Many charities set up a trading subsidiary to undertake trading activity which falls outside their charitable purposes (sometimes known as non-primary purpose trading). For example, in the case of an independent school, the charging of school fees furthers its charitable purposes and would be primary purpose trading; in contrast, property lettings or commercial sponsorship arrangements would be non-primary purpose trading and would usually be carried on through a trading subsidiary.
Operating through a trading subsidiary helps to reduce risk by ring-fencing the charity’s assets from potential trading losses. If non-primary purpose trading carries any significant risk, the Charity Commission generally recommends that the charity carry on this activity through a subsidiary.
This is also important for tax purposes. Non-primary purpose trading is liable to tax unless it falls within an exemption (e.g. the exemption on small scale trading activity). Charities usually do not have the power in their governing document to carry on trading activity to such an extent that it incurs a tax liability. This is another reason why charities may need to set up a trading subsidiary.
The trading subsidiary itself can reduce its tax liability by making donations to its parent charity under the corporate Gift Aid scheme. In principle, this can reduce the trading subsidiary’s taxable profits to zero.
Distribution of profits
The rules on distribution of profits under the Companies Act 2006 state that a distribution is “every description of distribution of a company’s assets to its members, whether in cash or otherwise”. A company intending to make a distribution must satisfy two essential rules:
- it must have profits available to make the distribution (i.e. “distributable profits”); and
- the distribution must be justified by reference to “relevant accounts”.
There is also a common law rule which restricts a company limited by shares from returning capital to its members.
Any distribution which does not satisfy these rules will be unlawful.
ICAEW technical guidance
However, the ICAEW has expressed concern where a trading subsidiary donates an amount to its parent charity which exceeds its distributable profits in order to reduce its taxable profits to zero. This is because a company’s “taxable profits” under tax legislation may not reflect the “distributable profits” under company law. These concepts are distinct and the two amounts are not necessarily the same.
The Charity Commission has nonetheless previously accepted this practice and the ICAEW likewise regarded it as “common practice” for a trading subsidiary to donate all its taxable profits. However, having obtained counsel’s opinion, the ICAEW has now published technical guidance confirming that this approach was not correct.
In summary, counsel has stated that, if a trading subsidiary makes a donation to its parent charity, this is a distribution under company law. But, if the donation is greater than the subsidiary’s distributable profits available as shown in its relevant accounts, the payment would be unlawful, just as it would be unlawful for the company to pay a dividend in those circumstances.
If the parent charity receives a donation in these circumstances, it would be under an obligation to repay the unlawful element (i.e. the amount in excess of the distributable profits). The directors of the trading subsidiary would also be potentially liable to the subsidiary if the charity failed to make repayment. The trading subsidiary would also be liable to corporation tax on any taxable profits.
HMRC is still considering the tax implications for charities. In the meantime academies and independent schools should identify if any historic (or planned future) donations might be in excess of the subsidiary’s taxable profits and, if so, what remedial action they should take. This is likely to require a detailed financial analysis. Because of the possible conflicts, it may be appropriate for the parent charity and its subsidiary to take independent advice separately.