The most tax efficient way to structure a charity

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The way in which a charity is structured, such as the use of a wholly owned subsidiary company, can have a significant impact on the amount of tax paid, as can the correct use of charity VAT relief.

Key Points 

Key Points

What is the issue?

In the charitable sphere, the word ‘trustee’ has a rather broader meaning than in the private client world, being used to describe those charged with governing a charity, whether it is set up as a trust, a corporate entity or a charitable incorporated organisation.

What does it mean for me?

Primary purpose trading is the area most likely to cause a charity to slip up and become subject to corporation tax.

What can I take away?

Charity taxation is a far from straightforward matter, but with the appropriate advice, a charity’s affairs can be structured in such a way to maximise the advantages available to them.

Being trustee of a charity can be quite an appealing prospect and is something that tax and accounting practitioners are often asked to take on as they reach the more senior end of their careers.

But it is not something to be undertaken lightly. Indeed, any of us who have been reading our industry publications will have been hard-pushed to miss the various tales of charity misadventure lately, which have been varied in nature but more often than not related to governance and sometimes tax.

Governance

In the charitable sphere, the word ‘trustee’ has a rather broader meaning than we might be used to in the private client world, being used to describe those charged with governing a charity, whether it is set up as a trust, a corporate entity or a charitable incorporated organisation. The structure chosen for the charity will naturally vary but for a charity that is looking to actively trade, rather than passively gift, incorporation is usually the chosen route.

Charities tend to be structured as a company limited by guarantee rather than by shares, and in this case you would be a director of the company and a trustee of the charity. This structuring may provide greater protection for the trustees than using a trust, and also makes it easier for the charity to continue unchanged where there is a change in trustees.

Whatever the structure, however, as a trustee you cannot normally be paid for your work in this role. Your role is as a volunteer and akin to a non-executive director: not usually involved in the day to day running of the charity but involved with policy making, setting strategy to achieve its objects and safeguarding the charity’s assets. Fundamentally, the rule is that you cannot be paid for acting as a trustee, nor can you be a paid employee of the charity.

In certain circumstances, however – and only if the charity’s constitutional document allows it or if the Charity Commission or courts approve it – a trustee can be compensated for providing certain skills to the charity, such as building work or accountancy and bookkeeping services.

There are certain legal requirements around such payments, which must be:

  • in line with the charity’s best interests;
  • reasonable;
  • by written agreement with the exact amounts specified; and
  • in the minority – that is, only a minority of the charity’s trustees may receive such payments.

Expenses reasonably incurred by trustees to carry out their duties can be reimbursed.

Corporation tax

As a default, a charity is subject to corporation tax, just like any other corporate entity. Tax relief then comes in the form of exemptions built into the legislation, the key ones of which are:

  • donations;
  • primary purpose training;
  • incidental income, such as rent; and
  • small trading exemption.

Primary purpose trading is the area most likely to cause a charity to slip up and become subject to corporation tax, because at the margins it can be quite a grey area. Primary purpose trading is trading in furtherance of a charity’s stated goals, whereas other ancillary income may be subject to corporation tax in the usual way. The best way to demonstrate this is by using an example.

Museums are generally set up as charities. This allows the entrance fees that they charge to not be subject to corporation tax as they are clearly charged with the express intent of providing education, which will be one of the charity’s primary goals. Selling reference books in the gift shop is a slightly greyer area, but should also be acceptable as ancillary to the primary purpose, as again it is in furtherance of the guest’s education.

However, what if the gift shop is also selling mugs, T-shirts and pencils, themed to the museum? The income here cannot be said to be in furtherance of the charity’s goals and, as such, would not fall within this exemption and would potentially be subject to corporation tax.

It is possible to mitigate this potential tax exposure. This is achieved by incorporating a wholly owned subsidiary company to the charity, which can be used for any trading that is at risk of not falling into the exemptions. This helps to mitigate the risk of the charity itself becoming subject to tax, while nicely ringfencing any non-exempt trading.

