Section 2 What is a trade? 2.1 - 2.3
Section 6 Concessional relief for small fund-raising activities 6.1
Section 9 Calculating the profits of the trade 9.1
Section 11 Using a trading company 11.1 - 11.2
1.1 Many charities carry on trades, either as part of their charitable activities or to raise funds for those activities. Provided certain conditions are satisfied the profits of these trades will be exempted from tax. charities need to be aware of the tax rules that apply to trading profits when they are deciding how best to arrange their trading activities.
1.2 The aim of this booklet is to explain how the Inland Revenue treats trading profits of charities for tax purposes. The booklet describes the exemptions from tax available for trading profits, both under statute and by concession. It goes on to look at some common trading activities of charities and also gives some guidance on calculating the amount of the profits of a trade carried on by a charity. And it describes ways in which non exempt trading profits can be passed to charity in such a way that no tax will be payable. Finally, the booklet looks at factors to be taken into account when investing in a trading company.
1.3 Further help and information can be obtained from Financial Intermediaries and Claims Office (FICO), the specialist office of the Inland Revenue which is responsible for the tax affairs of charities. FICO also has responsibility for the corporation tax affairs of most charity subsidiary companies.
For England, Wales and Northern Ireland:
FICO (Charity Technical)
St John's House
Merton Road
BOOTLE, Merseyside L69 9BB
Tel: 0151-472-6046 (Charity trading enquiries)
0151-472-6036 (general enquiries)
For Scotland:
FICO (Scotland)
Trinity Park House
South Trinity Road
EDINBURGH
EH5 3SD
Tel: 0131-551-8294 (Charity trading enquiries)
0131 - 552 - 6255 Ext - 2127 (general enquiries)
1.4 When writing to, or telephoning, FICO please quote your FICO reference number (if known).
VAT
1.5 These guidelines do not deal with value added tax. VAT, as it affects charities and their business activities, is explained in Customs & Excise leaflet 701/1/95
1.6 The existence of reliefs for income or corporation tax should not he taken to indicate that there is relief from VAT. VAT is not a tax on profit or income but a broad based tax on the consumption of goods and services. It applies to a wide range of goods and services supplied in the course of business. For VAT purposes "business" has a wider meaning than trading. VAT can apply also to any charitable activities which involve the supply of goods or services for a consideration.
1.7 Many areas in which charities operate, such as the supply of certain health and welfare services, are however exempt from VAT. There are also some special reliefs for charities which are explained in the Customs' leaflet. Where these reliefs apply to activities covered in these guidance notes you will be referred to Customs' leaflet for details.
1.8 If you require further guidance on VAT you should contact your local VAT office. The address is in the telephone book under "Customs and Excise".
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2.1 Normally a trade involves the sale of goods or services to customers as part of a commercial enterprise. A one-off or occasional venture may be treated as a trade for tax purposes if it involves the sale of goods or the provision of services for profit.
2.2 In most cases it will be clear whether an activity is, or is not, a trade. But sometimes it will not be easy to decide whether there is a trade. Whether an activity is, or is not, a trade depends on the facts in each case. When it is not clear which way the decision should fall it will be necessary to look at all the circumstances surrounding the activity.
2.3 When deciding whether an activity amounts to a trade it is irrelevant that the profits are intended to be used for charitable purposes.
Trading by charities
2.4 Trading by charities can take a number of different forms. But in general trades carried on by charities fall into one of two broad categories:
2.5 This distinction between primary purpose trades and other trades is important because it may determine how the trade is treated for tax purposes.
2.6 The following sections describe the tax rules which apply to trades carried on by charities and then go on to consider how those rules apply to different sorts of trades.
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3.1 The Taxes Acts provide for a limited exemption from tax for the profits of trades carried on by charities. To qualify for exemption the profits must be used solely for the purposes of the charity. In addition the trade must satisfy one of these two conditions:
3.2 If a trade does not satisfy one or other of the above conditions statutory exemption will not be available for the profits of the trade. Unless concessional relief is available (paragraphs 6.1 to 6.15) tax will be payable on the profits regardless of whether or not they are used for the purposes of the charity.
