledge the sponsor in publications, posters, etc. In such cases if this is simply a mere acknowledgement then the payment can be treated as a donation.

The key element is that the charity must remain passive – if the sponsor publicizes the fact that they have made a generous donation and derives benefit from that the donation will still be treated as a donation When looking at a transaction of this sort HMRC will examine the substance of the transaction and may conclude that the charity may be selling advertising services. HMRC looks carefully at this and have stated that, references to a sponsor which amount to advertisements will cause the payments to be treated as trading income. HMRC will regard a reference to a sponsor as an advertisement if it incorporates any of the following:

• large and prominent displays of the sponsor’s logo,
• large and prominent displays of the sponsor’s corporate colors,
• or a description of the sponsor’s products or services.

Similarly, if a charity provides the sponsor with goods or services in exchange for the payment it may be deemed to be trading with attendant tax consequences. Some of the examples provided by HMRC may seem to be fairly innocuous they include the use of the charity’s mailing lists, logo, exclusive right to sell goods and services on a charity’s premises etc.

This may not be altogether simple and clear. A corporate sponsor might make a very large payment and indeed receive some form of advertising benefit. Even though it may be argued that the benefit is not commensurate with the payment made, case law now provides that it is not possible to apportion the payment between the elements relating to the advertising service provided and a pure donation for VAT purposes. Unless there is a specific price for the benefit (which will bear VAT) and the balance of the payment being totally discretionary (a gift, which will not bear VAT), VAT could be due on the whole payment.

Allowing use of the Charity’s logo

Payments for the use of the charity’s logo can lead to the taxation of intellectual property. The marketing by charities of their name and logo to commercial organization who then use these to endorse the commercial organizations own products is likely to constitute a trading activity leading to taxable income.

It could also be interpreted as a supply of a trademark or sale of copyright. It is unlikely that a provision of a name or logo for a single fundraising event would give rise to tax liability. On the other hand if there is a form of contract governing the use of the charity’s name and its provision of promotional services to commercial organization, then the income may be assessable as trading income and would not be exempt.

The rules are not altogether straightforward and HMRC has explained that where the logo came into existence prior to 1 April 2002 a one off payment (received without any deduction of tax) is charged to tax as miscellaneous income and no exemption is available apart from the small trading exemption.

There is also tax exemptions for income which meet the criteria of an “annual payment” and this could apply where a commercial organization make annual payments solely for the use of a charity’s logo. Such arrangements need to be structured carefully to ensure they meet the definition of an annual payment.

Where the payer is a UK company, payment can be made without the deduction of income tax. However in certain other circumstances the organization making the annual payment may have to deduct tax at the basic rate from the payment and the charity can reclaim the tax. The payment must be:

• applied solely for charitable purposes

• made under a legal obligation

• recurring (the payments must be capable of recurring each year but the obligation may be contingent)

• treated as pure income profit in the hands of the charity (a sum is “pure income profit” if it comes to the charity without the charity having to do anything in return)

For charitable companies, where the logo came into existence on 1 April 2002 or later, a logo is treated as an “intangible fixed asset.” Non-trading gains on intangible fixed assets received by charitable companies are exempted from tax under as long as the gains are applied charitably.

The VAT position is somewhat different and the grant of a right to a business sponsor to use the charity’s logo is treated as a supply of taxable services for VAT purposes. HMRC have clarified that the granting of the right for a sponsor’s logo or name to appear in a charity’s publication or on their website is a supply of services for VAT purposes. The same principles apply when a charity grants the right to a business sponsor to use the charity’s logo.

This may seem at odds with the concept discussed earlier that where the charity remains passive and does not provide goods and services in exchange for a payment the payment will usually be treated as a donation. HMRC point out that it is the granting of the right to use the logo that triggers the taxable event for VAT purposes rather than any activity (or lack of it) undertaken by the charity or the size and/or prominence of the logo.

Research Income

Some charities often carry out research on a paid basis. If the payment is in the nature of a grant which merely requires the research to be completed, and if the carrying out of research is part of their charitable objective, there should be no problem. However, if the person paying for the research acquires rights to the results it could be construed that the research is not for the benefit of the public and thus not for charitable purposes and the charity could be deemed to be trading. This is not likely to be the case where the funding organization is itself a charity or a government body but could apply say with a pharmaceutical company funding medical research through a charity.

When considering this aspect HMRC and the Charity Commission will review whether the research is made available in the public domain and whether it is impartial and does not simply advance the views of the sponsoring organization.

HMRC’s published guidance for Higher Education Institutions .incorporates guidance from the Charity Commission on research and within that guidance they have explained that to be charitable, research carried out or funded by a charity must both fall within its objects and powers and be carried out for the public benefit. They explained that to do this the research must fulfil each of the criteria set out below:

• “Research must be in a subject, or be directed towards establishing an outcome, which is of value and calculated to advance or enhance knowledge and understanding. Research into a subject may be of public benefit whether or not it is directed at testing any particular hypothesis; and if it is so directed, whether the hypothesis which the research sets out to test is proved valid or invalid. In each case knowledge and understanding should be advanced or enhanced.

• Research must be undertaken with the intention that the useful knowledge acquired from the research will be disseminated to the public and others able to utilize or benefit from it and so advance charitable purpose.
• Any research which results in useful knowledge should be disseminated. It includes making the knowledge available or otherwise accessible. This applies equally to research which will use its results whose value is immediately apparent and may be of practical application, and to research the results of which simply add to the store of useful knowledge and which may be developed further by research in further generations. Dissemination may take the form of practical application of the research outcome.
• Research must be justified and undertaken for the benefit of the public and not solely for self- interest or for private or commercial consumption. Public benefit may arise from research in a variety of ways. In many cases, the dissemination of the useful knowledge gained will constitute adequate public benefit. In other cases, particularly, but not exclusively, where the charity’s objects are directed towards the provision of charitable relief for beneficiaries, public benefit may arise from the practical development and application of a research outcome. This might be achieved with or without collaboration with a commercial partner. Research undertaken not as charitable activity may still, nonetheless, be undertaken by a charity.”

Closed Courses

HMRC has also emphasized that closed courses will not be seen as a charitable activity for public benefit. They have explained that a closed course is broadly one where:

• The attendees are drawn from a narrow range of the public, or
• The criteria for selection for the course exclude the wider general public, or
• The benefit is not to a sufficiently wide sector of the public

A typical example would be where a University provides a course or training specifically for a single business. HMRC considers that courses which are “closed” typically have a different purpose to a university’s main educational activities. In determining the tax treatment of a closed course, as with research activities, the main point to consider is whether the activity passes the charitable purpose requirement. Closed courses are clearly within the charitable purpose heading of the advancement of education, but the question is whether they also provide a private benefit.

Notwithstanding the above there are clearly cases where a charity may make courses generally available but also run some courses which are focused on a narrower sector (e.g., a particular industry) and that in itself should not mean that the activity is taxable.

Non-student lettings and use of the other facilities

HMRC have reemphasized that the use of student residential accommodation and other university and school owned premises by non-students and associated income generation activities such as the provision of bars, external catering, and conferences, may be non-primary purpose trading activity. Providing accommodation, catering, and other facilities to conferences run by the university where the focus is on education and research topics and the sharing of knowledge or best practice in teaching or research, should be accepted as being part of a primary purpose trade.

However, the provision of accommodation and similar services to third parties for the purpose of generating income by utilization of surplus capacity would normally be non-primary purpose trading activities and subject to tax. (but there are some exemptions—see section below on property letting) HMRC has provided detailed guidance on the cost allocation principles.

Consultancy

With regard to consultancy income the same principles apply. HMRC have explained that consultancy services are usually carried out with a profit motive and will often not meet the primary purpose criteria. However, in many cases the consultancy services may be clearly furthering the charity’s objectives and simply because they also make a profit does not mean that the income is taxable as the primary purpose trading exemption should apply.

In the case of Universities HMRC has explained that where typically it can be demonstrated that the main purpose of the charity in carrying out the consultancy is to obtain access to results for academic research or teaching purposes it may be possible to treat it as a primary purpose trade. Similarly, if consultancy is carried out by the students it may meet the “beneficiary trading” rules. As with all non primary purpose trading proper cost allocation is needed.

Contracting

Many aspects of charity funding are moving from grants to contracts. The contract culture with its concept of an exchange transaction and service level agreements could lead to the charity being seen to carry out a trade. For example, a charity providing housing is in fact trading. The absence of a profit motive is not conclusive to establish that it is not trading. In most cases it is more than likely that charities which contract out their services will be fulfilling their primary purpose. In the example cited above if the charitable objective was to provide housing then it would be within the realms of primary purpose trading.

Similarly, charities are engaging more in public service provision and contracting with Local Authorities and government departments to provide services for a fee. In most cases the provision of such services is within the charitable remit of the organization and the activity should qualify as a primary purpose trade. On the other hand universities and schools whose primary purpose is education are seen to be trading if they hire residential facilities to tourists in the holidays, because holiday lets are unrelated to the provision of education. There are also of course VAT considerations. There are exemptions for welfare services carried out on a not for profit basis and charities should ensure that they are aware of the rules.

