For charities, setting up a trading subsidiary company can prove to be a very tax efficient way of raising funds. We explore below how this works, when it can be used and how to overcome the pitfalls that might arise.
How does it work?
Non-primary purpose trading of a charity can be operated through a wholly owned subsidiary company. Any trading costs relating to these activities are either charged directly to the subsidiary company or incurred by the parent charity and passed onto the trading subsidiary company via a management charge. At the end of the year any resulting taxable profit can be distributed back to the parent charity. The subsidiary company is not liable to corporation tax on the profits which it donates to its parent charity as corporate gift aid providing the distribution is made within nine months of the year end and is paid in cash rather than an intercompany transfer.
When should a charity set up a trading subsidiary company?
If activities such as non-primary purpose trading, which is outside of the charitable objectives, exceed a certain turnover of between £8,000 and £80,000 (depending on the charity’s income level) or where the trade could involve a significant commercial risk, a wholly owned trading subsidiary company can be used. Examples of non-primary purpose trading include external catering, IT consultancy, gardening/landscaping/maintenance services, finance consultancy to other charities, operation of a sports centre or other leisure facilities (such as a theatre), hire of sports facilities and property transactions.
For the small trading tax thresholds for charities, see https://www.gov.uk/government/publications/increases-to-charities-small-trading-exemption-limits/increases-to-charities-small-trading-exemption-limits. It’s also worth noting in the scenario of a multi academy trust, the limit relates to the trust rather than individual schools.
Before setting up a subsidiary, consideration should be given as to whether the charitable objectives are already wide enough to cover the trading activity. If they are not, could the objectives be changed to encompass the activity (ie provision of facilities for the community), rather than forming a trading subsidiary?
Another consideration is the annual administration required of a trading subsidiary and the consequential cost. The trading subsidiary would need to prepare and file a tax return and accounts each year and may need an audit. Could these costs outweigh any profit? Are the profits likely to grow in the future? It’s worth considering whether paying a small amount of corporation tax may actually be more efficient.
If setting up a wholly owned subsidiary company is the most appropriate option, it is easy and relatively inexpensive to set up. Please be aware that every charity’s situation is different and we advise you to seek professional advice specific to your situation.
What are the pitfalls?
- In which entity do the staff sit? If they sit in the subsidiary, are you fulfilling the statutory filing requirements (ie PAYE)? If they sit in the parent charity, how are you tracking time spent on the trading activity?
- How are other costs apportioned between the subsidiary and the parent charity? How are transactions between the subsidiary and the parent charity tracked and administered? The common mechanism for such costs is a management charge. The management charge should be calculated on a cost basis and set at a level to recover the actual costs of the trading activity. Management charges need to be reviewed each year and adjusted to reflect any changes in circumstances such as reduced levels of activity as a result of Covid lockdowns.
- By setting up a trading subsidiary, a group is created and therefore the parent charity needs to prepare consolidated accounts, which can be a bit more complicated. There will undoubtedly be transactions between the parent charity and the subsidiary that would require elimination on consolidation.
- In order to gain the tax relief, the gift aid distribution needs to be paid in cash to the parent charity within 9 months of the year end. It’s important to pay the right amount of distribution to avoid incurring corporation tax, especially if your accounts have been prepared on an estimated tax basis.
- Before a gift aid distribution is made, it's important the directors check that there are sufficient distributable profits. Corporate gift aid is legally defined as a distribution (as with a dividend), so can only be made from the company’s distributable profits. For many trading subsidiaries, the distributable profits will be an amount very close to the profits for the last financial year, if profits are donated every year.
- It might not be necessary for a trading subsidiary to be used in a given year – for example, little or no conference business during Covid lockdowns or no relevant property transactions occurring in a given year. Could a loss be generated? Does the balance sheet end up in a net liabilities position? This situation is explored further below.
How do I deal with a net liabilities balance sheet within the trading subsidiary?
Each company stands alone when the directors consider if the entity is a going concern or not. One of the key tests is the net assets/liabilities balance sheet test and whether a company has the resources to pay its debts as they fall due. A net liabilities balance sheet may indicate a going concern issue.
In the case of a corporate group, assuming sufficient reserves to do so, letters of support can be offered to provide the financial resources needed by a subsidiary in a net liabilities position. In the case of a parent charity wanting to provide support to its wholly owned trading subsidiary, it is not so simple.
Charities have charitable purposes and their activities must be within their charitable objects. Before promising a guarantee in a letter of support, trustees of a parent charity need to consider if a guarantee given to a wholly owned trading subsidiary risks charitable funds being used for a non-charitable purpose, if the guarantee is called upon. A useful consideration in these circumstances is the materiality of the numbers involved and the maximum exposure to the charity. Additionally, is the support just a temporary measure? This has been particularly pertinent during the pandemic and, with support being short term, the trustees may have concluded that it is unlikely to put the charitable funds at risk with the certainty of normal trade returning in the near future.
Letters of support are not the only means of helping a trading subsidiary. The following could be considered:
- Is the management charge still appropriate and reflective of the costs associated with the level of trading activity within the subsidiary?
- Additional cash could be injected into the trading subsidiary if the trading subsidiary had the potential to raise funds for the charity in the future and further investment could be justified.
- Where a net liabilities position arises from an intercompany loan, the support given could be in the form of a promise from the parent charity not to call the debt in until the trading subsidiary has sufficient funds to do so, thus limiting the exposure, assuming there is certainty that the trading subsidiary will settle the debt in the future.
- Profits could be retained, rather than being distributed, to build reserves for future loss-making years, although this would be net of corporation tax. This is especially useful when activity is lumpy or can be reliably forecast.
- External finance could be raised through debt and/or equity.
Unfortunately a parent charity cannot make a gift to a trading subsidiary, whether in cash or in kind, or settle the debts on behalf of a trading subsidiary.
Transactions involving land
We come across a lot of subsidiaries set up in advance of developing land or selling land to a property developer. This is clearly non-primary purpose and the sale of land would normally be taxable within a charity. Charities often choose to transfer the land to a subsidiary and then use the gift aid exemption to distribute any profits received to the parent charity from the sale of the land. However, some corporation tax leakage on the original land transfer within the subsidiary is normally unavoidable (this crystallises when the capital asset is appropriated to stock), albeit not usually material in the context of the overall development. An election can be made to defer the corporation tax until the eventual sale of the developed land by the subsidiary.
Some charities choose a more complicated structure involving a wholly owned subsidiary of the charity being a partner along with a promoter or developer in a newly formed joint venture LLP. The land is then transferred to the joint venture LLP. However, Stamp Duty normally arises on the market value of the land transferred to the joint venture LLP, but any profits paid from the joint venture LLP to the wholly owned subsidiary should be eligible for the gift aid exemption. This structure can become very complex and requires careful consideration before embarking upon.
It’s important for the charity trustees to put the interests of the parent charity first and foremost. Sometimes this will involve difficult decisions to liquidate or sell a failing trading subsidiary. If trustees keep a failing trading subsidiary at the charity’s expense, they may be liable personally for any consequential losses incurred by the parent charity.
Please note that this briefing does not constitute advice. This is a complex area and charities should seek advice to take into consideration any specific circumstances.
First published 14 April 2022
Last updated 14 April 2022
14 April 2022
Find out more about Katherine Wilkes