Agricultural shows
3.3 There is a separate statutory exemption from tax for the profit of exhibitions or shows held by agricultural societies. Such profits will not he taxable if:
Lotteries
3.4 Charities may run lotteries in order to raise funds for their charitable purposes. This could he a "society" lottery or alternatively a "small" lottery which is incidental to a bazaar, sale of work, fete, dinner, dance, sporting or athletic event or other entertainment of a similar character. These lotteries are defined in Section 3 and 5 of the Lotteries and Amusements Act 1976.
3.5 The profits both of 'society' and 'small' lotteries which are promoted by charities or by subsidiary companies on their behalf are exempt from tax.
3.6 Where a charity runs a society lottery, the charity will normally be registered as a society under the Lotteries and Amusements Act 1976. In the past, the Inland Revenue accepted that where a subsidiary company promoted a society lottery on behalf of a charity, the profits belonged to the subsidiary company and not the charity, for tax purposes. The company could relieve the income from tax by passing it to the charity under deed of covenant or by way of a Gift Aid payment (paragraphs 11.3 to 12.13). The Revenue were advised that in these circumstances the income from the lottery belonged to the charity, not the subsidiary company, and the charity would be taxable on the income. To remove this tax charge, the profits of lotteries promoted by charities or by subsidiary companies on behalf of charities have been exempted.
3.7 The exemption from tax applies to profits arising for the 1995/ 96 tax year onwards (in the case of charitable trusts) or for accounting periods beginning after 31 March 1995 (for charities which are companies or are treated as companies for tax purposes). The exemption is available only where the lottery profits are applied solely to the purposes of the charity.
3.8 However, where the subsidiary company, rather than the charity, is registered as the principal or 'society' under the Lotteries and Amusements Act 1976 the lottery profits will belong to the company and not the charity for tax purposes. The exemption will not apply and the company will need to pass the profits to the charity under deed of covenant or Gift Aid to obtain relief from tax (paragraphs 11.3 to 12.13).
3.9 For details of the VAT treatment of lotteries see Customs and Excise leaflet 701/28/84 'Lotteries'
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4.1 A primary purpose trade is one that is exercised in the course of the actual carrying out of a primary purpose of the charity. A charity's primary purposes can be identified from its trust deed or constitution.
Trades which are primary purpose activities
4.2 Some trades organised by charities may, in themselves, amount to primary purpose activities and therefore qualify for exemption. Examples of such trades are:
4.3 In each of the above examples it is assumed that the organisation carrying on the activity is a charity and that it is part of the organisation's charitable objects to undertake the activity described.
Trades which are ancillary to the carrying out of a primary purpose
4.4 All of the examples listed above involve trades which are, themselves, primary purpose activities. The exemption from tax also extends to other trades which are not primary purpose activities but which are ancillary to the carrying out of a primary purpose so that they can be said to be exercised in the course of the actual carrying out of a primary purpose. Examples of trades which qualify as primary purpose trades because they are ancillary to the carrying out of a primary purpose are:
Trades which are not wholly primary purpose trades
4.5 In some cases a trade may amount, in part, to a primary purpose trade but may not be wholly a primary purpose trade. For instance, the trade might deal in a range of goods or services only some of which are within the primary purpose, or the trade might deal with some customers who cannot properly be regarded as beneficiaries or patrons of the charity. Examples of such trades are:
4.6 In these circumstances the trade might not qualify as a primary purpose trade because part of the trade is not related to a primary purpose. In practice the Inland Revenue will accept that all of the profits of the trade will be within the exemption from tax if:
4.7 In any case where the profits of a trade cannot be exempted because part of the trade is not related to a primary purpose, the whole of the profits will be liable to tax, including that part of them which is related to a primary purpose.
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5.1 As well as exempting the profits of primary purpose trades, the Taxes Acts provide for exemption of the profits of a second category of trades. These are trades where the work in connection with the trade is mainly carried out by beneficiaries of the charity.
5.2 Where the work carried out by beneficiaries has a therapeutic, remedial or educational value the trade will often also qualify for exemption as a primary purpose trade. But the exemption is not restricted to such trades and covers all trades where the work is mainly carried out by beneficiaries. Thus, it includes a trade exercised solely for the purpose of raising funds for the charity.
5.3 Part of the work of a trade may be carried out by employees, contractors or volunteer workers who will not rank as beneficiaries of the charity. In these circumstances exemption will still be available provided it can be shown that the greater part of the work in connection with the trade is carried out by beneficiaries of the charity.