Property letting

For income or corporation tax purposes, income derived from property is taxable under Schedule A and/or Schedule D. Schedule A includes rental income, ground rents, amounts received as payments for right of access, etc.: (see ICTA 1988, s15(1)).

Many charities provide space that is used by third parties to run conferences and other events. Where all that is being provided is room hire, albeit furnished, and the only services being provided are those that a landlord would normally provide (cleaning, security, power supply etc) then the income received should be income from property taxable under Schedule A. However, if additional services are provided such as catering, hire of equipment, supply of materials then the whole of the income is likely to be treated as trading income. If the conferences are of a nature that promote the charities objectives then this income could be seen to be primary purpose trading.

Where there is a furnished letting, the income derived from it would fall under Schedule D, Case VI (see ICTA 1988, s.18(3)). ICTA 1988, s.505(1)(a) specifically exempts charity property income assessable under Schedule A or Schedule D, so far as it is applied to charitable purposes. In cases where accommodation is let and not only is it furnished but services are provided as well, e.g., if a university lets its bedrooms and provides laundry services and meals, the income becomes trading income (as in, e.g., a hotel trade) and is liable to tax.

HMRC’s guidance explains

“All rental income from land or buildings, received by a charity, is exempt from tax provided the profits arising are applied for charitable purposes.
“However, if services are provided along with the use of the land or buildings (for example, provision of a caretaker, food or laundry) these services in themselves might amount to trading. Letting activity will itself constitute a trade where the owner remains in occupation of the property and provides services over and above those usually provided by a landlord. Essentially the distinction lies between the hotelier (who is carrying on a trade) and the provider of furnished accommodation (who is not). An important difference is that in a hotel etc. the occupier of the room does not acquire any legal interest in the property. Each case must be considered on its own facts.”

The VAT rules of letting are more complex – in essence the charity may opt to tax, that is it may charge VAT on its rental income. The correct answer for the charity will require consideration of a number of factors and is not within the scope of this guidance note.

Property sales

Generally gains arising from the sale of property would call within the exemption found in Section 256 of the Taxable and Chargeable Gains Act but there is a need to be aware of another pitfall.

Charity trustees are required to obtain the best terms when disposing of charity property. This can often have tax ramifications and may cause tax problems. For example, it may be the best commercial decision to obtain planning consent before disposing of a property and, taking this one step further, the charity may plan to develop the property.

After considering the investment powers of the trustees and whether investing in development activity would be speculative and correct for the charity to undertake, there is a further question of whether the development profits would be taxable as trading.

S776 ICTA 88 was enacted to prevent the avoidance of tax by persons concerned with land or the development of land. The section will apply when land is acquired or developed with the intention of realizing a capital gain from the disposal. In these circumstances the profits or gains are chargeable to tax under Case VI of Schedule D and would not usually fall within the primary purpose trading exemptions exemption of s505 of ICTA 88.

The law is far-reaching and explains that “where, whether by a premature sale or otherwise, a person directly or indirectly transmits the opportunity of making a gain to another person, that other person’s gain is obtained for him by the first-mentioned person.”

Care must be taken with such transactions to ensure that the charity is not in breach of its investment powers or exposed to tax. Often the safest route is to use a separate trading subsidiary. However, the charity cannot gratuitously give away assets or rights to its trading subsidiaries and transactions will need to be on an arm’s-length basis.

Lotteries

Charities do not have to pay tax on profits from lotteries run to raise funds for their charitable purposes if the lotteries are promoted and conducted under a license issued under section 98 of the Gambling Act 2005 or Article 133 or 135 of the Betting, Gaming, Lotteries and Amusements (Northern Ireland) Order 1985. There is the overall requirement that the lottery profits are applied solely to the purposes of the charity.

In some cases a subsidiary company may be registered as “the Society” under the legislation. In such cases, the lottery profits will belong to the company and not to the charity for tax purposes. The exemption will not apply and the company will need to pass the profits to the charity as discussed further in this guidance note.

The Finance Act 2006 made changes to primary legislation but maintains the existing exemption from tax for charities for the profits from charitable lotteries run in accordance with lottery regulations.

Earlier the exemptions were given by section 505(1)(f) ICTA 1988) by reference to the Lotteries and Amusements Act 1976. The relevant sections of the 1976 Act have been replaced by sections of the Gambling Act 2005. The 2005 Act also brings in a new regulatory framework for lotteries. The Finance Act 2006 ensures that only lotteries which are lawful under the 2005 Act receive tax relief, but does not extend or restrict the existing relief. These amendments were brought into force to coincide with the introduction of the new licensing regime under the 2005 Act, on 1 September 2007.

Changes to tax law in the Income Tax Act 2007 (ITA 2007) separate charitable trusts from charitable companies, so that section 505(1)(f) ICTA 1988 will only apply to charitable companies. The legislation also amends the law to ensure that charitable trusts continue to receive the relief.

For VAT purposes a lottery is the distribution of prizes by chance where the persons taking part in the operation, or a substantial number of them, make a payment or consideration in return for obtaining their chance of a prize. The right to take part in a lottery is exempt under VAT Act 1994, Sched. 9, Group 4, Item 2. The value of the exempt supply is the gross proceeds from ticket sales less only the amount of cash prizes given or the cost, including VAT, of goods given as prizes. However, where an element of merit or skill is introduced the event is not a lottery but a competition and VAT rules for sports competitions will apply.

The 2005 Act brings in a new licensing regime for some large lotteries. Where this licensing regime applies, relief will not be given for lotteries which do not have the required license, as the lottery would be unlawful.

Overseas operations

Many charities trade overseas and in addition to the UK laws and regulations there are local laws to consider. UK statutory exemptions discussed above will apply for UK tax purposes even if the trade is carried out overseas.

However, local tax law will in the overseas regime not automatically allow the same concessions and exemptions as apply in the UK. Charities have found that they face local tax liabilities because the exemptions do not work in the same way as they do in the UK. In many overseas regimes the concept of charity as it is in UK is not recognized and simply setting up an operation overseas can lead to the creation of a permanent establishment for tax purposes.

In some cases it may be better to trade through the UK operation but even if this does not create a taxable presence overseas there could be withholding tax. These taxes usually apply if there is an activity that involves the payment of royalties and dividends. Withholding tax can often be mitigated or avoided altogether through the application of relevant double tax treaties.

In some cases it may be possible to use one overseas establishment in a favorable tax regime to cover operations in different countries.

3. TRADING SUBSIDIARIES

Trading subsidiaries—The answer?

As we have seen, charities are now increasingly exposed to the implications of trading. Some of the areas of exposure are new but the issues have been around and discussed for a long time. In their 1980 report the Charity Commissioners stated that drawing the line between the charity which is merely raising funds and furthering its activities by trading and what is in substance a trading institution wearing a charitable mantle is not easy. They went on to say that where a charity wishes to benefit substantially from permanent trading for the purpose of fundraising it should do so through a separate non charitable trading company so that its charitable status is not endangered.

Essentially, trading through a separate trading company has a number of benefits. It is encouraged under charity law, it is possible to arrange matters so that all the profit is transferred to the parent charity in a tax efficient manner and if properly structured the trading subsidiary will be a separate entity with limited liability. However, care must be taken to ensure that all the detail is fully considered so that none of the potential benefits are lost.

Setting up and financing the trading company

It is usual for a trading company to be owned by the charity.

The trading company will usually require working capital that could be made available by any of the following ways:

• borrowing from a commercial source
• borrowing from the charity
• issue of share capital

When it comes to financing or refinancing the trading company there seems to be a slight difference of opinion between HMRC and the Charity Commission. HMRC have stated “Most commercial companies use their profits to maintain and develop their business. If a company intends to distribute all of its profits every year, this may leave it without these necessary funds. To avoid this problem, when a charity sets up a trading company, it should ensure that it provides the company with enough capital to enable it to shed its profits every year and stay in business.”

The Charity Commission’s old guidance stated, “Normally, investment in a subsidiary trading company should take the form of secured loans by the charity on market terms. Charities should not ordinarily subscribe anything more than nominal sums for the issue of share capital by the subsidiary trading company (in order to satisfy the formal requirements of company law). The subscription of shares in the subsidiary trading company by the charity normally exposes the charity’s investment to greater risk (because the repayment of share capital, in the event of the liquidation of the subsidiary trading company, has a lower priority than the repayment of loans).

My experience is that some responses from the Commission still seem to focus on this old guidance. It is therefore important to recognize that the Commission appear to have taken a more reasoned approach to financing of trading subsidiaries in their new guidance which explains:

However, there are valid reasons why a parent charity might choose to capitalize a trading subsidiary by means of share capital rather than loan capital. For example:

• the subscription by a parent charity of substantial share capital in its trading subsidiary can give confidence to suppliers, customers, creditors, prospective creditors and others with whom the trading subsidiary has a business relationship; or
• where a trading subsidiary would be exposed to the risk or actuality of insolvency if it were to be capitalized by loan, trustees will have little choice but to invest share capital (subject to the considerations set out in section D8 of the CC35 guidance, above).The fact that share capital subscribed by the parent charity in a trading subsidiary might not be repaid in full, or even in part, on the dissolution of the subsidiary, is only one factor which the charity’s investment adviser should consider when deciding whether to recommend the trustees of the parent charity to subscribe for share capital. The adviser would have to consider the overall economic return to the charity, balancing Gift Aid payments and any anticipated distributions against the risk of capital loss.

