28: Why might a charity set up a Trading Subsidiary?

There are various reasons why a charity might set up a trading subsidiary, the main ones being a result of charity law considerations, ring-fencing of risk or tax implications. Many charities carry out trading activities, whether as part of their charitable objects (primary purpose trading), ancillary to the primary purpose (ancillary trading) or sometimes in order to raise funds in a way which is not linked to the charitable objects (non-primary purpose trading). Provided that a charity has the power to trade within its governing document, it can, if appropriate, trade in the ways mentioned. However, in order to protect a charity’s assets and, in the case of non-primary purpose trading to reduce tax implications, it may be preferable to set up a wholly-owned trading subsidiary to carry out these activities.

Why set up a trading subsidiary – charity law requirements and risk management

One of the reasons a charity might choose to set up a trading subsidiary to carry out its trading activities is due to charity law requirements in relation to risk management. Generally, a charity cannot carry out significant ‘non-primary purpose’ trading as it could risk being seen as a purpose in itself, which would not be charitable. Trading activities can also lead to risks whether from potential liability and / or potential loss, and establishing a trading subsidiary to carry out such trading can be a way for charity trustees to manage such risks.

For example, in relation to non-primary purpose trading, the Charity Commission’s guidance on ‘trustees, trading and tax’ states that:

‘a trading subsidiary 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 key factor for a charity will be protecting its assets from the risks of trading while being able to benefit from non-primary purpose trading which might reach a wider audience resulting in greater profit for the charity. For this reason, it will usually be preferable for a charity to carry out its non-primary purpose trading through a trading subsidiary so as to ring-fence its charitable assets from the risks of that trading. For example, if a charity incurs loss from non-primary purpose trading which is carried out by the charity itself, then it could result in a restriction of the charity’s tax exemptions on other income or gains, the charity’s other assets may need to be used to make good any debts due to third parties from the trading activity and the charity trustees could be at risk of allegations of breach of duty or trust. If, however, a trading subsidiary makes a loss, its parent charity will not generally be liable for such losses.

It is also worth noting that it may be prudent for a charity to run its primary purpose or ancillary, trading through a trading subsidiary if the trading is considered to be risky, or if the charity is not incorporated, so as to protect the charity (and potentially the charity trustees themselves) from liability. (However, if an unincorporated charity is carrying out trading activity that would be a reason to consider incorporating the charity itself).

Why set up a trading subsidiary – tax efficiency

A charity may choose to set up a trading subsidiary to be tax effective. Although some commentators may consider this a tax avoidance scheme, it is approved by HMRC.

Generally, charities do not need to pay direct tax on the profits made from primary purpose, or ancillary trading provided that the profits are applied for their charitable purposes. The profits from non-primary purpose trading will be taxable unless it is below a certain level (as set out later), in which case the profits will be exempt from income / corporation tax. A trading subsidiary will be liable to pay tax on its profits, however, it can pass taxable trading profits back up to its parent charity and claim charitable donations relief reducing the subsidiary’s corporation tax liability potentially to zero if all profits are donated.

More information on HMRC’s stance on trading and business activities can be found in its guidance.

The position is slightly different for fundraising that derives from activities other than trading, such as events and lotteries. The supply of goods or services at or in connection with a wide range of fundraising events is exempt from VAT, and the profits made from such activities are exempt from corporation tax subject to various conditions being met (HMRC’s overview guidance on this can be viewed here). This exemption has no turnover limits but where significant risk attaches to a charity fundraising event, the event must be conducted by a trading subsidiary, and not by a charity itself.

Examples of primary purpose, ancillary and non-primary purpose trading

Primary purpose trading is trading which contributes directly to one or more of the objects of a charity, for example, the holding of an art exhibition by a charitable art gallery in return for admission fees.

Ancillary trading is trading which is not in itself primary purpose but is ancillary to primary purpose trading, for example, a charitable art gallery selling food or drink to those who attend the art exhibition. It is important to note that the trading has to be ‘ancillary’ to the primary purpose trading. For example, food and drink at the art gallery which was also available to the general public would not be ancillary to the primary purpose trading of holding the art exhibition. Similarly, if the sale of food and drink to the exhibition attendees was significant, it may start to appear that the sale of refreshments was not ‘ancillary’ to the art exhibition, but rather the other way around.