5.4 A charity may wish to pay salaries to beneficiaries who work in a trade carried on by the charity. This will mean that the beneficiaries will become employees of the charity. Provided that they can still properly be regarded as beneficiaries of the charity, the exemption of the trading profits will not be affected. PAYE must be operated on the earnings of beneficiaries who are employed by a charity in the same way as for other employees.
5.5 Examples of trades commonly carried on by charities where the work is mainly carried out by beneficiaries are:
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6.1 Where trading activities carried on by a charity are not covered by the statutory exemptions described above the profits will be taxable. However, by concession the Inland Revenue do not seek to tax the profits of some small scale events arranged to raise funds for charity. The full text of this concession is set out below.
The concession
6.2 "Bazaars, jumble sales, gymkhanas, carnivals, firework displays and similar activities arranged by voluntary organisations or charities for the purposes of raising funds for charity may fall within the definition of "trade" in Section 832, Income and Corporation Taxes Act 1988, with the result that any profits will be liable to corporation tax. Tax is not, however, charged on such profits provided all the following conditions are satisfied:
Events covered by the concession
6.3 The concession contains a list of events to give an idea of the types of fundraising activities covered. This list is not exhaustive and other similar events such as fetes, concerts, dinner-dances and sports matches will often also fall within the concession.
6.4 Sales of donated goods at auctions, jumble sales and other venues are not regarded as trading (paragraph 7.3). No liability to tax will therefore arise on the proceeds of these sales. It follows that the terms of the concession do not need to be applied to these cases.
6.5 Events such as jumble sales and car boot sales where the organisers charge an entrance fee to people wishing to sell their own goods at the event will fall within the concession provided the necessary conditions are satisfied.
6.6 The types of activities and the conditions listed in the concession make it clear that it is restricted to activities which are reasonably small in scale. Factors to be taken into account in considering whether an activity is small in scale include the following:
6.7 All the relevant factors need to be considered together to determine whether a particular event falls within the scope of the concession. For example, a major gala or charity opening night organised on fully commercial lines at a recognised and regular venue for the activity concerned would be very unlikely to fall within the concession. On the other hand, a performance given to a small group of people might well come within the concession even though the performer was very well known.
Profits covered by the concession
6.8 The concession applies to all the profits of the event including not only admission charges but also ancillary sources of income such as:
6.9 Each ancillary source of income must properly form part of the event and must not constitute a separate profit-making activity. The turnover of the ancillary source of income must be sufficiently modest so that it can properly be regarded as incidental to the main event.
6.10 However the sale of raffle tickets may amount to a small lottery within the Lotteries and Amusements Act 1976 so that statutory exemption may apply (paragraphs 3.4 to 3.9).
Not regularly carrying on these trading activities
6.11 The concession does not apply to activities which are carried on on a regular or frequent basis. Normally, any event which takes place more than three times a year in the locality is regarded as "regularly carried on". For this purpose each type of event is considered separately, so that it is acceptable to arrange three gymkhanas and three firework displays in the same year. The size of the locality considered will vary from case to case according to the catchment areas of the particular events.
6.12 A two or three day series of concerts or other events for which there is a single admission charge will be regarded as a single event notwithstanding that the number of concerts within the series exceeded three. But where there is a separate admission charge payable for each day or for each concert the series as a whole cannot be regarded as a single event. The concession does not extend to a programme of events for which patrons can buy a season ticket but where each event can properly be regarded as standing on its own.
What will happen if an event is not covered by the concession?
6.13 If an event falls outside the terms of the concession, and it is not covered by the statutory exemptions, the profits will be taxable.
6.14 It may be possible to organise the event so as to minimise the amount of tax payable. For instance, the charity might set a basic minimum charge (which will be taxable) and invite those attending the event to supplement this with a voluntary donation. The additional contributions will not be taxable if all the following conditions are met:
Note
6.15 The concession described above is of general application, but it must be borne in mind that in a particular case there may be special circumstances which have to be taken into account in considering the application of the concession. The concession will not be given in any case where an attempt is made to use it for tax avoidance.
6.16 For details of VAT relief available for charity fund-raising events see Customs and Excise leaflet 701/1/95 "Charities".
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7.1 The tax treatment of the profits arising from the above trades will depend upon the circumstances in each case. For example, the trade may be primary purpose or undertaken by the beneficiaries of the charity. Additionally, the profits may fall within the extra statutory concession or simply be subject to tax in the normal way.