In their guidance on investing in a trading subsidiary the Commission and HMRC have explained that they would expect the charity to consider carefully issues such as the:

• investment powers of the charity
• need to diversify investments
• risk profile of the trading activity
• financial viability and business prospects of the subsidiary
• suitability of the investment

In all cases it must be seen that making the investment is expedient in the interest of the charity.

In the past the Commission also stated that if funds are needed to sustain or expand the activities of the trading company they should normally be obtained from commercial sources. There are however many problems with obtaining money from a commercial lender who will almost certainly want a guarantee from the charity.

In the first instance the charity must have the constitutional powers to give such a guarantee. As a general rule it is a fundamental tenet of charity law that the charity should not give away its own assets except in the furtherance of its charitable purposes. The giving of a gratuitous guarantee of this nature could be tantamount to giving away assets if the guarantee was called. However case law has shown that in certain cases the giving of such a guarantee would be within the powers of a corporate charity but this would only apply if the company on whose behalf the guarantee was given was a wholly owned subsidiary of the charity and was carrying out the objects of the charity. The first condition is not difficult to achieve but the second may be a stumbling block.

At any rate, the Charity Commissioners would look very closely at any guarantees given on behalf of a trading subsidiary. They have explained that “Such guarantees, if given, will often be unenforceable against the charity and may expose trustees to personal liability.”

Furthermore, I do not think that it is always a sound financial decision to obtain external funding. It seems pointless if the trading subsidiary is paying external interest at a rate above that which the charity may be obtaining on money it has invested. The route followed by most charities with trading subsidiaries is to finance internally. If there is going to be a need for a fixed amount of working capital it is perhaps better to provide this through the issue of share capital.

As discussed above the charity’s trustees must consider two questions when considering investment in subsidiary companies. These are:

• does the charity have the wide investment powers to make such an investment; and
• is a trading venture of this sort too speculative and risky for the charity?

The first of the above conditions would require scrutiny of the constitution, and if necessary the widening of the investment powers given to the Trustees.
The second question is more subjective—trustees should not make hazardous or speculative investments. The general rule that a trustee should act as an ordinary prudent man of business was expanded in Learoyd v Whiteley (1883) when Lord Watson said: “Businessmen of ordinary prudence may, and frequently do, select investments which are more or less of a speculative nature: but it is the duty of a trustee to confine himself to the class of investment which are permitted by the Trust and likewise to avoid all investments of that class which are attendant with hazard.”

Therefore, it is important that there is adequate evidence that the trustees have carefully considered their investment. There should be business plans and forecasts to show the expected return on the investment. Additionally, it is important that the trustees show that they regularly reconsider the appropriateness of their investment in the trading subsidiary. In my opinion the trustees should, at least each year, formally minute that they have reviewed the trading operation and considered whether it is appropriate to continue to invest in it.

In their latest guidance on Trading the Charity Commission have explained that:

• the trustees must reasonably consider that it is in the charity’s interests to make the investment, after making a fair comparison of this form of investment with other forms of investment which might be selected;
• this fair comparison must involve an objective assessment of the trading subsidiary ‘s business prospects;
• the trustees must be satisfied as to the financial viability of the trading subsidiary, based on its business plan, cash flow forecasts, profit projections, risk analysis and other available information; and
• the trustees must ordinarily take appropriate advice on the investment, and the financial viability of the trading subsidiary. What is “appropriate” will depend on the circumstances: the cost of taking the advice is a relevant factor, and the cost should be commensurate to the size of the proposed investment.”

Schedule 20 ICTA 1988

Furthermore, in 1986 various provisions were introduced which are now enshrined in Section 506 of the Taxes Act 1988. These provisions broadly state that the charity could lose tax exemption already obtained if it incurs expenditure which is non qualifying. (Now termed non charitable expenditure). Charitable expenditure includes the list of qualifying investments and qualifying loans contained in part 1 and part 2 of schedule 20 to the Taxes Act.

Unfortunately, that list does not include investment in or loans to subsidiary companies. There is, however, a provision that a charity can make a claim to the HMRC to treat such loans or investments as qualifying but it should be clear that they are made for the benefit of the charity and not for avoidance of tax.

Regrettably, the law does not provide any prior approval procedures and normally the claim can only be made after the charity has completed the investment or loan. Both HMRC and the Commissioners expect the transactions with the trading subsidiary to be on an arms-length basis. That is to say the investment stands up to commercial scrutiny. This will be tested in the case of a loan by the rate of interest payable, the terms of repayment and security. Any transactions between the parent and subsidiary should be at arm’s length and no extended credit should be provided. In the case of share capital the trustees should be able to demonstrate that the investment is not speculative by considering the profitability of the trading subsidiary.

In their guidance to charities, HMRC has explained:

Charities which own companies set up to carry on non-exempt trading activities will usually need to consider investing funds in the company when the company is set up. The company may also need injections of money to fund expansion or development of its business after it has been established.

There are special rules in the Taxes Acts that apply to investment of a charity’s funds in a trading company. If these rules are not followed the charity will risk losing some or all of its tax exemptions. To qualify for relief an investment must be made:

• for charitable purposes only
• for the benefit of the charity, and
• not for the avoidance of tax.Investments will be regarded as made for charitable purposes and for the benefit of the charity if they are commercially sound. Usually, charities should ensure that investments are secure, carry a fair rate of return (actually paid) and, in the case of loans, provide for recovery of the amount invested in due course.

They go on to explain:

When looking at the qualifying expenditure of a charity we not only consider the direct charitable payments a charity makes, but also the nature of the investments and/or loans made by the charity.

If a loan is not an investment it will be a qualifying loan if it is:

• a loan made to another charity for charitable purposes only;
• a loan to a beneficiary of the charity, and made in the course of carrying out the purposes of the charity;
• money placed in a current account at a bank; or
• any other loan made for the benefit of the charity, and not for the avoidance of tax.An investment or loan will normally be “for the benefit of the charity” where it is made on sound commercial terms. Whether or not an investment or loan is commercially sound should be considered by reference to the circumstances prevailing at the time it was made.There is no one test of commercial soundness, and each case must be viewed on its own facts.Where a loan or investment:
• carries a commercial rate of interest; and
• is adequately secured; and
• is made under a formal written agreement which includes reasonable repayment termsWe will normally accept that the investment or loan is for the benefit of the charity.Many charities have subsidiary companies that pass their taxable profits to the parent charity. Where an investment is made in, or loan to, such a subsidiary company, the charity is unlikely to be able to obtain normal security for the investment or loan. In such cases we may ask to see the business plans, cash-flow forecasts and other business projections which informed the charity’s decision to make the investment or loan.

I am often asked if a claim to HMRC must specifically be made – the answer is that if the charity believes that they have incurred non charitable expenditure then they would need to disclose this In their guidance notes on the Charity tax return form HMRC state

Investments and loans within Schedule 20 ICTA 1988

Qualifying investments for the purposes of Section 506 ICTA 1988 are specified in Part I, Schedule 20 ICTA 1988. Qualifying loans for the purposes of Section 506 ICTA 1988 are specified in Part II, Schedule 20 ICTA 1988.

Any loan or other investment not specified may be accepted where the charity makes a claim to HM Revenue & Customs Charities for it to be treated as qualifying, and the loan or other investment is made for the benefit of the charity and not for the avoidance of tax (whether by the charity or any other person). If HM Revenue & Customs Charities cannot agree the claim, you have the right of appeal to the Special Commissioners. If the charity has made a loan or investment in the period that it thinks is qualifying, for which a claim is required and for which no claim has been made, you should submit a claim with the Return.

Alternatively, you should provide a computation of restriction of the relief under Section 506(3) ICTA 1988. Any claim made for this purpose should give sufficient details of the loan or investment in question for us to be able to understand its nature and should indicate which paragraph of Schedule 20 it is made under.

Investments and loans made outside Schedule 20 ICTA 1988

If the charity has made any investments or loans which do not fall within Schedule 20 ICTA 1988 and no claim is to be made with this Return, enter the total of such loans or investments in box 7.38.

HMRC have also provided detailed guidance on their website which explains the Reporting Requirements.

Where a charity receives a tax return

If a charity is satisfied that all of its investments or loans fall within the categories listed at Sections I paragraphs 2 – 8 or Section II paragraphs 10 (1) (a) to (c) of Schedule 20 it should tick the box on their tax return as follows:

• Company return box E26 of the charity supplementary page (CT600E);
• Trust Return the question about qualifying investments on the charity supplementary page (SA 907).

The charity need do nothing more.

If the charity is satisfied that any other loan or investment, not falling within the relevant paragraphs of Sections I or II of Schedule 20, still qualifies because: it is made for the benefit of the charity and not for avoidance of tax; there are two options: tick the box on the appropriate return page (as above) and be prepared to make a formal claim in respect of the relevant investment if requested by HMRC Charities; make a formal claim with the return, or separately.

