Charities do not have a blanket exemption from tax. Instead there are specific exemptions that apply for certain types of income and for capital gains, provided the income or gains are applied for charitable purposes.
Income from property is one of the key exemptions and applies to rental income from letting property in the UK or overseas. The exemption does not cover the provision of services and where the services provided are extensive the activity may be considered a trading activity rather than exempt income from property. Trading income is exempt from tax only if it falls within the primary purpose trading or small trading exemptions.
This is best illustrated by the examples below:
- A charity that is a care home providing fully serviced accommodation will be carrying on a trade, but that trade would be within the primary purpose trading exemption;
- An educational charity that lets its buildings during school holidays as conference facilities and provides catering, accommodation and support services may find that the activity is a taxable trade because the provision of services is so extensive and the activity is not within its primary purpose objective of the provision of education;
- A theatre charity that lets out meeting rooms and, separately, provides catering might be able to apply the property exemption to the letting income and the small trading exemption to the catering (provided that all other income from non-exempt activities is below the annual small trading turnover limit, the overall upper limit of which is now £80,000).
Unexpected tax liabilities can arise when disposing of surplus properties. In the current environment, where charities are looking to rationalise their activities and maximise the financial return from their assets, the sale of surplus properties can provide a necessary source of funds. A simple disposal of a property should qualify for exemption from tax under the exemption for capital gains provided the proceeds are applied for charitable purposes, which could include the acquisition of new property for the charity to use or to hold as an investment. The situation is more complex where the disposal involves the development of the property prior to sale or where the agreement for sale provides the charity with the right to share in future development profits.
There is a potential exposure to corporation tax (or income tax for charities that are trusts) if the charity engages in property development directly or through a joint venture arrangement or partnership or is entitled to receive an overage payment from a developer.
Obtaining planning permission alone does not constitute development and HM Revenue and Customs (HMRC) generally takes the view that a property owner may apply for planning to enhance the capital value of an asset in advance of a sale without that act giving rise to a supervening trade. Where this is the case, any profit on the subsequent sale will normally be treated as a capital gain and so exempt from direct tax for a charity if the proceeds are applied for charitable purposes. HMRC may also accept that some infrastructure works do no more than enhance the value of a property and do not constitute trading but this depends on the extent of the works undertaken.
The complication comes with the transactions in land rules which are tax anti-avoidance provisions that seek to counteract arrangements to convert income profits into gains that are typically subject to a lower rate of tax. There is no exemption from the transactions in land rules for charities.
They can apply to tax a profit on the sale of land by a charity as a trading transaction rather than an exempt gain where one or more of the following conditions are met:
- Condition A: the main purpose or one of the main purposes of acquiring the land was to realise a profit or gain from disposing of the land;
- Condition B: the main purpose or one of the main purposes of acquiring any property deriving its value from the land was to realise a profit or gain from the land (an example of this would be where shares are purchased in a company with a view to procuring that the company sells land that it holds);
- Condition C: the land is held as trading stock; and
- Condition D: where the land has been developed, the main purpose or one of the main purposes of developing the land was to realise a profit or gain from disposing of the land.
So, for example, if a property is acquired with a view to sale any profit is likely to be subject to direct tax. A more common scenario might be that a charity negotiates an overage or ‘slice of the action’ agreement with a developer that entitles it to share in the future profits of the developer (usually above a certain level) from its development of the land. The advantage to the charity is that it may thereby realise more value from the disposal. The gain on the initial sale will usually be exempt from tax as a capital gain but the later profit share is likely to be subject to tax. Such transactions may be caught because there is a ‘common purpose’ between the entities.
This principle was established in the 1983 tax case Page v Lowther, where the trustees of a settlement held land which they had not acquired with a view to reselling at a gain, but which needed redevelopment. The trustees granted a 99-year lease to a development company in return for a rent and a proportion of the premiums that the development company obtained from the grant of under leases. The Court of Appeal held that, although the trustees of the settlement did not themselves carry out the development, there was an arrangement or scheme in existence with respect to the land because of the lease granted to the development company, and that the ‘common purpose’ was that of enabling a gain to be realised by the trustees who were parties to the arrangement which enabled a gain to be realised.
Mitigation of tax
A common way to mitigate this tax exposure is to transfer the land to a trading subsidiary so that it is the subsidiary that receives the profits. The profits in the subsidiary will be subject to corporation tax, but this could be reduced where the subsidiary makes a cash donation out of its profits to the charity, provided it has sufficient cash and distributable profits to make the donation. Careful consideration will need to be given to how the sale of the land to the subsidiary is financed and whether the investment in the subsidiary is a qualifying investment under charity law and a qualifying investment for tax purposes. There can be mismatches between the tax and accounting base costs of the property transferred that impact on the subsidiary’s ability to donate a sufficient amount to eliminate its corporation tax and, in these situations, it may be necessary to look at whether the subsidiary can make a reduction of share capital to create distributable reserves to support a donation.
We recommend that appropriate advice is sought in respect of land transactions to ensure that unexpected tax liabilities do not arise. There may also be VAT and Stamp Duty Land Tax (and Scottish, Welsh or Northern Ireland land transaction taxes) to consider.
David Humphrys, Director