7.2 Common examples of trades carried on to raise funds for charities are:
Sale of donated goods
7.3 Many charities raise funds by selling donated goods, such as clothes or bric-a-brac. This may be a regular activity carried on at a shop or market stall, or it may be an occasional activity carried on at a jumble sale or auction. At first glance this may appear to be a trade similar to the retail sale of goods by other commercial businesses. But the way in which the goods are acquired makes it different from most retail trades. Traders usually sell goods which they have manufactured, or have purchased for resale; they do not usually receive goods by way of donation; it is simply a realisation of the value of a gift. For this reason the sale of donated goods is generally not regarded as a trade for tax purposes. This is so even where the donated items are sorted, cleaned and given minor repairs. However, if the goods are subjected to significant refurbishment or to any process which brings them into a different condition for sale purposes than that in which they were donated, the sale proceeds may be regarded as trading income. For example, where donated cloth is made into garments for sale this will amount to a trade.
7.4 There is a VAT zero rate for the sale of donated goods by charities. See Customs and Excise leaflet 701/1/95 "Charities".
Profits from lettings
7.5 Some charities raise funds from their land or buildings when they are not being used by the charity for its charitable activities. For instance:
7.6 Often the profits from such lettings will not fall to be treated as trading profits but will be treated as rental income (the tax exemptions for which are wider than for trading income). However, if services are provided along with the use of the land or buildings (for example, provision of a caretaker, food or laundry) these letting activities might amount to trading. Each case must be considered on its own facts.
7.7 For details of the VAT treatment of rents see Customs and Excise leaflet 742 "Land and Property".
Other fund-raising
7.8 Some other arrangements such as partnerships, franchises and sponsorship can give rise to trading income.
7.9 Charities sometimes enter into transactions in financial futures or options. They may also become involved in underwriting and similar activities. In some circumstances these transactions may be regarded as activities giving rise to a tax liability.
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8.l It is common for charities to enter into sponsorship arrangements with businesses in order to raise funds. Business sponsors may fund the general work of the charity or a particular charitable project. Sponsorship arrangements often link the name of the business with the charity or its project, creating in the minds of the public an affinity between the business and the charity.
8.2 The tax treatment of payments received by charities under sponsorship arrangements will depend on the nature of the arrangement. The payments may be regarded as:
8.3 For many business sponsors the affinity with charity created by sponsorship is a valuable marketing asset. Charities often stress the benefits of such arrangements when approaching potential sponsors. Just because a sponsor derives good publicity or public relations benefits from payments to charity, does not automatically mean that they are trading income in the hands of the charity. What is important is whether the sponsor's purpose in making the payment was to supplement income of a trade carried on by the charity. There may be a specific trade of providing services in return for sponsorship income. Alternatively the payments may form part of the income of a wider trade, such as the production of a stage performance by a theatre.
8.4 If the payments are not in return for goods or services provided by the charity, they will normally have the character of charitable donations rather than trading income in the charity's hands. The fact that the business sponsor takes steps to publicise or exploit the affinity with the charity will not change the treatment of the payments in the hands of the charity.
8.5 But if the charity agrees to provide some goods or services in return for the sponsorship payments they may be treated as trading income. Most commonly a charity will play a part in publicising the business sponsor's affinity with the charity by including references to the sponsor in publications, posters, etc. and at events organised by the charity. Provided that such references amount to no more than acknowledgements of the sponsor's contributions they will not cause the payments to be regarded as trading income. However, references to a sponsor which amount to advertisements will cause the payments to be treated as trading income. The Inland Revenue will regard a reference to a sponsor as an advertisement if it incorporates any of the following:
8.6 There are other services which a charity might provide in return for sponsorship payments which will be factors in determining whether the payments are trading income. Examples of such services are:
8.7 Once it has been determined that sponsorship payments are trading income in the charity's hands the next step is to consider whether the sponsorship arrangement is a stand-alone trade in its own right or whether the sponsorship payments merely form part of the income of a wider trade.
8.8 Where the arrangement amounts to a stand-alone trade the treatment of the profits for tax purposes will not be affected by the tax treatment of the other income of the charity. But where the sponsorship is intended to fund an activity of the charity which is itself a trade, the payments will be regarded as part of the income of that trade so that their tax treatment will follow the tax treatment of the profits of that trade. For example, where a business sponsors a stage production by a theatre the sponsorship payments will be regarded as part of the income of a trade of putting on the stage production, and the profits will be exempted from tax along with the other income of the trade (paragraphs 4.1 to 5.5).