No tax return received

A formal claim for determination of whether a loan qualifies can be made at any time after a loan or investment has been entered into. HMRC cannot make a determination about whether the loan or investment qualifies before an investment/loan arrangement is made.

Claims

Where a charity wants to make a formal claim or if a formal claim is requested by HMRC charities that claim must be in writing and must specify:

• the nature of the investment (loan, shares etc);
• the amount involved;
• the accounting period in which the loan or investment was made;
• whether the claim is made under paragraph 9 or 10 of Schedule 20.
  It is also helpful if any other relevant information is supplied at the time of the claim, e.g. details of the terms of a loan.

Loans or investments outside Schedule 20
Where a charity has entered into investments or loan arrangements which do not satisfy the requirements of Schedule 20 the total of such loans or investments must be entered at: Box E27 of the charity supplementary pages to the CT return or, Box 7.38 of the charity supplementary page to the Trust return.

4. PROFIT SHEDDING

Profit Shedding

In order to avoid a tax charge the trading company must use a tax effective method of transferring its profits from itself to the parent charity. There have been three time honoured methods for doing this:

• Variable Deed of Covenant;

• Gift Aid; and

• Dividends. Deeds of Covenant
  
  Some charities continue to make payments under Deed of Covenant but the rules are now similar to the Gift Aid rules. A payment under a deed of covenant is a charge on income. In essence, this means that if a company makes a profit and properly covenants all of its profit to a charity there will be no tax charge.Where the company is wholly owned by the charity, for the payments after 1 April 1997, the payment can be made be made up to nine months after the end of the accounting period. This saves the “gives, pay and repay” charade which had been necessary. Gift Aid
  
  The Gift Aid regime is much simpler than that for a deed of covenant in that the deed must be properly drawn up and properly executed so that it is legally binding. With Gift Aid, once the money has been given the actual procedure for reclaiming the tax can be completed subsequently. However, the rules are precise and no refund can be permitted.The gross amount of the payment is allowed as a deduction against the company’s profits for corporation tax purposes for the accounting period in which the payment is made. The option to make the payment up to nine months after the end of the accounting period is available to trading subsidiaries that are wholly owned by charities.

  Dividends
  
  The subsidiary can of course elect to pay its profits to the charity using dividends. This method should only be used if the subsidiary has not used the covenant or gift aid route and it has to pay tax on its taxable profits.

  From 6 April 1999 Advance Corporation Tax was abolished but there are transitional provisions for charities and the tax credit recoverable was reduced over 6 years to zero by 6 April 2004. This means that the charity will now not be able to recover the tax on the dividends. There is also anti avoidance legislation which imposes a tax liability when dividends are paid out of pre-acquisition profits. However, this does not apply in most cases since charities do not often buy subsidiaries that have pre-acquisition profits.

  Choice of Method
  
  In my opinion either the covenant / gift aid route is the most suitable although it does require that the covenant is properly set up and execute—an overpaid covenant can be repaid.

  Some charities wrongly believe that to show the viability of the investment in the subsidiary there should be a dividend stream. Consequently, they have been using the dividend route even when it leads to a loss of tax. The viability of the investment is measured by the return to the charity and the method of transferring profits is not really relevant. Apart from the tax rate issue already discussed the dividend, if it is paid before the year end, suffers from the same problems of estimating the profits. If it is paid after the year end then there will be cash flow disadvantages since the advance corporation tax in respect of the dividend cannot be used to offset the mainstream corporation tax liability until the following year’s tax liabilities have been agreed.

  Does the Gift Aid have to be paid?
  
  A trading company that is wholly owned by a charity or charities has up to 9 month after its year end to make the payment. Regrettably, I continue to see cases where management have forgotten to make the Payne tin time and this exposes the trading subsidiary to a tax liability.

  There are some issue to consider that might mitigate the situation. I sometimes see cases where a charity and its subsidiary operate intercompany accounts in the accounting records with each making payments on behalf of the other (e.g., one invoice may cover both the charity and the trading company).

  This often leads to the position that the Gift Aid payment from the trading subsidiary has not been paid by an exchange of checks or transfers between bank accounts but is discharged through the intercompany account. This is not seen to be the favored option as the Gift Aid rules refer to a payment of a sum of money and I have seen HMRC be concerned about this in the past.

  However, they appear to be more open to discussion on this and in correspondence with me they have stated:

  Following a very recent Solicitors’ Opinion on a similar matter we have reconsidered our view on what constitutes a “payment of a sum of money” in certain circumstances.

  We now take the view that, where a wholly owned trading company makes payments on behalf of its parent charity (for example, one invoice may cover both the charity and the trading company) and an intercompany account is in operation, the trading company can make Gift Aid payments by discharge through the intercompany account. That is, we regard the discharge of the debt owed to the trading company as a “payment of a sum of money” at the time the discharge is made – if the discharge is within the 9 month period then the Gift Aid payment can be carried back to an earlier accounting period.

  The above view has not been tested and, to avoid doubt, the best course of action remains for the trading company to physically make a payment from its own bank account to the charity.

  It is important to appreciate that this does not mean that the Gift Aid can simply be discharged by creating a liability through the inter company account. HMRC appear to be allowing a situation where the subsidiary is owed something from the charity and then the liability is cancelled by the use of the inter company account for payment.

  My view is that, although I have put cases to HMRC on the basis of the above stated guidance and they have been accepted, this route could be open to challenge and that it is best to make the payment from the subsidiary to the charity.

  Deducting the tax
  
  Prior to 1 April 2000 companies had to deduct basic rate tax from the covenanted or Gift Aid amount paying over the net amount to the charity. There is no longer a need to do this and the gross amount is paid to the charity.

  Comparison of Taxable and Accounting Profits
  
  Since the trading company pays up the taxable profit there may be a complication where the taxable profit differs from the accounting profit. This is likely to occur for a number of reasons. Most commonly, where the subsidiary has fixed assets, the depreciation charged in arriving at the accounts profit is different from the capital allowances given in calculating the taxable profit. Similarly, there may be other items of expenditure in the trading subsidiary such as entertaining that may be disallowed for tax purposes.

  As a consequence the taxable profit may be larger than the accounts profit and since the aim is to transfer the taxable profit this would result in a negative Profit and Loss Reserve. Negative Profit and Loss reserves may become a problem particularly where there is an overall negative net assets position as the trading company may be insolvent under a balance sheet test.

  This creates unnecessary complications and I generally prefer the situation where the accounting and taxable profits are not different so if the subsidiary is profitable and sheds all its profits there should be no negative Profit and Loss Reserve.

  I see a number of situations where the subsidiary is profitable but may still wind up with negative reserves. This usually happens where depreciation as calculated for accounting papooses is more that the capital allowances deducted for tax purposes. In such cases the accounting profit is lower that the taxable profit and if the subsidiary Gift Aids up the taxable profit this could lead to overall negative reserves. Therefore I generally try to avoid situations where the taxable and accounting profits are different and recommend that charity owns all the fixed assets and makes an appropriate charge to the subsidiary for their use.

  Negative reserves and Gift Aid payments
  
  Negative reserves will usually mean that the subsidiary will not have any distributable reserves and this may cause problems. The definition of a “distribution” in Section 263 of the Companies Act 1985 is extremely wide and is defined to include “ Every description of distribution of a company’s assets to its members in cash or otherwise.” The exceptions that are listed would not really apply in typical cases. Therefore there has been concern that a Gift Aid payment made when there are negative reserves would be an illegal distribution.

  This issue does need to be carefully addressed in each situation to establish a satisfactory solution. We have discussed this with the Charity Commission and a senior lawyer at the Commission has clarified as follows:

  My view is that if a gift is made in furtherance of the declared objects of the company, it is not a “distribution” for the purpose of section 263, and can be made out of a company’s subscribed capital, if the company’s objects authorize this. A charity trading company typically will have an object directed towards the support of the charity which owns it. An ordinary commercial company would not, ordinarily, have a comparable object.

  I am aware of three cases which are regarded as authority for the gifts are “distributions” argument. But the cases all concern applications of company property which were not authorized by the objects of the companies concerned. None is a charity case.

  The payments which had been made by the companies in Ridge Securities v IRC (1964) I WLR 179 were dressed up as loan interest for the purposes of a tax avoidance scheme, but were, in fact, regarded by the court as gratuitous payments, which were not authorized by the paying companies’ objects.

  In Re Halt Garage (1964) Ltd (1982) 3 All ER 1016 payments had been made to two directors under a corporate object which made provision for remunerating them, but the court decided that the object could not be relied upon as authority for payments which could not reasonably be described as “remuneration” at all.

  In Aveling-Barford Ltd V Perion Ltd (1989) BCLC 627, the company had the power to sell land, but no explicit power to sell at an undervalue (which is what it did), and no implied power to sell at an undervalue where the purpose of the sale was to effect an unauthorized return of capital to a shareholder, and thereby reduce the assets available to creditors in the insolvent liquidation which ensued. That transaction was again treated as ultra vires.

