Routing commercial activities through trading subsidiaries can help charities to generate extra money more tax efficiently. We highlight some top tips to help you utilise trading subsidiaries more effectively.
Be clear on the rationale for the subsidiary
There are many reasons why a charity might set up a subsidiary. The main ones being to protect charity assets from the commercial risks of trading, and to minimise the tax payable on trading activities. Being clear on what you are trying to achieve will help you to structure and manage activities effectively.
Establish what trades are taxable in the charity
Charities can trade without tax becoming payable provided:
- The trade advances their charitable purposes, for example, fees paid to a care home for residential care; or
- Trading is ‘small scale’ – larger charities can generate up to £80,000 of income from non-charitable trading without paying tax on the profits.
Being aware of the reliefs available to your charity can help you to make the most of commercial opportunities without fear of an unexpected tax bill.
Where a charity’s income from non-charitable trading exceeds the small-scale trading threshold, all the profits from relevant activities become subject to corporation tax. From 1 April 2023, the rate of corporation tax for all but the smallest companies will be 25%. This means that charities could pay £25,000 of tax on every £100,000 of profit from taxable trading. Planning is key.
Be realistic about the resources required
Using a trading subsidiary will require management time and resources. Consider whether the charity can provide the necessary support or whether additional resources will be required. HM Revenue & Customs (HMRC) expects the charity to charge the trading subsidiary an arm’s length rate for goods and services provided. Including the expected costs in the subsidiary’s budget will help you to assess its profitability more accurately.
Consider the VAT implications
As the trading subsidiary is a separate legal entity, it must register for VAT if its vatable supplies exceed the VAT registration threshold (currently £85,000). Charges from the charity to the trading subsidiary, for example, for staff time, are also likely to be within scope of VAT. This could cause the charity to breach the VAT threshold.
It is usual practice for the charity to form a VAT group registration with its trading subsidiary because if the trading subsidiary is generating taxable income, then this can be used to maximise the VAT recovery on general overheads. It should be noted that if the charity has a special partial exemption method in place, this will be removed when they de-register and cannot be used by the group. A new method would need to be requested from HMRC, and this comes with some risks.
Ensure that there is a robust business case
Trading subsidiaries are generally financed by the parent charity through a combination of share and loan capital and intercompany accounts. Trustees need to be satisfied that it is in the charity’s best interests to provide this support – there should be a robust business case supported by plans and cash flow forecasts. Where charities are not able to show that investment decisions were made on a reasonable basis for the benefit of the charity, HMRC may deem the investments to be non-charitable expenditure, and therefore subject to tax.
Distribute profits on a timely basis
Trading subsidiaries can eliminate the tax payable on their profits by distributing them to charity. To qualify for tax relief:
- The distribution must be made in the year in which the profits are made or, provided the trading subsidiary is wholly owned by the charity, within nine months of the year end.
- The distribution can only be made from the trading subsidiary’s distributable reserves.
- There must be an actual transfer of cash from the subsidiary to the charity (not merely an accounting entry).
Consider the impact of trading on the charity’s exposure to risk
The Charity Commission has expressed concern about the risks to charities from connections to non-charitable organisations. The Commission’s Guidance for charities with a connection to a non-charity can help trustees to ensure that they effectively manage risk in this area. It includes a checklist for charities with trading subsidiaries.
Monitor performance and protect the charity’s interests
Although the company directors are legally responsible for the subsidiary, trustees also need to keep its performance, activities and plans under review to protect the charity’s interests. Where the charity’s trustees are also directors of the trading company, steps will need to be taken to manage the potential conflict of interest and ensure that the interests of the charity and the trading subsidiary are considered separately where appropriate.
Put written agreements in place
Putting written agreements in place can help to protect the charity’s interests and ensure that there is internal clarity about how things will operate. Agreements may include:
- A deed of covenant – to govern the distribution of profits from the trading subsidiary to the charity.
- A shared resource agreement – to govern the shared use of staff, services and other resources.
- A loan agreement – to confirm interest and loan repayment terms.
If you have any questions regarding trading subsidiaries or on any other points raised in this article, please speak to your usual Saffery contact, or get in touch with Helen Wilkie.