Jane Whitfield considers if a charity is allowed to provide financial support to its trading company if the company is struggling and, if so, whether a charity should go down that path.
One of the effects of COVID19 has been the dramatic fall in income for almost every company in the country that relies on trading. This is also true for the trading companies of most charities, with charity shops closed and other trading activities brought to a sudden halt.
Many charities are now looking at whether or not they can inject some desperately needed funds into their trading companies in an attempt to address short term financial concerns.
But why should a charity have a trading company at all?
A charity is only allowed to carry out charitable trading activity. This includes:
- “Primary purpose” trading, which is trading that directly furthers the charity’s specific charitable purposes,
- “Ancillary” trading, which is trading that is complementary to, or derived from, the charity’s specific charitable purposes, or
- Trading that is mainly carried out by a charity’s beneficiaries – for example, the manufacture and sale of items by learning-disabled adults working for a charity whose purpose is to benefit adults with learning disabilities.
The profits from charitable trading are exempt from income and corporation tax.
If a charity carries out any other kind of trading, this is deemed to be non-charitable trading and may either result in a direct tax liability or pose other significant risk to the charity. Hence the need for non-charitable trading activities to be undertaken by a separate, wholly-owned trading company.
The Charity Commission’s guidance summarises the position as follows:
“A trading company must be used in any case where there would be a significant risk to the assets of the charity, if it were to carry on non-primary purpose trading itself. The trading company must be set up in such a way as to protect the parent charity and its assets from the risks involved in the trading. The need to protect the charity’s assets from any significant risk involved in non-primary purpose trading is paramount. The fact that the trading profits would have been exempt from tax if the trading had been carried on by the charity itself does not necessarily mean that it is appropriate for the charity to carry on the trading.”
What does a trading company look like?
A trading company will usually be a private company limited by shares, with a minimum of one director. That said, in practice there is normally a board of directors comprising a mixture of trustees of the parent charity and some independent individuals who have specific expertise. It is important that some of the directors are independent of the charity because the two entities must be kept at arm’s length and any conflicts of interest or loyalty carefully managed. If a conflict does arise, both the charity and the trading company must have sufficient unconflicted individuals to make proper decisions.
A trading company’s structure is normally a company limited by shares, because it is a standard form of corporate structure that is well used and understood. In addition, it can issue shares and declare dividends on those shares, which is a useful method of financing the company.
It is normal for the parent charity to have the power to appoint and remove directors of the trading company, as this allows the charity to retain a level of operational control.
What is profit shedding?
A trading company can pass taxable trading profits up to its parent charity and claim charitable donations relief under the corporate Gift Aid scheme. This is known as “profit shedding”.
Although maximum tax efficiency is achieved by the trading company donating all of its profits to the parent charity, this can create cashflow problems for the company. It is likely therefore that the trading company will need to retain some of its distributable profits in order to operate, even though such profits would be liable to corporation tax.
It may be necessary to take specialist advice on the level of corporate Gift Aid payment to be made by the trading company to its parent charity and on the need for the trading company to enter into a legal obligation to pay. This is because a Gift Aid payment must be accounted for as a distribution and, for such a payment to be recognised as a liability at the end of the reporting period, charity accounting rules require a legal obligation for the trading company to make the payment to exist, such as by entering into a deed of covenant.
Financing a trading company
The working capital of a trading company is typically made available through borrowing from the parent charity, or through the parent charity investing in the trading company’s shares. In either case, the trustees of the charity parent must:
- Ensure that the charity has the power to make the investment
- Justify such financial support as an appropriate investment of the charity’s resources
- Consider the tax treatment of any investment in the trading company
So, can a charity fund a struggling trading company to prop it up?
It is common for a charity to have to provide working capital funding regularly to its trading company, because the Gift Aid rules operate to promote a company shedding as much profit as possible to its parent charity.
The paramount duty of the charity trustees is to act in the charity’s best interests alone and to ensure that the charity’s assets are used only to support and carry out its charitable purposes.
It is important to remember that the trading company is a normal commercial company and not a charity, so any funding by the charity will be considered as an investment. The charity rules that apply to investment state that, if a charity invests in a non-charity, the aim must be to obtain the best level of financial return as possible, within the acceptable levels of risk.