  The judges in these cases made observations in them to the effect that companies could not intra vires make non-commercial payments, unless they were dividends made out of accumulated profits, or were authorized reductions of capital. But the judges’ observations have to be taken in the context of considering corporate objects which were of a wholly commercial nature, and which did not, in fact, permit the making of gratuitous payments, where there was no commercial purpose.

  The position where the objects of a company did permit the making of gratuitous payments – notwithstanding the absence a commercial purpose – was considered by the Court of Appeal in the case of re Horsley and Weight Ltd (1982) Ch 442. This is the case which I mentioned at the meeting at the Home Office at which the proposed version of CC35 was discussed.

  In that case, payments were made for the benefit of a director in pursuance of an object of the company which explicitly permitted this. The liquidator of the company claimed that the payments were ultra vires because of the perceived lack of commercial justification. The response of Buckley J was—“The objects of a company do not need to be commercial; they can be charitable or philanthropic, indeed they can be whatever the original incorporators wish, provided that they are legal. Nor is here any reason why a company should not part with its finds gratuitously, or for non-commercial reasons, if to do so is within its declared objects.”

  As the judge pointed out in the Aveling-Barford case, the purpose of Part VIII of the Companies Act 1985 is to protect creditors from the unauthorized return of capital to members. But the subscribed capital of a company can be applied towards the furtherance of its objects: that is what it is there for. If the objects explicitly permit the company to apply its assets non-commercially, then creditors can hardly regard themselves as being unfairly treated if it does so.

  Of course, any gratuitous transaction of a company is potentially capable of being recalled under section 238 Insolvency Act 1986, whether the transaction is constitutionally authorized or not. And, in an insolvency situation, the directors of a company can he made liable to make payments to the company for the benefit of its creditors if they conduct its business, even in a way which is in terms authorized by the company’s objects, so as deliberately (s213) or negligently/recklessly (s214) to cause unnecessary damage to creditor interests. But these considerations are not, in my view, relevant to the question whether a payment by a company is or is not a “distribution.”

  This view has been reinforced in CC 35 The Charity Commission’s guidance on trading. In it they specifically address the question: “Can a trading subsidiary pay more to its parent charity in Gift Aid than the level of trading profits (in accounting terms) which it has earned?”

  The short answer
  
  Yes. This issue will generally arise when the trading subsidiary’s level of trading profits for tax purposes is greater than its level of profits for accounting purposes. Any tax liability will depend on the level of taxable profits. If that liability is to be eliminated entirely, the whole of the taxable profits will have to be paid to the charity, even if that is greater than the profits for accounting purposes. The balance will, in most cases, need to be financed out of share capital, since the trading subsidiary is otherwise likely to be insolvent.

  In more detail
  
  If a trading subsidiary earns, in an accounting period, taxable profits in excess of its profits for accounting purposes, it may pay to its parent charity a greater sum in Gift Aid than it has profits for accounting purposes, in order to eliminate its corporation tax liability. As a result, all or part of the Gift Aid payment may be made out of the company’s subscribed share capital, including any share premium account.

  Although there are differences of legal opinion on this issue, it is considered that such Gift Aid payments may be made out of the trading subsidiary’s subscribed share capital, provided that the objects of the trading subsidiary authorise such gifts. The parent charity can, by subscribing additional share capital in the trading subsidiary, enable the subsidiary to do this, without making the subsidiary insolvent.

  It is possible that the trading subsidiary may prefer to acquire the resources needed to make the full Gift Aid payment out of funds borrowed from the parent charity. However HMRC Charities take a critical view of any apparently circular arrangements. Parent charities and their trading subsidiaries contemplating such a course of action should take professional advice, and take into account the investment propriety and insolvency issues.

  It is worth recognizing that subsidiary may have a negative reserves at the balance sheet date but a subsidiary that are wholly owned by a charity has up to 9 months after its year end to make the Gift Aid payment and by that time it will have earned more profit which may mean that there is no negative reserve at the time of the payment.

  Additionally, a charity can allocate a notional charge for goods and services supplied to it at undervalue. This could include volunteer time and reduced rates for professional fees.

  A question of interest
  
  The Charity Commission and HMRC consider that loans from charities to their trading subsidiaries should be on commercial terms and that charities should charge interest to these trading subsidiaries.

  The “War on Want” enquiry several years ago spotlighted this issue. The enquiry found that advances to finance the trading company were not at arms length and said that if they were not repaid with interest they represented an application of charitable funds for non charitable purposes. They went on to recommend that if repayment was not possible, consideration should be given for an action under Section 28(7) of the Charities Act 1960 for recovery from the members of the Council of Management.

  Capital gains and Gift Aid
  
  The exemption from capital gains tax which is given by virtue of Section 256 of the Capital Gains Tax Act 1992 (if the gain is used for charitable purposes) is available only to the charity and not the subsidiary.

  Of course the trading subsidiary may dispose of its own property or other assets and make capital gains. The subsidiary can deduct Gift Aid payments from total profits, which includes chargeable gains as well as all other income.

  5. OPERATING AT “ARM’S LENGTH”
  
  The general principle is that a charity and its trading subsidiary should operate at arm’s length and there are some “rules” that need to be followed. However, there is a risk that structures are over engineered unnecessarily. There is no need to reinvent the wheel and there are trusted and tried models that operate successfully which have been accepted by the regulators..

  Liabilities and losses of the trading subsidiary
  
  Not all trading companies are profitable. In fact, there have been incidents where trading subsidiaries have gone bust whilst owing considerable amounts of money. The Charity Commissioners addressed this matter in their 1988 report which referred to the liquidation’s of Search 88 & Co Limited owing £700,000 and Sports Aid Limited owing £2-£3 million. In both these cases the charity trustees and promoters followed sound and recommended advice in order to protect the assets of the Charities.

  In one of these cases the creditors thought that they were dealing with the charity rather than an arms length limited liability company. It is vital that it is made clear to those involved as to whether the transactions are with the charity or its subsidiary.

  Failed subsidiaries often leave the charity’s trustees in a dilemma. In order to avoid the adverse publicity which may arise and because of a perceived moral obligation to the creditors, they may wish to settle the liabilities of the trading subsidiary. Such a course of action would normally be outside the trustees’ powers.

  Whilst talking about subsidiaries failing it is worth mentioning that it is possible that directors of a trading subsidiary could be guilty of wrongful trading under Section 214 of the Insolvency Act. When a subsidiary is making losses there is perhaps a tendency to expect better times. Directors should act with extreme caution and when there appears to be no reasonable prospect of avoiding liquidation there is a need to take immediate steps to minimize the loss to creditors.

  A director is expected to conform to an objective standard of ability and should be aware of the current position of the company. A director may be personally liable if the company is allowed to continue trading when it is effectively insolvent. Similarly, the charity’s trustees may be personally liable if they continue to prop up a failing subsidiary by lending it charitable funds.

  HMRC will also look at a loss making trading subsidiary to consider whether the charity by funding it is incurring non charitable expenditure that could jeopardize its tax exemptions. Previously they took the view that they would exclude notional charges and indirect cost allocations when considering this. Similarly in the pats they disregarded the element of the loss that is created by the allocation of fixed costs if it can be shown that the charity would have incurred that expenditure in any case. However this view appears to have changed – see the section on management charges and cost allocations.

  It is important to recognize that if the trading subsidiary is carrying out activities that further the primary purpose of the charity then losses made by it even if they are subsidized by loans or grants from the charity will not be non charitable expenditure. In essence, the charity would have to be able to show that it could have incurred the expenditure that created the loss.

  Management charges and cost allocations
  
  Many charities and their trading subsidiaries operate from the same premises and may use joint facilities such as staff, communication services, computer system etc. In fact many trading subsidiaries do not have any staff or facilities of their own.

  In most cases the charity’s facilities are used by the trading subsidiary and following the arms length principle the charity should levy a fair and reasonable charge. VAT should be accounted for on these charges if the charity is registered for VAT and there is no group Vat election. In fact this can usually work to the organization’s advantage.

  Many charities are not registered or are partially exempt for VAT, consequently they cannot reclaim all their input VAT. It is not always fully appreciated that the unrecoverable element may decrease proportionally as vatable supplies increase.

  Depending on its VAT recovery methodology it is often beneficial for a charity to try and increase their vatable outputs especially when the supply is to a “person” who can recover the VAT charged. Therefore, by accounting for management charges with VAT the charity may indirectly increase the amount of input VAT it can recover. Of course, the trading subsidiary should be able to recover all the input VAT.

  The allocation of costs should include both direct and indirect overheads. It is important to ensure that the management charges are a fair calculation and only amount to a reimbursement since any profit element could perhaps be regarded as a trading receipt which would not normally fall within the trading exemptions. Alternatively, HMRC may seek to disallow any excessive amounts in the subsidiary company’s tax computations as not being wholly and exclusively expended for trading purposes.

  Following the Finance Act 2006 and the changes to the trading exemptions found in Section 505 ICTA ‘88 HMRC have published new guidance. This explains that, trading receipts should be allocated between trades that are taxable and non taxable on a reasonable basis.

  HMRC clarify that the profits of taxable non-primary purpose trading, including capital allowances if applicable, should be calculated in the same way as for any other trader. They emphasize that “This may involve apportioning what was originally charitable primary purpose expenditure to a non- primary purpose or deemed non-primary purpose trade. Any such apportionment will only apply for tax purposes.”