While the subsidiary itself will be subject to tax, it can then donate its profits to the parent company. These donated profits will be subject to tax relief (which HMRC refers to as ‘gift aid for companies’) against its taxable profits. This in turn can be used to reduce the subsidiary’s taxable profits to nil, notwithstanding the possibility of a mismatch between taxable and accounting profits.

As noted above, this income received at charity level is not subject to tax because it is a donation.

While there is no additional relief at charity level for these gift aid donations, they provide 100% relief against taxable profit in the subsidiary, thereby ensuring that charity tax reliefs apply.

There is a further benefit of structuring this way. Usually, when a company makes a donation that it wishes to be subject to gift relief, it must be made during the year in which the relief is claimed. However, where the company in question is a wholly owned subsidiary of a charity, there is an additional nine months to make the donation and still be able to offset the donation in the prior year. This allows time for the taxable profits to be accurately calculated and an appropriate donation and claim to be made accordingly.

It should be noted that this only applies to donations made freely. A donation made under covenant must be claimed in the year covered by the covenant (i.e. in the year in which the donation is made) and care should therefore be taken in this respect.

For smaller charities, there is also a small trading exemption aimed at avoiding the need for the complexities of corporation tax compliance or indeed incorporating a subsidiary where income levels are low but some of the income would otherwise be taxable. Where a small charity has incidental income not subject to any exemptions, as long as it falls within the limits (currently £8,000 or less than 20% of total income capped at £80,000), it is automatically exempt.

This is beneficial where, for example, a charity might look to raise some additional funds through selling Christmas cards.

Distributable reserves

Donations by a trading subsidiary to its charity parent are distributions and may only be made from distributable reserves. The ICAEW issued a guidance note in 2016 (see bit.ly/3Bop4rG), which explained the position and helped charities and practitioners in cases where donations might have been paid in excess of reserves. It is worth noting that an excess donation does not qualify for gift aid relief and a repayment to the trading subsidiary is not taxable. A more recent note covers the position where a trading subsidiary might have incurred losses during the Covid pandemic (see bit.ly/3HVrLnj).

VAT

It is always tempting when writing an article such as this to simply say ‘speak to a VAT expert’ and move on. Certainly, it is true that VAT is a complex tax – even more so where charities are concerned – and some expert guidance will go a long way towards getting matters correct and saving money in the long run.

However, given that it is estimated by the Charity Tax Group that VAT now costs the not-for-profit sector in excess of £1.8 billion per year, an awareness of the fundamentals can be crucial to identifying where expert advice needs to be sought.

Charities cannot charge VAT on non-business activities (e.g. provision of donations and grants), nor on exempt goods and services (e.g. provision of welfare services, education, membership services and administration to cultural events to name a few), and cannot usually recover the associated input VAT, leading to this VAT cost. Like any other business, charities must register and apply VAT to their sales if their VAT-able turnover is above £85,000.

Charities are entitled to certain reliefs on costs in some areas, as set out in the box on the left. These need to be claimed, however (usually by issuing a certificate); and the cost of understanding whether they apply, and the subsequent claim, can at times be disproportionate to the benefit of doing so.

Donations themselves are not subject to VAT, as long as they are genuine donations, because there is no reciprocal supply of goods or services. However, sometimes receipts of substantial donations can have certain conditions attached, or benefits to the ‘donor’, and the charity must then give careful consideration as to the nature of the arrangement. If the donation is seen as a supply, then VAT could apply to the whole value of the donation, even if treated differently for other tax purposes.

Charities are not exempt from Making Tax Digital if they are VAT registered. From 1 April 2022, all VAT registered businesses, including charities, must be signed up and maintain digital records in respect of a number of matters, including transactions made by volunteers in respect of charity fundraising.

Final thoughts

Charity taxation is a far from straightforward matter, but with the appropriate advice, a charity’s affairs can be structured in such a way to maximise the advantages available to them. Should you require advice, speak to a charity expert who can guide you accordingly.

 

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