8.9 Payments solely for the use of a charity's logo may be annual payments rather than trading income. This will depend on the precise terms of the agreement for the use of the logo. The payments must be made under a legal obligation, be annually recurring and be in the nature of pure income profit in the hands of the charity (rather than a receipt against which expenses have to be set in determining the charity's income). If the payments are annual payments the payer will have to deduct basic rate tax from them. The charity can reclaim the tax deducted provided the income is applied solely for charitable purposes.
8.10 For the VAT treatment of sponsorship see Customs and Excise leaflet 701/41/90.
8.11 For details of special VAT arrangements for charity affinity credit card schemes see Customs guidance in the Customs and Excise leaflet 701/1/95.
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9.1 The profits of trades carried on by charities which fall outside the statutory and concessional exemptions described above will be taxable. The whole of the profits will be taxable despite the possibility that part of the activities of a trade might be said to fall within one of the exemptions. The profits, including capital allowances if applicable, should be calculated in the same way as for any other trader. However, there are some factors which may be particularly relevant when calculating the profits of a trade carried on by a charity.
Allocation of indirect overheads
9.2 As well as deducting direct expenditure of the trade when calculating the profits, the charity should deduct indirect expenditure which it has incurred and which is attributable to the trade. For example, if the trade is carried on in the charity's premises it will normally be proper to allocate to the trade part of the costs of the premises such as:
9.3 Apart from the use of premises, other indirect overheads which may be partly attributable to the trade are:
9.4 The proper basis of apportionment of indirect costs will depend on the facts of each case. In the case of the use of premises, the apportionment might be based on the size of floor space allocated to the trade. Alternatively, where student accommodation is let to tourists out of term, the apportionment might be based on the number of days in the year when the premises are allocated to the trade. In the case of employee salaries the apportionment might be based on the amount of employee time devoted to the trade compared to total employee time.
Goods or services provided at undervalue
9.5 It is common for charities to receive goods or services in their trades at no cost, or at less than their full market price. For example:
9.6 Where a trade falls outside the statutory and concessional exemptions the Inland Revenue will charge only those profits calculated on a commercial basis. Thus, where a charity has received goods or services free, or at less than their full market price, the charity may deduct a notional market price when computing the profits of the trade.
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10.1 Charities may make trading losses. If the trading activities are within the charitable objects of a charity, losses will be regarded as charitable expenditure. But if trading activities are not within the charitable objects losses may be regarded as non-charitable expenditure. The exemptions from tax for the profits of charities all depend on the profits being applied for charitable purposes. The exemptions may be restricted where there is non-charitable expenditure. Where a trading loss arises as a result of the deduction of a notional market price in respect of goods or services provided free or less than market price the loss will not be regarded as non-charitable expenditure.
10.2 Similarly a trading loss might arise as a result of the allocation of a proportion of the charity's fixed costs. Again the loss will not be regarded as non-charitable expenditure, provided that:
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11.1 Charities carrying on trades outside the statutory and concessional exemptions usually arrange for the trade to be carried on by a wholly owned trading company. Using this approach it is possible for the trading profits to be applied for charitable purposes tax free.
11.2 Companies owned by charities are liable to pay tax on trading profits in the same way as other companies. But, like other companies, they can get tax relief for donations to charity. By donating all of their taxable profits to charity the company can get a tax deduction equal to the amount of the profits, so that no tax will be payable. In the hands of the charity the donation will not be regarded as trading income, so that it will be exempted from tax (provided, of course, it is used for charitable purposes).
"Profit-shedding" deeds of covenant
11.3 The most common method of paying up the profits of a wholly owned company to the parent charity is by way of a "profit-shedding" deed of covenant. This is a deed which commits the company to paying up the whole of its profits each year. The Inland Revenue cannot comment on draft profit-shedding deeds of covenant prior to their execution. Trading companies should consider taking legal advice when drawing up their own profit-shedding deed of covenant.
11.4 When deciding how much of their profits to give to charity, companies need to take account of the following:
11.5 It must be remembered that a deed of covenant is a legal document, not a tax form. To be effective it must be executed in accordance with the law. Charities should consult a professional adviser if necessary.
