Generally speaking, charities are able to trade under certain circumstances as long as the profits made are from primary purpose trading. However, when trading involves a significant risk to the charity assets or there are significant amounts of non primary purpose trading, a charity will often set up a trading subsidiary to ringfence the activity for risk-management and tax reasons.
When a charity has a trading subsidiary it is important that the governance is structured in such a way to manage the relationship between the charity and trading subsidiary.
Some key areas to consider are:
Structure
Charity trustees should clearly document the activities to be undertaken by the charity and the trading subsidiary to ensure the arrangements are appropriate from a charity law and tax perspective, whilst trading in the most efficient manner. This includes making sure there are clear lines of responsibility, reporting and oversight for the charity trustees and trading subsidiary directors to monitor the performance of the trading subsidiary.
Board structure
The trading subsidiary should have its own board of directors. It is important that whilst some of these are also trustees of the parent charity, the trading subsidiary should have directors that are also independent of the charity. This will help to reduce any conflicts of interest, especially where there are transactions between the charity and the trading subsidiary.
The charity trustees must always consider what is in the best interest of the charity. Where the interests of the parent charity and those of the trading subsidiary conflict, the interests of the charity must come first.
Financial support for a trading subsidiary
Where financial support is put in place for a trading subsidiary, such as a loan, formal arrangements and agreements must be put in place. For example, a loan should be provided on a commercial basis with an appropriate repayment plan and interest rate charged that is aligned with market levels. Similarly, there should be a business plan that supports an injection of share capital.
Whilst finance can be provided, if in the long term the charity is supporting a loss-making entity, then like any other investment made by the charity, difficult decisions may need to be taken. This could include closure of the trading subsidiary, or restructure to prevent future losses.
Where long term losses are made, the parent charity would be using charitable money to support the trading subsidiary without receiving any benefits. The charity trustees have a duty to protect the charities assets and must act in a way that fulfils their legal duties.
Gift Aid payments to the parent charity
Gift Aid payments from the trading subsidiary to the parent charity must be physically paid across to the parent charity within nine months of the year end to reduce or eliminate the tax liability within the trading subsidiary. At the time that the Gift Aid payment is made, the trading subsidiary must make sure there are sufficient funds and cash flow within the trading subsidiary to ensure a legal distribution.
Sometimes there will be a formal agreement between the parent charity and trading subsidiary in place, called a deed of covenant, which makes it legally binding for the trading subsidiary to pay a defined amount or the entire profits to the parent charity each year. This approach has advantages and disadvantages and, if in any doubt, professional advice should be sought to determine the best approach.
Financial management
As separate legal entities, separate accounting records should be maintained for the parent charity and the trading subsidiary. Any transactions between the two entities should also be appropriately recorded. There should also be separate cashflow forecasts and budgets for trading subsidiaries, both to support the directors of the trading subsidiary in concluding on the going concern status of the entity, and to provide the trustees of the charity with necessary oversight.
Reputational risk
Whilst the trading subsidiary does not have the same operational restrictions as the parent charity, it is important that the ethos is shared and that the charity trustees are confident that the trading subsidiary will be operated in a way that mitigates risks. There should be sufficient monitoring and processes in place to prevent the trading subsidiary damaging the reputation of the parent charity.
Sharing resources
Many trading subsidiaries will share resources such as premises, equipment and staff. Where resources are shared there must be formal agreements in place. The trading subsidiary should also pay a fair or open market rate for the use of any charitable resources. For example, you should consider the use of premises, staff and other shared costs. This is an area where particular care needs to be taken from both a direct tax and a VAT perspective.
Summary
A trading subsidiary is a necessity for many charities, but there are a number of complexities to consider. If in any doubt, I would strongly recommend taking legal, accounting, or tax advice.
