Using a trading subsidiary

There have been many lessons drawn from the Pandemic, one key lesson has been how a large number of charities, including independent schools, have had to reassess their relationship with their trading subsidiaries.

Background

Charities are exempt from corporation tax on certain sources of income as long as it is then used for charitable purposes. This exemption will increase in importance from 1 April 2023 when the corporation tax rate increases from 19% to 25% for many entities.

Where the income does not fall within those exemptions, charities typically run the activity in a subsidiary company, which then manages its corporation tax liability by making a tax-deductible gift aid payment and so, ultimately, no corporation tax is due. This form of tax planning is both common-place and is described as “Reasonable and prudent tax planning by charities” by the Charity Commission for England and Wales in their guidance published on 21 January 2015, which they still refer to in correspondence.

Charities should also use trading subsidiaries where the activity being undertaken would otherwise pose a significant risk to the assets of the charity.

While running a trading subsidiary as a separate entity can lead to corporation tax savings, there are additional costs in operating the company and so charities, including schools should consider whether these costs are worth incurring. This is particularly relevant for low-risk activities where the annual income is typically less than £80,000 or, if smaller, 25% of the charity’s total income as the small trading exemption could remove any related profits from the corporation tax net.

Lesson 1 For wholly owned subsidiaries, the gift aid payment can be made up to 9 months after the end of the relevant year and still be offset against that year’s profits. In other circumstances, only payments made in the year can be used. In order to make a gift aid payment, the subsidiary needs to have both the cash available and also sufficient distributable reserves to cover the payment. During the pandemic, a delay in making the payment, coupled with a significant drop in income and a smaller reduction in costs, led many subsidiaries to be in a position where they did not have the cash available to make the gift aid payment. Where this was due to the subsidiary making losses in the subsequent year, then these losses could be carried back to reduce the profit subject to tax, but this was not always sufficient. The key learning from this is that it may be sensible to make more regular gift aid payments to manage cashflows rather than making one large payment around the deadline.

 

Lesson 2 While the subsidiary is a separate legal entity and should be treated as such (a point reaffirmed in the Charity Commission guidance published on 29 March 2019), in many cases there remains a close working relationship between the charity and the subsidiary. This is not surprising given that many subsidiaries are relatively small and so need support from the charity in terms of administrative services for example. We often see that the two entities share employees with the actual employment contract with the charity. Typically, the payment of the shared costs by the subsidiary is haphazard and so, at any given time the subsidiary could owe the charity a reasonable sum of money, as the charity effectively funds the working capital cycle of the subsidiary. When that cycle was interrupted by COVID-19, charities including schools, found themselves being owed money with little immediate chance of that being repaid, which really highlighted that funding situation. This gives two challenges for the school, firstly their own tax relief depends on using income only for charitable purposes and meeting the spending requirements of a subsidiary that is not carrying on a charitable activity is not charitable purpose spending. Secondly, if the cash allocation is more like a loan than subsidised expenditure then the charity needs to follow the guidance around investments. HMRC issued updated guidance on approved charitable investments on 21 April 2022. If the rules therein are not followed then the loan could be deemed to be non-charitable expenditure and so give a tax charge in the charity.

It is clear over time, some charities have become complacent in managing the relationship with their subsidiary and have not focussed on the risk that they were taking because cash flowed nicely in the good times and so the fact that the subsidiary is not well capitalised or costs were being incurred in the wrong place never seemed to matter. While managing this relationship is not the most interesting part of having a subsidiary it is the price to pay to in order to engage in the 'Reasonable and prudent tax planning' that the Charity Commission recommend.

If you require any further advice on any of the above, please contact Rob Gunn, or your usual Crowe contact.