Tax relief for payments under profit-shedding deeds of covenant
11.6 After the trading company has executed a profit-shedding deed of covenant it can start making payments to the parent charity under the terms of the deed.
11.7 The company gets tax relief for a covenanted payment by deducting it in its corporation tax computation. New rules were introduced for covenanted payments made by companies owned by charities in 1997. These new rules apply to accounting periods beginning on or after 1 April 1997. For accounting periods beginning before that date, the company could deduct a covenanted payment only in the corporation tax computation for the accounting period in which the payment was actually made. If the company waited until after the end of an accounting period before making a covenanted payment, it could not carry back the deduction for that payment into the earlier accounting period. (Nor could covenanted payments be carried forward for deduction in later accounting periods.) For this reason it was essential that the covenanted payment was made before the end of the accounting period to which it related.
11.8 The need to make the covenanted payment before the end of the accounting period meant that it had to be made before the final amount of the profits payable under the deed could be determined. The company estimated its profits for the accounting period and paid over the estimated amount. The estimate needed to be as close to the actual profits as possible, erring on the generous side rather than the conservative side. That way, if the profits turned out to be slightly higher than anticipated, the estimated payment would still cover them.
11.9 The new rules for accounting periods beginning on or after 1 April 1997 allows companies "wholly owned by a charity" to make covenanted payments at any time up to nine months after the end of the accounting period and still get tax relief against the profits of that accounting period. It is important that the deed requires the payment to be made within the accounting period of the company.
11.10 The new provisions are not confined to share capital companies. Some companies controlled by charities are companies limited by guarantee. Such companies are included in the provisions if only charities are entitled to share in the company's profits, or assets if the company is wound up. The Memorandum and Articles of Association of a company limited by guarantee will normally indicate if the company meets these conditions.
11.11 Although most charity owned companies pay to the charity under a profit-shedding deed, the new provisions are not confined to this type of deed. A deed providing for payments of fixed amounts would also be within the provisions if the other conditions are met.
Deducting tax from the covenanted payment
11.12 Companies must deduct income tax at the basic rate from covenanted payments to charity. When the trading company makes the payment described above it should first of all deduct from the payment income tax at the basic rate and pay over only the net amount to the charity.
11.13 The tax deducted from the payment should be accounted for to the Inland Revenue on a return form CT61(Z) (this return form can be obtained from the company's tax office). A CT61(Z) return should be sent to the Inland Revenue for any return period in which a company:
11.14 The return should be submitted for the following return periods:
11.15 The return (and accompanying payment) should be submitted within 14 days after the end of the period to which it relates.
Form R185(AP)
11.16 Along with the net covenanted payment the company should give the charity a completed form R185(AP) certifying that the payment was made under deduction of income tax. The charity will submit the R185(AP) to FICO along with its claim for repayment of the income tax.
11.17 A copy of form R185(AP) is at Appendix A. Supplies can be obtained from FICO.
Claiming repayment
11.18 Charities can claim repayment of the income tax deducted from the initial estimated covenanted payment. To claim repayment charities should:
11.19 Supplies of claim form R68 can be obtained from FICO. A fresh form will usually be sent out automatically following the processing of the last claim. FICO will usually repay the claim within one week of receipt.
11.20 Later, when the final amount of profits payable under the deed has been determined, the charity should inform FICO of any excess tax repaid to it. FICO will then recover this tax from the charity. At the same time the company can claim back from its tax office (normally FICO) the excess tax deducted. Alternatively, the charity and the company can ask FICO to set off these two amounts against each other.
11.21 The excess estimated covenanted payment that the company made to the charity will also be repayable by the charity to the company.
Example of profit-shedding using a deed of covenant
11.22 In this example the trading company's accounting period is the year ended 31 December 1996.
Estimate made on 1 December 1996 of profits for the year ended 31 December 1996: £100,000
Income Tax deducted at 23 per cent (to be paid to the Inland Revenue on or before 14 January 1997): £23,000
Net payment to the charity (along with form R185 (AP)) before 31 December 1996: £77,000
Repayment to the charity from FICO: £23,000
Total received by charity: £100,000
Suppose the company's profits for the year ended 31 December 1996 are finally determined at £80,000.