  HMRC has placed much more importance on cost allocation and they state,

  For most charities the challenge will be to maintain adequate accounting systems to properly identify the separate primary purpose and non-primary purpose deemed trades, to allocate and where necessary apportion costs to each. Charities are strongly recommended to do this. The approach may vary. For example, there could be a “high level” approach of identifying the trading activity of a particular department, division or building, etc. as primary or non-primary purpose. Alternatively, there might be a “middle level” approach of, for example, identifying particular contracts or projects, or the work of individuals as primary or non-primary purpose. At the most detailed level, charities might identify each individual piece of work done, flag it primary purpose or non-primary purpose in the accounting system, and allocate costs accordingly

  HMRC’s view is that a high or medium level approach may be justified on the facts – a department or a project may be identifiable as wholly primary purpose or wholly non-primary purpose. However, this approach would be inappropriate for mixed primary/ non-primary purpose activity. In HMRC’s view, a “low level” approach to accounting for primary and non-primary purpose activity will be more appropriate. This will give the greatest accuracy and take the least risks with charity law, which places a responsibility on trustees to identify non-primary purpose trading carried on by the charity for which they bear responsibility.”

  HMRC has gone into much detail about cost allocation and stress that for a non-primary purpose deemed or part-beneficiary trade, the new legislation now requires that there be a “reasonable apportionment of expenses and receipts.” They explain that in their view this will involve taking into account direct expenditure and a reasonable proportion of indirect expenditure such as overheads, whether or not these were originally incurred for charitable purposes.

  They have provided the following guidance to illustrate what they would expect:

  If a non-primary purpose trading activity is the charity’s only trading activity, is carried on in the charity’s premises and takes 30% of the floor area, it might be proper to allocate to the non primary purpose trade 30% of the costs of the premises such as:

• heat and light

• rent

• building repairs and maintenance.

Apart from the use of premises, other indirect overheads that may be partly attributable to the trade are:

• employee salaries

• computer costs

• telephone charges

• postage costs

• accountancy and legal fees

• general administration.The proper basis of apportionment of indirect costs will depend on the facts. In the case of the use of premises, the apportionment might be based on:

• the size of floor space allocated to the trade.

• where student accommodation is let to tourists out of term, the number of days in the year when the premises are allocated to the trade, and actively marketed.

• in the case of employee salaries, the amount of employee time devoted to the trade compared to total employee time.

In correspondence with us HMRC have explained:

S505B (ICTA ‘88 requires that a reasonable apportionment of expenses is made between the primary purpose and non-primary purpose deemed trades created by that section. HMRC does not normally accept a marginal costing basis for the apportionment and looks for an apportionment of all direct and indirect costs. In the higher education sector, for example, the “full economic costing” which is being introduced may often give the right answer.

Cost-sharing with a subsidiary does not normally give rise to problems so long as, on the facts, that is what it is. Again, we would expect all direct and indirect costs to be apportioned on a reasonable basis. If a marginal costing approach is adopted then the charity is incurring indirect costs on behalf of the subsidiary. Those costs may well be non-charitable expenditure.

It is necessary to be clear about whether the charity is dividing costs or providing a service. Many charities find simple division of costs offers the advantage of simplicity. Your example of the computer system is not clear but it seems possible the charity is providing a service. In that case, it is possible that (if the charity is a large enterprise and otherwise within the criteria of INTM 432090) UK-UK transfer pricing may apply. A mark-up may be appropriate, or possibly a charge-rate referenced to conditions obtaining in the open market.

In the past this area of cost allocation between charities and their subsidiaries were not given much importance – the thinking was that it all came out in the wash and if more costs were allocated to the subsidiary the Gift Aid payment back would be smaller and vice versa. This approach is risky.

Loss making trades

This is of particular relevance where a charity is carrying out a non-primary-purpose trade to generate income to contribute towards expenditure. So for example, a charity may use its premises for running training courses which fall within its primary purpose. Spare capacity may be used by the charity for non primary purpose activities or the charity may allow other organizations to run courses on its premises. A full cost recovery situation may mean that in fact the non primary purpose trade is loss making.

If such a trade is carried out by the charity then this could be problematic and potentially lead to income that it taxable. If it is carried out in a trading subsidiary and full cost allocation has to be made then the trading subsidiary may be loss making.

The rules are somewhat complex and convoluted and there is a detailed explanation provided by HMRC in its guidance to the British Universities Finance Directors Group (BUFDG) and I have attempted to paraphrase relevant aspects. However if a charity is in this situation it should refer to the full guidance.

In their guidance for universities HMRC have explained that if the result of the deemed non-primary purpose trade calculated is a loss after adjustment for tax; tax law treats this loss as non-charitable expenditure. Where a charity incurs non-charitable expenditure, it has the following impact:

• Charitable tax exemptions otherwise available against the primary purpose income are restricted;

• The restriction is applied such that for every pound of non-charitable expenditure, one pound of tax exempted income is excluded from tax exemption;

• The restriction removes exemption from charitable income such that is becomes chargeable to tax in the university. This is referred to as “deemed income” and is chargeable to tax.

HMRC have gone on to explain that in certain circumstances a loss on non-primary purpose trading may in be offset against the deemed income it creates. Utilizing the loss against deemed income should reduce the chargeable deemed income and taxation liability to nil (see HMRC’s flow chart reproduced at Appendix 1.)

In effect, tax law provides relief for losses arising on trading activities where the trade is carried on a commercial basis and with a view to the realization of gain. To avail of the benefits of this concept the charity would have to show that it passed one of two further tests and if it did the non primary purpose loss should be available to set off (under Section 393[A] ICTA 1988) against the deemed income created by the non-charitable expenditure restriction.

The first test is to confirm whether the deemed non-primary purpose trade is carried on a commercial basis with a view to the realization of a gain. If the non-primary purpose trade loss does not pass this test it is seen to be an “uncommercial” loss and under tax legislation cannot be offset against other income of the same period. This other income would include the deemed income because relief is given only for losses of a trade carried on a commercial basis and with a view to the realization of profit.

However, there is a second statutory test, (the latter part of s. 393A (3) (b) ICTA 1988). If this test is passed it will allow the loss on the non primary purpose trading activities to be offset against the deemed income and reduce the chargeable income to nil.

The basis of the Test = is explained in HMRC’s guidance published on their website and set out at CTM04620. This explains that the disallowance of relief for uncommercial losses should not be applied in respect of a loss in a trade which is not itself carried on with a view to the realization of profits where that trade forms a part of a “Larger Undertaking”; and the whole undertaking is carried on with a view to gain.

If the deemed non-primary purpose trade is part of a Larger Undertaking that is carried on with a view to realization of a gain, then losses on the non-primary purpose trade will be allowable even though not in itself a commercial loss.

Regrettably, there is no real definition of a larger undertaking and for the purpose of this test HMRC have explained that, the phrase “Larger Undertaking” is interpreted, for tax purposes, as normally the whole of the charity’s trading activities and all its activities, though each case depends on its own facts.

Due to the complex rules and the concern that they cannot be met charities have in the past often channeled such non primary purpose trades through a subsidiary. In the past, a view prevailed which worked on the basis that the charity would have had to incur fixed costs in any case regardless of whether it used its premises for non primary purpose activities. Therefore, only the extra marginal costs were evaluated when considering whether it was worth carrying out the non primary purpose trade to contribute towards total costs. This is probably the right approach from the perspective of whether it is correct for the trustees use the premises to generate additional income.

However HMRC are not ready to accept a marginal costing approach and with the thrust to full cost allocation the trading subsidiary is likely to be loss making with all the attendant concerns that a charity is subsidizing a loss making trade. This unfortunate situation has led to the situation where some charity trustees have decided that it is not worth trying to generate further income from non primary purpose activity. This is not a happy state of affairs and it is hoped that ongoing discussions with the regulators will lead to a satisfactory resolution and a simplification of the rules.

Conflicts of Interest

It is often the case that one or more of the charity’s trustees or employees act as directors of the trading company. There are differing views about this. On the one hand there is an argument that this is a good way of ensuring that there is operational control over the subsidiary. Conversely, it is felt that charity trustees’ duty to the charity may be in conflict with their duty as directors of the trading subsidiary.

Similarly, some charities use joint employment contracts for their staff who are then employed by both the charity and the trading subsidiaries. In my opinion, there should not be total commonality between the trustees/staff of the charity and the directors/staff of the subsidiary. Whilst some commonality may be advantageous it is imperative that there are procedures in place to ensure that there is no detrimental conflict of interest.

Many subsidiaries have on their board independent directors who have the requisite skill and experience to add value to the subsidiary’s business.

Joint VAT Registrations

The issue is that it is sometimes expedient, in the interest of the charity, to have a joint VAT registration with its trading subsidiary. This arrangement can often mitigate the VAT burden for the charity and its subsidiary by allowing enhanced recovery of input VAT and dispensing with a need to charge VAT on intercompany transactions.

However, the taking of such joint registration also means that all parties to the joint registration are liable for any VAT liabilities of each other.