The rules do not allow a charity’s trading company to receive special treatment because of its operational links to the charity.
So, before investing in a trading company, the trustees of the parent charity must consider such investment as they would any other investment of the charity’s resources. This means asking the following questions:
- Is the investment suitable for the charity, having regard to its other investment options?
- Are the charity’s investments suitably diversified?
- Looking at the company’s business plans, cashflow forecasts and profit projects etc, has the charity considered the company’s business projects and is the charity satisfied of the trading company’s financial viability?
- Has the charity obtained and considered appropriate expert advice on the three points above?
If the answer to all of the above is yes, then the charity can resolve that it is in its interests to make the investment.
Loan or purchase share capital?
If the trading company is struggling, then the Charity Commission would normally consider a loan (preferably secured on the trading company’s assets) to be the more appropriate way for the parent charity to provide further funding to the trading company, as opposed to purchasing share capital.
The reason for this is that, if the trading company were to become insolvent, the parent charity should be more likely to receive repayment of a formal loan. The shareholders of an insolvent company would be the last to be repaid and in some cases receive nothing at all.
Should a charity loan funds to a struggling trading company?
The starting point on this is that any loan from a charity to its trading company must be treated by the charity trustees as they would any loan to a non-charitable third party. So, the questions the charity trustees need to ask are as follows:
- Does the charity have the required investment and lending powers in its governing document?
- Is the trading company going to be able to repay the loan? (This will include reviewing the business plan and detailed profit and cashflow forecasts.)
- What would be the appropriate commercial rates for such a loan?
- Is it appropriate to register a charge over the trading company’s assets to ensure first option on any assets should the company become insolvent?
The terms of any loan from the charity should be captured in a formal loan agreement signed by the authorised representatives of both entities.
The charity trustees must be able to justify financial support for the trading company as an appropriate way of investing the charity’s resources generally. This is absolutely crucial to the charity because, if not, then such a loan might represent non-charitable expenditure.
The parent charity needs to be extremely careful that it does not stray into the area of “non-charitable expenditure”. A charity which incurs non-charitable expenditure will in most cases lose its tax exemption on the equivalent amount of its income or gains which would otherwise have been eligible for tax exemption, so hideous consequences for a charity on all counts.
Specialist advice is recommended in this area, as getting it wrong is easy to do but expensive and difficult to rectify.
Ongoing monitoring of a loan to a trading company
If a charity does make a loan to its trading company, it will need to monitor it on a regular basis, to decide whether it remains in the best interests of the charity.
If, on review, it appears that the trading company is going to make significant financial losses, then the trustees of the charity are under a duty to safeguard the charity’s assets and thus minimise any loss to the charity. If the trustees do not act to minimise any loss to the charity, they may be in breach of trust and therefore possibly also then personally liable for that loss.
The Charity Commission’s guidance warns charities not to subsidise a trading company that is in financial difficulties, and it has not amended that guidance even in light of COVID19.
The trustees of a charity must therefore consider carefully the financial viability of its trading company when making a decision whether or not to invest in that company, or whether or not to continue maintaining an investment in that company, by way of loan or otherwise.
You must seek professional advice urgently if the trading company of a charity becomes insolvent, as you may need to take steps to wind up the trading company.
If you would like any further advice on charities and trading subsidiaries, please contact either Martin Reynolds or Jane Whitfield on 0118 958 9711.
Get in Touch
Jane Whitfield can meet with you to discuss your personal circumstances, your options and your next steps. This would normally take place in our office in Reading, Berkshire. During the coronavirus situation, however, all of our meetings are currently being carried out either by telephone or by video link.
If you would like to meet with Jane, please telephone the office so that an appointment can be made for you. If you would like to take up our offer of a one-hour £95 fixed fee meeting, please click for more details.
Jane is a Solicitor specialising in Private Client matters. Jane is a qualified Trusts & Estate Practitioner with STEP (Society of Trusts & Estates Practitioners) and a fully accredited member of Solicitors for the Elderly, as well as being a Dementia Friends Champion. Jane is also President of the Berks, Bucks & Oxfordshire Law Society.