Charities often involve themselves in non-prime purpose activities to generate income from which they can fund their charitable purposes. Where these activities meet the “badges of trade” (see below) and breach certain size thresholds it is not tax efficient for them to remain within the charity itself so a trading subsidiary will often be established so that the charity may minimise the tax effects of trading.
Badges of Trade:
Repetition of activity
Identifiable selling organisation or mechanism
Items are acquired for the purpose of resale
The trading subsidiary will be formed as a limited company and subject to Corporation Tax rules. In the past, “profits” were gift aided up to the parent charity as a “donation”. The donation was accrued and recognised in the trading company accounts as an expense (donation) and accrued and recognised in the parent charity accounts for the same period as voluntary income. As long as the “donation” was then paid up to the parent charity within 9 months of the year end date this was an allowable expense in the corporation tax computation and the tax liability on trading profits could be legally mitigated, with the tax treatment following the accounting treatment.
Gift aid donations from trading subsidiaries came under HMRC scrutiny back in 2015 and the ICAEW provided clarification that these gift aid payments were not an expense in the trading subsidiary, but rather a distribution of profits, and as such should not be accrued at the year end date unless a deed of covenant existed that legally obliges the subsidiary to make the payments. This also means that the amount that may be gift aided is now limited by the level of profits available for distribution. HMRC also issued guidance advising that a company will not obtain a tax deduction for any unlawful distributions for accounting periods beginning on or after 1 April 2015.
Deed of covenant
The drafting of a deed of covenant is a reserved legal service and can only be offered by those with an appropriate legal qualification.
However, some trading subsidiaries have continued to accrue for gift aided donations where no deed of covenant exists arguing “custom and practice” or similar as reasons to do so; so for clarification during the triennial review of FRS102 it has been established that the accrual can only be made where a deed of covenant is in place. This amendment is deemed a clarifying amendment effective for periods beginning on or after 5/10/2018 as the FRS is merely reflecting existing requirements, although early adoption is allowed.
The impact for trading subsidiary accounts will be that profits will be recognised within year end reserves until payment is made, at which point distributions will be recognised in the accounts. However, no tax provision is required where any potential tax liability will be offset by the distribution payment (gift aid donation) resulting in different treatments for tax and accounting purposes (donation for tax: distribution for accounts).
Where adoption of the clarified treatment results in a change in accounting policy a prior period adjustment will be required.
Concern arises where, historically, profits have been gift aided to the parent charity leaving very minimal reserves within the trading subsidiary. The trading company may now find itself in a position whereby its taxable profits exceed its distributable reserves. Trustees are advised to review factors affecting taxable profits and determine whether these adjusting items on the tax return may be avoided, i.e. tax profit = accounting profit.
Additionally, there is the expectation that funds should flow in only one direction: from the trading subsidiary to the charity. Where the gift aiding of profits has led to insufficient capital in the trading subsidiary it is tempting to loan funds from the charity to the subsidiary, however, trustees must first ensure that this is within the charity’s investment powers, otherwise it will be considered illegal. HMRC may also consider the loan to be non-charitable expenditure and would result in a partial loss of tax emption for the charity.
Where loans exist from a charity parent to its trading subsidiary, the charity needs to be able to demonstrate that the loan is a commercially sound investment and, at the very least, a commercial rate of interest should be being applied.
If you would like to discuss any of the issues raised above and the impact on your charity, please feel free to contact a member of our specialist Charities Team – Brian Jukes, Geoffrey Cox or Deborah Austin.