There is a view that this is similar to the charity giving a guarantee on behalf of the trading subsidiary which may result in the charity having to meet the VAT liability of the subsidiary. To my mind, joint registration could perhaps be seen as not giving of a gratuitous guarantee where there is a definite financial benefit to the charity to undertake such a joint registration.

In my opinion, if the trustees have taken sound professional advice that it would be in the financial interests of the group to enter into joint VAT registration then the probability of the trading subsidiary failing and the charity having to meet any VAT liability would be justified.

6. ACCOUNTING FOR TRADING SUBSIDIARIES

This section addresses principally the issues concerning trading subsidiaries of charities established under the Companies Act to carry out “non charitable” or “trading” activities of the charity. Such companies are typically established in order to minimize any direct tax or VAT costs which may arise if those activities were accounted for in the charity. Charities have historically accounted for their trading subsidiaries in a variety of ways.

What is a subsidiary?

The SORP explain,

In relation to a charity, an undertaking is the parent undertaking of another undertaking, called a subsidiary undertaking, where the charity controls the subsidiary. Control requires that the parent can both direct and derive benefit from the subsidiary.
(a) Direction is achieved if the charity or its trustees:
(i) hold or control the majority of the voting rights, or
(ii) have the right to appoint or remove a majority of the board of directors or trustees of the subsidiary undertaking, or
(iii) have the power to exercise, or actually exercise, a dominant influence over the subsidiary undertaking or
(iv) manage the charity and the subsidiary on a unified basis.
For a fuller definition, reference should be made to sections 258 and 259 Companies Act 1985.
(b) Benefit derived can either be economic benefit that results in a net cash inflow to the charity or can arise through the provision of goods or services to the benefit of the charity or its beneficiaries.
It is important to look at the substance of the arrangement and I have seen cases where controls is achieved even where the above do not apply.

Financial Reporting Standard 2 (FRS2)

FRS2 came into force for accounting periods ending on or after 23 December 1992 and applies to all entities required to prepare financial statements that give a true and fair view, to the extent that the requirements of the FRS are permitted by any statutory framework under which the entity reports. The effect of FRS2 therefore was to introduce a single set of requirements relating to the preparation of consolidated accounts that apply to charities regardless of their constitution.

FRS2 requires exclusion from consolidation in the following circumstances:

• Where there are severe long term restrictions which hinder substantially the exercise of the parent undertakings rights over the subsidiaries undertakings, assets or management; or

• The Group’s interest in the subsidiary undertaking is held exclusively with a view to subsequent resale and the subsidiary undertaking has not previously been consolidated; or

• The subsidiary undertaking’s activities are so different from those of other undertakings to be included in the consolidation that their inclusion would be incompatible with the obligation to give a true and fair view.

Whereas the Companies Act permits exclusion in cases I and II above, the FRS requires exclusion in such circumstances because the same conditions that justify exclusion also make consolidation inappropriate.

It is worth considering the rationale and principles that underlie the concept of group accounts. FRS 2 defines consolidation as “the process of adjusting and combining financial information from the individual financial statements of a parent undertaking and its subsidiary undertakings to prepare consolidated financial statements that present financial information for the group as a single economic entity.” The FRS goes on to explain the purpose of consolidated financial statements, “For a variety of legal, tax and other reasons undertakings generally choose to conduct their activities not through a single legal entity but through several undertakings under the ultimate control of the parent undertaking of that group. For this reason the financial statements of a parent undertaking by itself do not present a full picture of its economic activities or financial position. Consolidated financial statements are required in order to reflect the extended business unit that conducts activities under the control of the parent undertaking.”

Clearly the aim of consolidated accounts is to present the activities of the group as “a single economic unit.” Therefore it seems appropriate to present the results on the basis of the activity rather than the entity which carries them out. In practice charities may set up subsidiaries to campaign, perform research, fundraise etc. Due to the views of HMRC a number of fund-raising activities that traditionally were carried out by the charity itself and reported in its own accounts are now channeled through a trading subsidiary. These include innovative fund-raising schemes that may involve corporate sponsorship where it could be held that the charity is trading. Similarly, the agreements reached with the tax authorities on charity affinity cards will mean that an element of the income is deemed to be trading and will have to be channelled through a trading subsidiary.

Different Activities

What does FRS 2 really mean by “activities that are so different”? FRS 2 makes specific reference to not for profit undertakings, stating that the contrast between a “profit” and a “not for profit” undertaking is not sufficient of itself to justify non consolidation.

Many charities hold the view that trading is fundamentally different to charitable activity and that trading activity has no place in a charity’s accounts. However, over the years the distinction between the type of activities that are accounted for in the trading subsidiary and those that are accounted for in the charity has become somewhat blurred. Many charities channel fund-raising activities through the trading subsidiary such as innovative schemes which may involve corporate sponsorship and could be held to be trading. Similarly, the agreements reached with the tax authorities on charity affinity cards mean that an element of the income arising is deemed to be trading and is therefore channeled through the trading subsidiary whilst the remainder is channeled through the charity itself. The sale of donated goods in a charity shop is not considered by the Charity Commission or HMRC to constitute trading and is generally accounted for in the charity whereas the sale of bought in goods, such as Christmas cards in the same shop are accounted for through the trading subsidiary.

Clearly, under the circumstances described above, it would be anomalous that only a percentage of a similar activity is reported in the charity’s accounts.

For example, if a charity receives two corporate donations and one donor has asked for its logo to be used in the acknowledgement then the charity would rightly conclude that this donation should go through the trading subsidiary for tax reasons. Clearly it is anomalous that one donation is shown as a donation with the other netted off in the trading income line. Therefore the Charity SORP advocate a treatment that achieves parity of presentation and disclosure on items that are only artificially segregated due to the tax treatment or other management reasons.

Charity SORP

Some charities were concerned that the consolidation of subsidiaries may adversely affect the ubiquitous cost ratios since the cost of generating income in most merchandising operations is higher than that of raising voluntary or statutory income by the charity. They preferred therefore to relegate the subsidiaries’ costs to the notes. This is not acceptable and Paragraphs 393 et seq of SORP 2005 explain the method of consolidation that should be used:

393 The normal rules will apply regarding the method of consolidation, which should be carried out on a line-by-line basis as set out in FRS 2.

394 All items of incoming resources and resources expended should be shown gross after the removal of intra-group transactions. Clearly it is desirable that similar items are treated in the same way. For instance, incoming resources from activities to generate funds in the charity should be combined with similar activities in the subsidiary, and charitable activities within the charity should be combined with similar activities in the subsidiary. Similarly, costs of generating funds and/or governance costs in the subsidiary should be aggregated with those of the charity.

395 Each charity should choose appropriate category headings within the permissible format of the Statement of Financial Activities and suitable amalgamations of activities. The headings used should reflect the underlying activities of the group. If it is not possible to exactly match items between the subsidiary undertaking and the parent charity, segmental information should be provided so that the results of the parent charity and each subsidiary undertaking are transparent.

The effect of consolidation is usually not likely to be very material on the balance sheet but can alter the picture shown on the Income and Expenditure account. There is a fear that important information about the trading subsidiary such as its profitability can be concealed in a consolidated profit and loss account. For example, the fact that a charity may be propping up a loss making subsidiary will not be apparent from a consolidated income and expenditure account. The 2005 SORP recognizes this and requires that where a separate charity only SOFA is not included in the financial statements sufficient information should be provided. In particular, the gross income/turnover and results of the parent charity should y disclosed in the notes and the group accounts must contain the entity balance sheet of the parent charity.

7. CHARITY SHOPS

Many charities operate charity shops, some of these sell only donated goods, some of them sell only bought in goods and some sell a mix of both. Donated goods can be collected house to house and also donated directly at the shops.

Shops owned by subsidiaries

In some cases the shops are operated through the subsidiary and whilst this structure will work. I think there are problems associated with it and it is cumbersome. I usually advise that where most of the goods sold are donated, the shops should be operated through the charity with the trading subsidiary accounting for the new goods and costs associated with those. It might be useful to briefly consider the different types of goods charities sell.

When a charity sells new goods it is trading and unless this trading qualifies for the statutory trading exemptions found in S.505 of ICTA 1988 the profits will be taxable. To qualify the trading should be part of the charity’s primary purpose or a trade carried out by the charity’s beneficiaries. Additionally, significant non-charitable trading can jeopardize charity status. The circumstances that qualify are limited, for example, if the primary purpose was to relieve poverty then the sale of bought goods at a reduced price to an approved class of beneficiary might qualify or a charity set up to advance religion could sell religious books.

Even here there are special rules and the Charity Commissioners have decided that community shops per se are not charitable. In their 1991 Report they discussed the case of the Community Shop, Leeds, a charity established to relieve poverty by the provision of clothing and other goods at low cost to people in need. The constitution did not preclude the sale of bought in goods and it was not possible to control who bought goods in the shop. The Commissioners considered there was a risk of non-charitable trading and the charity was advised to set up a trading subsidiary to shelter taxable profits which would then be transferred to the charity in a tax effective way.

