The answer all charities are still waiting for: Gift or distribution?
11th February 2015 by Adrian Piddington
When it comes to the issue of direct taxation for charities, this can be a minefield for charitable organisations to understand, and then to arrange their affairs so that they are compliant and not exposed to tax.
Generally, for any trading carried on by charities to be exempt from the charge to tax, the activities must directly relate to the charity’s main aims, usually set out in their charitable objects. Directly related activities are classed as primary-purpose trading in tax terms and these purposes are usually approved as being charitable.
The problem comes when charities have primary and non-primary purpose trading. For example, a museum may receive income from a shop it runs selling historical books relevant to the exhibition (primary purpose) alongside celebrity biographies (non-primary purpose). There is a small trading exemption which covers low levels of non-primary purpose trading; but, say in the example above, the sale of non-relevant books exceeded this limit and these profits therefore became chargeable to tax.
In order to mitigate this exposure to tax, charities usually hive off taxable activities into a subsidiary company wholly owned by the charity; the profits of which are assessed to tax in the normal way. Any resultant taxable profit is then gifted to the parent charity, as what is known as a ‘qualifying payment’. Providing it is paid within nine months of the company’s year-end, it will qualify to be deducted in the accounting period in which it was nominated to be paid from. The payment is then exempt as a donation in the parent charity’s income. This model is formally accepted by HM Revenue & Customs (HMRC). Although, it is important to consider the wider issues, including VAT, before setting up a trading subsidiary.
An anomaly arises where the subsidiary company’s taxable profits are greater than the profits recognised in the accounts; perhaps due to timing differences when certain expenditure is recognised for accounting purposes and relieved for tax purposes. For example, remuneration accrued at the year-end is expensed to the profit and loss account but not paid until more than nine months after, so tax relief is not available until the next period in which it is paid. Therefore, a company may make a payment to the parent charity in excess of its distributable reserves.
Last year, the Charity Commission withdrew Guidance on these types of arrangement, which implied that it was not necessary for there to be sufficient reserves to cover a payment of this kind. The Institute of Chartered Accountants in England & Wales (ICAEW) issued a Technical Note in response based on a legal Opinion from Counsel; this inferred that these transactions are unlawful to the extent they are made in excess of the company’s reserves. Where this conflicts with the tax legislation is that in order for a payment made to the parent charity to be qualifying and therefore relieved against the taxable profits, there must be no condition as to repayment. In company law, unlawful distributions are repayable to the company.
Currently, the certainty of this practice from a tax point of view is all up in the air, as HMRC is still to release its own interpretation of the law in response to the ICAEW’s Technical Note and the acceptable practices which should consequently be adopted. Some hope lies in the fact that in company case law, the Courts have looked at the substance rather than the form of a transaction in deciding whether or not it is a distribution and in turn unlawful. Indeed, in a notable case, a Law Lord commented on the concept of a transaction to a shareholder which results in a transfer of value not covered by distributable profits being an unlawful return of capital, “a relentlessly objective rule of that sort would be oppressive and unworkable.*”
Tax case law, which is not compatible with company law and cannot influence the legal implications raised by the ICAEW, has developed clearer, although not entirely crystal, principles as to what constitutes a distribution. Broadly, these look at the mechanism** employed to execute such transactions. There is also an established principle in that a distribution is a “payment out of part of the profits in respect of a share in a company***.” The company’s Articles of Association will usually codify the manner in which a distribution is to be made. Therefore, it might be argued from a tax law point of view that any ‘excessive’ qualifying payments from a subsidiary to a parent charity in excess of distributable reserves is not a distribution in nature unless the formalities prescribed by the Articles have been adhered to.
The Corporation Tax Act 2010 expressly states that payments from a subsidiary to a parent charity are not to be regarded as a distribution. However, it is the non-repayable condition attached to the payment which makes it a qualifying deduction for tax purposes and if the amount of the payment in excess of the reserves is held to be unlawful from a company law perspective and the ramification is that it must be repaid to the subsidiary, this part will be re-exposed to tax, meaning many charities in this situation will potentially be landed with an unexpected tax bill.
Until HMRC release a statement setting out their views on this important issue, charities along with their affected trading subsidiaries are sitting in limbo and anxiously awaiting clarification in terms of the correct practice which complies with the actual intention and interpretation of the law, and if they do not, the implications of being assessed to tax in prior years. While we wait, the key action point is to be clear that there are sufficient distributable reserves to cover any Gift Aid payments made to the parent charity. This might just be a case of carefully considering the management accounts as you would for a dividend, or it could involve a more complex exercise to generate additional reserves.
The views expressed in this article are my own and are opinions of interpretations which may be explored and do not represent any certainty of treatment for tax purposes, which will be set out in HMRC’s forthcoming statement.
For further information or assistance, please contact Andrew Scott.
* Progress Property Co Ltd v Moorgrath Group Ltd 
** First Nationwide v HMRC 
*** Esso Petroleum Co Ltd v Ministry of Defence  & Memec plc v IRC 
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