It has long been common practice in the UK for charities to establish wholly-owned companies through which to carry out trading activities, rather than running such operations from the charity itself. Doing so allows charities to avoid restrictive rules about what a charity can and cannot do. It can also be beneficial from a tax perspective: although charities benefit from wide-reaching tax exemptions, the exemptions in relation to trading activities are relatively narrow. Where trading profits would potentially be taxable for the charity, use of a trading subsidiary can help mitigate this cost.
That may be old hat, but there is a part of the puzzle that is often overlooked: how to fund that trading subsidiary, both upon incorporation and going forward, in a way that does not jeopardise the intended tax analysis of the structure.
The intended tax analysis
Before turning to the tax considerations to bear in mind when deciding how to fund a charity’s trading subsidiary, it is worth summarising the intended tax analysis:
- Downstreaming of funds. The investment in the trading subsidiary needs to be an “approved charitable investment” for the charity. In broad terms, this means the investment must be made for the benefit of the charity and not for the avoidance of tax. If this requirement is failed, the investment will be “non-charitable expenditure” and the charity risks losing certain of its tax exemptions.
- Upstreaming of profits. The trading subsidiary will, as a basic matter, be liable to corporation tax on its profits. To avoid that tax leakage, the trading subsidiary may choose to donate an amount equal to its total taxable profits to the charity each year. Provided this is done within nine months of the end of the relevant accounting period, the donation should be allowed as a deduction for tax purposes, reducing the corporation tax due for that period to nil. The charity should not be liable to tax on receipt of such amounts either, provided it applies such funds to charitable purposes only.
Debt versus equity
So what is the best way to structure the investment by the charity into its trading subsidiary? This is not a one-off binary choice between equity and debt – a mixture can be used, and the approach taken may vary from time to time – but it is nonetheless important to take care, as there could be a real cash cost to the charity if the intended tax analysis fails.
From a tax perspective, there are two main considerations.
Firstly, will the trading subsidiary be in a position to donate an amount equal to its total taxable profits each accounting period to the charity? As noted above, this is the mechanic by which trading subsidiaries can eliminate their corporation tax liabilities – a mechanic HMRC guidance explicitly recognises and lists as a reason why charities may choose to use trading subsidiaries – and as such any restriction here risks reducing the charity’s post-tax return. If it is anticipated that the trading subsidiary might have taxable profits in excess of its accounting profits and distributable reserves, then this will be a live issue because company law constraints would prevent the subsidiary from donating more than its available distributable reserves. Taxable profits might diverge from accounting profits for myriad reasons, but a common problem is that the subsidiary might incur expenditure which is not tax-deductible. One way to manage this issue is for the trading subsidiary to undertake a reduction of capital, effectively converting amounts in its share premium account into distributable reserves. Structuring the investment from the parent as equity (ideally with a low nominal value) gives the trading subsidiary more scope to do this if necessary.
Secondly, is it possible to get comfortable that the chosen funding structure is “for the benefit of the charity”, so as not to amount to “non-charitable expenditure”? HMRC interpret “for the benefit of the charity” as meaning either (a) for the financial benefit of the charity (i.e. to generate income or gains to enable the charity to carry out its objects, or (b) for the charitable benefit of the charity (i.e. carrying out its charitable objects). Depending on the facts, both equity and debt investments in trading subsidiaries can meet this requirement – but structuring the funding as debt that complies with HMRC guidance (i.e. debt that contains proper provision for repayment, carries an interest rate that reflects the level of risk, and is accompanied by a market-standard security package) rather than equity often makes it easier for trustees to get comfortable on this point because of the increased prospect of economic return to the charity.
There may well be important non-tax considerations to weigh-up when deciding how to structure an investment in a trading subsidiary. These should not be overlooked, but nor should they drown out a discussion about the possible tax implications of the possible options.
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