Can charities support their trading subsidiaries?
As with any other business, charities are deemed to be trading if they sell goods or services to customers. However, unlike other businesses, charities will not pay tax on their trading profits in the following three circumstances:
- They only undertake ‘primary purpose trading’.
- Their trading level which is not primary purpose trading falls below the small trading tax exemption.
- Their trading is carried out through a subsidiary trading company.
A subsidiary trading company can be useful (or sometimes essential) if your charity:
- Makes trading profits that do not arise from ‘primary purpose trading’.
- Receives trading income that’s higher than the small trading tax exemption.
- Wants to protect its assets from trading losses.
- Wants to have a separate entity to undertake its trading activities.
The trading subsidiary company can be a company limited by shares, a company limited by guarantee or a Community Interest Company, limited by shares or by guarantee. The company is liable to corporation tax in the same way as all other companies, except it has the ability to donate its profits to its parent charity. The profit must be Gift Aided to the charity within nine months of the company’s accounting period so, for example, a trading subsidiary with a 31 December year end must Gift Aid the profit by 30 September of the following year.
The charity will not pay tax on these profits as long as it uses the money for its charitable purposes.
How can the charity fund the trading subsidiary?
The charity trustees must ensure they always act in the interests of the charity. This ‘rule’ also applies to the charity’s relationship with its subsidiary trading company, so the parent charity must be protected from the risks involved in trading.
Before considering the various methods of funding, charities should invest in a trading subsidiary only if:
- The trustees can show evidence that the investment was made to benefit the charity.
- Assuming a loan is made, that there are terms and conditions showing how the company will pay the charity back. Such terms should include a rate of interest and the date when repayment is due.
- The charity will get a fair return (in cash) which is then spent on the charity’s primary purpose.
The main methods of funding a subsidiary company are:
- Purchase of share capital in the company
Often, only one share is issued as this is sufficient for the charity to wholly own the company. However, if the charity wishes to invest a permanent amount in the company to provide working capital, for example, it could buy 20,000 shares for £20,000. In this way, the purchase of share capital could be used exclusively to fund the trading subsidiary.
The major advantage of this method of funding is that the investment by a parent charity of substantial share capital in the trading subsidiary gives confidence to suppliers, customers, creditors, and others that have a business relationship with the trading subsidiary.
- Provision of loan finance for a fixed or undefined period
Loan finance would usually be provided by the parent charity but it could also be obtained from a third party, such as a bank. The formal terms and conditions should be documented and agreed by the two parties.
A combination of loan finance and purchase of share capital is often used, so that the charity can recover some of its investment in the future.
The provision of loan capital can increase the risk of the trading subsidiary becoming insolvent. If profits are Gift Aided to the charity each year, the trading subsidiary may retain insufficient resources to repay the outstanding loans. This would render the trading subsidiary insolvent and, as a company must not trade whilst insolvent, could lead to the trading subsidiary being dissolved or sold as a going concern. This can even happen when the subsidiary is trading profitably, due to the majority of reserves being paid to the charity to avoid a corporation tax liability.
- By the company retaining some of its profits
This method is not especially popular as the tax system discourages it. Any retained profits are liable to corporation tax, thereby reducing the amount that can be paid to the charity. This can be the preferred method where third-party commercial funding has been used to set the charity up, as the profits can be used to service the loan.
Once the trading subsidiary starts trading, what’s next?
Having set up a trading subsidiary, it is crucial that the charity’s trustees monitor the performance of the subsidiary. In the majority of cases, the subsidiary company performs well and Gift Aids profits to the charity. However, if the subsidiary starts to run at a loss, trustees must act to minimise any losses to the charity. Whatever they decide to do, the trustees’ first concern must always be the charity, irrespective of any moral obligation they feel towards the trading subsidiary. Unless there is a real reason to believe the trading subsidiary can be turned around, trustees should not invest further funds into a struggling subsidiary, as they are putting themselves at personal risk to make good any losses to the charity.
The advantages enjoyed by charities in the tax treatment they receive in relation to trading and trading profits come at a cost, namely the restrictions in how much trading a charity can undertake. It is, perhaps, unfortunate that a charity should have to incur the costs of setting up a new entity to carry out its trading, together with ongoing annual costs, but in the majority of cases, the returns to be made far exceed these costs. So, if your charity is trading, please always consider whether the trading has reached a level at which a subsidiary trading company needs to be set up.
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