Over-repayment of tax recovered from the charity by FICO (£20,000 at 23 per cent): £4,600
Excess tax deducted repaid to the company by the Inland Revenue: £4,600
Amount deducted in the company's corporation tax computation for the year ended 31 December 1996: £80,000
Excess net payment repayable to the company by the charity (£77,000-£61,600): £15,400
Example of profit-shedding where new rules apply
11.23 In this example the trading company's period is the year ended 31 December 1998.
Estimate made on 1 December 1998 of profits for the year ended 31 December 1998; £100,000
Income Tax deducted at 23 per cent (to be paid to the Inland Revenue on or before 14 January 1998): £23,000
Net payment to the charity (along with form R185(AP) before 31 December 1998): £77,000
Repayment to the charity from FICO: £23,000
Total received by charity: £100,000
Suppose the company's profits for the year ended 1 December 1998 are finally determined at £130,000. Under the new rules the company have until 30 September 1999 to top up the covenanted payment, for example
Final net payment to charity made for the year ended 31 December 1997 on 20 September 1999: £23,100
Income Tax deducted at 23 per cent (to be paid to the Inland Revenue on or before 14 October 1999): £6,900
Total received by charity: £30,000
Amount deducted in the company's corporation tax computation for the year ended 31 December 1998: £130,000
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Calculating the company's profits
12.1 To assist in estimating the trading profits companies should have good up-to-date records. Some companies also prepare part-year accounts ahead of the end of the accounting period so that they can make the estimate more accurately. In the case of a seasonal trade (for instance, the sale of Christmas cards) it will often be useful if the company's accounting date can be arranged to fall during the quiet part of the trading year.
12.2 If the charity's premises, staff and services are shared with the trading company an appropriate allocation of the costs should be included in the company's accounts. The amount charged by the charity for the shared resources should generally not exceed the cost. Any profit in the hands of the charity may be taxable as non-exempt trading income.
12.3 See paragraphs 9.1 to 9.4 for more information on how to calculate the profits of a trade.
Making the covenanted payment
12.4 Covenanted payments may be made by a payment of money from the company to the charity. The company and charity should avoid sharing one bank account so that this transfer can take place.
12.5 If the charity owes money to the company (perhaps on the excess payments for earlier years) the covenanted payment may be made by set-off against that debt. An appropriate entry should be made in the records of the charity and the company. However, it is not possible to make a covenanted payment by creating, or increasing, the indebtedness of the company to the charity.
Making payments during the year
12.6 It often assists the cash flow of charities if the company makes regular payments during the accounting period rather than waiting until just before the end of the accounting period.
12.7 However, charities cannot claim repayment of the income tax deducted from these payments until after they fall due under the terms of the deed. If it is decided to make in-year payments it is best if the deed is worded so that payments fall due during the accounting period, say monthly or quarterly. Alternatively, the trading company may make occasional in-year donations under the Gift Aid scheme and use the profit-shedding deed only to make the final payment in the period. Gift Aid is a tax relief for single cash gifts made to charity. It is described in booklet IR113 "Gift Aid. A guide for donors and charities" which is available from FICO.
Profit-shedding using the Gift Aid scheme
12.8 It is also possible to use the Gift Aid scheme to pass up the whole of the profits of the trading company in a tax effective way. The mechanics of this method are broadly the same as those for profit-shedding deeds described at paragraphs 11.3 to 11.11. The differences between the Gift Aid method and the deed of covenant method are:
12.9 The Gift Aid method is simpler to operate than the deed of covenant method because there is no need to adjust the estimated payment when the actual amount of the profits for the accounting period have been determined. However, there is the drawback that an over-estimate of profits by the company may cause a serious drain on its working capital which will require a formal investment of funds by the charity. The Taxes Acts contain special rules relating to charity investments which may result in the restriction of the charity's tax exemptions. More details of these rules are at paragraphs 13.1 to 13.5.
12.10 In order to avoid the drawback referred to above most charities use a profit-shedding deed of covenant rather than Gift Aid to pass up the profits of the trading company.
Example of profit-shedding using the Gift Aid scheme
12.11 In this example the trading company's accounting period is the year ended 31 December 1996.
Estimate made on 1 December 1996 of profits
for the year ended 31 December 1996: £100,000
Income tax deducted at 23 per cent (to be paid to the
Inland Revenue on or before 14 January 1997): £23,000
Net payment to the charity (along with Gift Aid certificate R240(SD)) before 31 December 1996: £77,000
Repayment to the charity from FICO: £23,000
Total received by charity: £100,000
Suppose the company's profits for the year ended 31 December 1996 are finally determined at £80,000.