There are no limits on the extent to which a charity can carry out primary purpose trading activities. There is no limit, as such, on the level of ancillary trading, but as noted above, it should be kept under review to be confident that it remains ancillary to the primary purpose trading.

Non-primary purpose trading is trading which results in funds for a charity but which is carried out to generate funds, rather than to further the charity’s objects. For example, if a charitable art gallery operates a shop, some of its trading may be primary purpose (e.g. a catalogue of an exhibition) while other trading may be unrelated to the gallery’s purposes (e.g. selling stationery or clothing).

The profits from non-primary purpose trading will be taxable unless it is below a certain level, in which case the profits will be exempt from income / corporation tax. This level is known as the small trading tax exemption limit and is currently as follows (please note that the limits apply to a charity’s turnover and not its profits):

So, if a large charity with a gross annual income of over £320,000 was making a turnover from its non-primary purpose trading activities of more than £80,000, it would not fall within the exemption and tax would be payable. Subject to any allowance permitted where the charity’s trading is unexpectedly successful and it has good evidence to show that it had a reasonable expectation at the start of the accounting period that the turnover would not exceed the small scale trading limit.

Charities are not permitted to carry out substantial non-primary purpose trading which poses a significant risk to the assets of a charity e.g. a situation in which the turnover is insufficient to meet the costs of carrying on the trade resulting in the charity using its assets to supplement such costs. This, therefore, would be one of the reasons for setting up a trading subsidiary and would reduce risk to a charity and help to ring-fence a charity’s assets so that they are protected, as mentioned earlier.

Forming and funding a trading subsidiary

A trading subsidiary of a charity will usually be a ‘normal’ private company limited by shares, with the sole shareholder being the parent charity meaning that the charity would own all the shares in the trading subsidiary. The company must have a minimum of one director although in practice it is likely to have several. A trading subsidiary should have some directors who are independent from the parent charity – this is both to maintain independence in decision-making between the charity and its trading subsidiary, but also to ensure that both entities will be able to form a quorum in the event of a conflict of interest and / or loyalty on either board (for example, in deciding how much of the profit to transfer to the charity).

Another consideration will be how to fund the trading subsidiary. Where a charity sets up a trading subsidiary, it is common for the trading subsidiary to be funded initially by its parent charity. Care is needed in making any decision to pay funds, make loans or provide services to the trading subsidiary as the trading subsidiary is not a beneficiary of the charity. Investing charity funds in (or making loans to) the trading subsidiary must be justifiable as a qualifying investment under tax legislation. Similarly, the charity would need to ensure it makes fair charges for any services of the charity used by the trading subsidiary.

Lastly in relation to funding, a trading subsidiary can fund itself by the retention of profits although there will be tax implications in doing this.

Relationship between a charity and its trading subsidiary

It is important to maintain independence in the management of a charity and its trading subsidiary; the relationship between the two entities must be appropriately documented, for example, in a shared resources agreement, and the relationship must be kept at arm’s length. It is worth noting the Charity Commission’s guidance on charities with a connection to a non-charity in this regard.

Particular points to be aware of when considering the relationship between a parent charity and its subsidiary include:

• independence between the two entities, including holding separate meetings and preparing separate accounts (although the charity will need to prepare consolidated accounts);
• documenting any shared services, facilities or resources;
• documenting any use of a charity’s property by its trading subsidiary;
• ensuring any loan made to a trading subsidiary is at arm’s length including interest at market rate;
• licensing the use of a charity’s name, logo and intellectual property by its trading subsidiary;
• ensuring funding to a trading subsidiary is a justifiable investment and not just a subsidy; and
• following the necessary procedures relating to benefits to the trustees of a charity; and conflicts of interest, if, for example, a trustee (or someone connected with them) is paid to provide a service to the trading subsidiary.

If you have any specific queries in relation to setting up a trading subsidiary or the relationship between your charity and its trading subsidiary, please do contact your usual BDB Pitmans contact or Preena Patel at [email protected].