This has led to some advisors suggesting that charity shops should be operated through a trading subsidiary. However, as explained earlier, neither the Charity Commissioners nor HMRC treat the sale of donated goods as trading. This endorses my view that donated goods should be sold through the charity and not the trading company.

For VAT purposes there is no special concession and the VAT treatment would follow the type of goods, for example the sales may be standard rated, zero rated or exempt. In particular, the sale by, and the supply to, a charity of donated goods is zero rated.

Previously, this zero rating was only given if the sale was made by a charity and consequently to benefit from the zero rating many charities channeled the income from the sale of donated goods through the charity whilst bought in goods were rightly channeled through a trading subsidiary.

This changed on 1 April 1991 and VAT zero rating on the supply of donated goods now also applies to a “taxable person” who has covenanted by deed to give all the profits of that supply to a charity. These provisions mean that donated goods can be zero rated even if they are sold by a trading company so long as the company concerned covenants the profit of that supply to the charity. Following this change some charities decided that they would channel both the donated goods and bought in goods through the non-charitable trading subsidiary. This leads to certain problems.

Who owns the goods?

Charities that sell donated goods through the trading subsidiary which then transfers the profits up to the charity need to consider how the goods became the property of the trading company. For example when goods are collected “house to house” charities must comply with the House to House Collections Act 1939. (This is an area that many charities often neglect believing that the rules governing house to house collections only apply to collections of cash and not collections of goods).

House to house collection licenses are granted in the name of the charity that means that goods are being collected by the charity and, in the eyes of the donor, for the charity. Similarly, when a donor donates goods at a shop surely their belief is that they are donating to the charity and not a separate non-charitable trading company. (Also see the rates issue point below.) The question is how are these donated goods “transferred” to the trading subsidiary to sell. There are, of course, complicated agency agreements that might allow this but then the profits of the sales must appear in the charity’s books and not in the trading subsidiary’s.

The principle being that charity should not gratuitously give goods donated to it to the subsidiary. I have heard the argument that the gift of the goods is given in exchange for the trading subsidiary covenanting or gift aiding back the profits. This is a dangerous argument, as it would invalidate the tax effectiveness of a deed of covenant payment. I have also heard the argument that the goods are being donated directly to the subsidiary but this causes other problems.

The rates issue

Section 43 of the Local Government Finance Act 1988 (LGFA) gives mandatory relief from non- domestic rates to charities where the rate payer is a charity or trustees for the charity and the property is wholly or mainly used for charitable purposes. This means that the channelling all the shop activities through a non charitable trading company could fall foul of a proper interpretation of this relief. The rate payer being a trading company is not a charity and the property being used by the trading company is not used wholly or mainly for charitable purposes. The fact that the trading company subsequently passes profits up to the charity does not in my opinion strictly allow it to obtain this relief. I have seen this point being taken by local authorities that are then denying rates relief.

Section 64 (10) of the LGFA extends the normal relief and explains that “A hereditament shall be treated as wholly or mainly used for charitable purposes at any time if at the time it is wholly or mainly used for the sale of goods donated to a charity and the proceeds of sale of the goods (after any deduction of expenses) are applied for the purposes of a charity.”

Some advisors believe that this allows the sale of donated goods to be taken through the subsidiary and that the shops should be run through the subsidiary but a relevant point in section 64 is that the goods must be donated to a charity – in which case the proceeds should be recognized by the charity.

The VAT issue

As explained, the law allows zero rating for goods sold by a trading company so long as they covenant all the profits of that supply to the charity. Interestingly, despite the specific reference to covenants in the legislation, in practice HMRC appear to accept that if a charity subsidiary transfers its profits by gift aid or dividend this will suffice.

However, I have seen them being fairly strict in the interpretation of the words “all the profits of that supply.” For example, consider a case where the trading subsidiary makes profits from the supply of donated goods of £100,000 and the trade of bought in goods has resulted in a loss of £10,000. In effect the trading subsidiary will have a composite profit of £90,000. In this case if it covenants the £90,000 to the charity it will not be covenanting “all the profits” of the supply of donated goods. I must confess that I have not seen this point taken but having discussed it with HMRC they do recognize the point and say that they would expect that all the profits of the subsidiary are passed to the charity to allow zero rating.

The Capital Gains Tax issue

If the shop property is owned by the trading company and is then sold at a gain the gain could be taxable. The exemption from capital gains tax conferred by S.256 of the Taxation of Chargeable Gains Act 1992 is available only to charities and not trading subsidiaries. Consequently, if there is a covenant in place it should be properly worded to allow the inclusion of capital gains.

The solutions

Clearly there are a number of problems associated with the structure of using the non-charitable trading subsidiary to sell all the goods. Consequently where the charity primarily sells donated goods I have always advocated that the shops should be owned by the charity and the “spare capacity” in the shops can be used to sell bought in goods for the trading company. This means that the charity must make an appropriate charge for overheads, rent and other costs including staff to the trading company.

Of course, direct costs of the purchase of new goods would be charged to the trading company in any case. Other costs can be apportioned in a fairly straightforward way. Many charities use a method based on turnover, for example if a shop sells 40% bought in goods and 60% donated goods then costs which are not directly attributed are simply divided on a 40/60 basis. HMRC have become tougher on the issue of cost allocation and the law now requires that costs are properly allocated.

For VAT purposes all input VAT relating to the shop should usually be recoverable since the shop will, in the main, be either selling zero rated goods via the charity and standard rated goods via the trading company. Thus even if the charity has to charge VAT to the trading subsidiary on the “management charge” the subsidiary should be able to recover it.

The law states that a property will pass the wholly or mainly used for charitable purposes test if it is wholly or mainly used for the sale of goods donated to a charity and the profits of sale are applied for the purpose of a charity. When a shop sells both donated and bought in goods I believe it qualifies so long as more than half the goods are goods donated to a charity for resale. I have seen some rating authorities take the view that “mainly” requires a much larger percentage but they have changed their mind when faced with the words of Lord Morton of Henryton. In Facet Properties Ltd v/s Buckingham City Council he acknowledged that the word “mainly” gave rise to difficulties but suggested that it probably did mean “more than half.” Clearly, the ratepayer must be a charity selling goods donated to the charity.

I usually recommend a structure where the charity owns the shops and is the ratepayer. This will also ensure that all donated goods collected in the charity’s name are sold by the charity and all bought in goods purchased by the trading company are sold on behalf of the trading company that is appropriately charged. Income and related expenditure on the sale of donated goods should directly flow through the charity’s accounts and turnover and costs associated with the bought in goods should go through the trading company which would transfer these profits the charity by gift aid or Deed of Covenant. This is the way that most of the large charity shop chains operate.

8. CONCLUSIONS

Guidance notes of this length can merely highlight some issues. There are several others such as consumer protection legislation, accounting, staffing, financial management, evaluation, rates relief etc. that must be considered.

Admittedly, the whole process does seem unnecessarily long winded and it appears that the charities do have to go through hoops and loops to ensure that income generation by trading is possible. But, the laws exist and ignorance is not bliss. Those charities that get it wrong could find themselves in very awkward and costly situations. It is perhaps useful to quote from the 1988 report of the Charity Commissioners:

Trustees have a duty to consider the tax effectiveness of the arrangements between them and any associated trading company, and they may be personally liable to account for taxation liabilities which are unnecessarily incurred directly or indirectly as a result of the inefficient administration of the charity. It makes no difference that the liabilities may arise not from the disqualification of the investment made by the charity, but from the disallowance to the associated trading company of corporation tax relief. The associated trading companies are not charities and are not directly subject to our jurisdiction, but we are of course concerned as to the manner in which charity trustees exercise the administrative rights which the ownership of the shares in those companies gives them.

In essence, when entering into activities that may appear to be trading it is important to consider:

• What is the activity – is there any exchange of goods or services or is there any benefit to a third party?

• What are the charity law, direct tax and VAT implications?

• Does the charity’s constitution allow it to carry out the activity?

• Should the transactions go through a trading subsidiary?

• Is the trading subsidiary properly set up and treated on an arm’s length basis?

• Is the profit being properly passed over?

• Is the profit commensurate with the financial investment and effort?

There should also be proper procedures to enable the charity to transfer assets for use and exploitation by the trading company. In addition, the subsidiary’s constitution should allow it to transfer profit to the charity.

Prior to establishing a trading subsidiary it is important to ascertain exactly what “trade” is to be carried out. There are many examples where trading subsidiaries have been established without considering whether it was necessary. Therefore, consider the rules – is it primary purpose trading?

It is also important to consider the question of financing and vital to remember that there needs to be a proper infrastructure to monitor and control the trading operation. © Pesh Framjee
APPENDIX 1 – FLOW CHART REPRODUCED FROM HMRC’S GUIDANCE TO BUFDG

Note

1 Pesh Framjee is a Partner and Head of the unit serving Non-Profit Organisations at Horwath Clark Whitehill. He is Special Advisor to the Charity Finance Directors’ Group. He is also a member of the Charity Commission’s SORP Committee. He is author of Charities and Trading: Law, Accounting and Tax Issues, which was published by the Charities Advisory Trust in 1995. Until 30 August 2008 he was Head of Non-Profits at Deloitte. Copyright 2009 by Pesh Framjee.