Amount deducted in the company's corporation tax computation for the year ended 31 December 1996: £80,000
12.12 No adjustment is made to the repayment received by the charity or the tax deducted by the company. Nor does the excess of the net Gift Aid payment over the company's profits become repayable to the company by the charity.
12.13 The company can deduct a Gift Aid payment in the corporation tax computation only for the accounting period in which the payment was actually made. It is not possible to carry back the deduction into an earlier period, or to carry it forward into a later period.
Profit-shedding using dividend payments
12.14 When companies make dividend payments they must account to the Inland Revenue for Advance Corporation Tax (using the return form CT61(Z) referred to at paragraph 11.13). Any Advance Corporation Tax paid by a company will be set off against the corporation tax payable by the company on its profits for the accounting period in which the dividend was paid.
12.15 Until 5 April 1999 a dividend paid to a charity will carry a tax credit of 20 per cent and the charity can claim payment of this tax credit from FICO. In addition, for dividends paid to a charity in the period 6 April 1993 to 5 April 1997, the charity will be entitled to a special payment equal to a fraction of the dividend. A charity will not be able to claim payment of tax credits on dividends paid on or after 6 April 1999. For dividends paid to a charity in the period 6 April 1999 to 5 April 2004, it will, however, be entitled to a special payment equal to a percentage of the dividend. More details of these special payments can be obtained from FICO.
12.16 The payment of dividends by trading companies is generally not the most tax effective way of passing up profits to charity. This is because the difference between the rate of Advance Corporation Tax payable on dividends and the rates of corporation tax payable on company profits will result in the company having to pay some tax on its profits.
12.17 However payment of a dividend on or before 5 April 1999 may be useful if a company has incurred a liability to tax because it underestimated its profit-shedding payment in a previous accounting period. This is because, unlike the relief for covenanted payments or Gift Aid payments, the set off for Advance Corporation Tax can be carried back into earlier accounting periods. A company that has underestimated its profit-shedding payment should consider asking its accountant about making a dividend payment.
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Charities which own companies to carry on non-exempt trading activities will usually need to consider investing funds in the company when the company is set up. The company may also need injections of money to fund expansion or development of its business after it has been set up.
Charity investments and tax
13.2 There are special rules in the Taxes Acts which apply to investment of a charity's funds in a trading company. If these rules are not followed the charity will risk losing some or all of its tax exemptions. To qualify for relief an investment must be made:
13.3 Investments will be regarded as made for charitable purposes and for the benefit of the charity if they are a commercially sound investment. Usually, charities should ensure that investments are secure, carry a fair rate of return and, in the case of loans, provide for recovery of the amount invested in due course.
13.4 When deciding whether to make a proposed investment charities should bear in mind the requirements of charity law relating to:
13.5 Charities should also of course bear in mind the scope of their investment powers as set out in the charity's governing document. All investment decisions should be properly minuted, including the factors on which the decisions were based. Depending on the size of a proposed investment, the decision may be based on the following:
Investments should be reviewed regularly.
Investing in a company with a profit-shedding deed
13.6 Most commercial companies keep part of their profits to provide them with funds for day-to-day expenses, working capital and normal development of their business. But companies which operate profit-shedding deeds of covenant will distribute all of their profits every year so that they may not be able to keep the funds they need to carry on in business. Charities should therefore make sure when a company is set up that it is provided with enough capital to enable it to shed its profits every year and stay in business.
13.7 In any case where the operation of a profit-shedding deed results in a serious drain on the company's cash, care should be taken to avoid a pattern of frequent injections of funds by the charity in order to keep the company in business. Such a practice might put at risk both the charity's tax exemptions and the company's deductions for its covenanted payments. In some cases where the operation of a profit-shedding deed leads to a serious cash drain in the company, it will be necessary for the company to change its practice so that it keeps part of its profits. In these circumstances some tax will become payable by the company.
Getting professional advice
13.8 Where a charity is considering making an investment in a trading company, or where the operation of a profit-shedding deed of covenant is causing a cash drain in a trading company, the charity should consider seeking professional advice.
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