Authors: Virginia Mariscal-Rios and Alex Smith

Charities have specific tax exemptions on the profits of any property rental business, interest income and capital gains. However, charities may unwittingly end up paying tax if they carry out trading activities and these are not specifically covered by the existing exemptions.

According to HMRC’s own guidance: ‘Your charity will not pay tax on profits it makes from trade if:

• You are making money to help your charity’s aims and objectives, known as ‘primary purpose trading’
• your level of trade that is not primary purpose falls below the charity’s small trading tax exemption limit
• you trade through a subsidiary trading company.

Your charity must pay tax on any other profits’.

We explain each of the above exemptions in more detail below:

Primary purpose trading

This will cover those trading activities that are carried out in the course of achieving the charity’s objectives as identified in its trust deed, constitution or governing document (i.e. sale of tickets for a theatrical production staged by a theatre charity), or those activities which are ancillary to them and help the charity’s primary purpose (i.e. the charitable theatre serving its audience refreshments in a bar during breaks or intermission). However, charities need to be aware that not all income might be exempt, and they might need to pay tax if they carry out non-primary purpose trade activities. For example, if the theatre bar was also open to the public and not limited to its audience then this would be considered a mixed trade, having ancillary and non-primary purpose trade. Another example taken from HMRC’s guidance is ‘when a university rents student accommodation to the general public during the summer break. The university may pay tax on profits from the rent because its primary purpose is to educate’.

Small trading tax exemption

This exemption applies to all non-primary purpose trading. However, charities need to be aware that the below limits apply to the income and not to the profits arising:

Charity’s gross annual income               Maximum permitted small trading turnover

Under £32,000                                           £8,000

£32,001 to £320,000                               25% of the charity’s total annual turnover

Over £320,000                                          £80,000

Using a subsidiary trading company

a) Tax Considerations

If the charity only has small amounts of non-primary purpose trade and the turnover is well within the above limits, then the above exemption would be enough. If, however, the charity wishes to carry out trading activities that do not fall within the above exemptions, then it is common for the charity to set up a subsidiary trading company to undertake these activities on its behalf.

The trading subsidiary can then reduce its taxable profits to nil by transferring the profits arising from the non-primary purpose trade back to the parent charity under the Gift Aid scheme. Provided this is done within nine months of the end of the relevant accounting period, the donation should be allowed as a deduction in the corporation tax return of the trading subsidiary, reducing the corporation tax due for that period to nil. It is also important to note that the payment must be an actual transfer of cash from the subsidiary to the charity. Therefore, it is important that the trading subsidiary and the parent charity do not share the same bank account and should not use the intercompany account for Gift Aid payments. This ensures that the gift aid payment is made in a timely manner, and that it represents an actual transfer of funds, which are key requirements for the tax deduction to be valid. The charity will not pay tax on the amounts it receives as long as such funds are applied to charitable purposes only.

b) Accounting and regulatory considerations

The trading subsidiary can only accrue the gift aid donation to its parent charity in their accounts if there is a legal obligation on the subsidiary to make this payment, for example under a deed of covenant under which all taxable profits of the trading subsidiary are covenanted to the parent charity. The FRC makes it clear that a board decision to make a gift aid payment to the parent charity which has been taken prior to the reporting date, is not sufficient to create a legal obligation, nor is a pattern of past practice. This means that only if there is sufficient evidence in place of the subsidiary’s obligation to make the donation, then the donation will be accrued in the accounts and allowed in the tax computation if paid within 9 months of the year end.

When a trading subsidiary makes a Gift Aid payment to its parent charity, the donation is considered to be a distribution to the owners of the trading subsidiary (i.e. the parent charity). It is therefore crucial that the trading subsidiary ensures that the payment made does not exceed its distributable profits (i.e. the accumulated realised profits) at the time of the payment. Where a donation is paid in excess of the distributable profits, this will be an unlawful distribution, which means that the payment cannot legally be made, which could result in an unexpected corporation tax liability.

When it comes to making the actual gift aid payment, it is important to note that it would indeed be considered a “qualifying payment”. To be certain of this, we recommend seeking advice from a qualified charities finance professional, however usually satisfying the following conditions would make a gift aid payment qualifying:

• The payment is in money
• It is not subject to a repayment condition (but there is one important exception)
• The charity is not acquiring property in exchange, including from an associated party
• There are no associated benefits
• The company is making a distribution (a dividend, not an expense).

Failure to satisfy the above conditions can leave gift aid disallowed, with corporation tax applied in the usual manner.