With our upcoming event on 12/12/11, 'Charity Trading: Cashing In?' one of our speakers, James Maloney - Associate at Farrer & Co, has written a guest blog on some of the legal issues that surround Charity Trading.
As grants are cut and donations fall, it is natural for charities to look at other ways to generate income. One way is through trading which, more often than not, involves the establishment of a subsidiary trading company.
However, while many charities benefit from the profits of their trading companies, their use gives rise to a host of tricky legal and governance issues – particularly in the current climate.
Why set up a trading company?
The impact of charity and tax law means that charities are only allowed to trade in limited ways:
1. They can do what is called primary purpose trading, which means trading in a way that directly helps to carry out the charity's purposes (e.g. the sale of arts and crafts made by disabled people by a charity for the disabled).
2. They can also do what is called ancillary trading, which means trading that indirectly supports the charity's purposes (e.g. the sale of interval refreshments at a charitable theatre performance).
3. They can carry out small-scale trading that doesn't support the charity's purpose within certain limits (these vary depending on the annual income of the charity, but there is an absolute limit of £50,000 even for larger charities).
Charities that trade outside these very narrow exemptions can face a tax bill. In this scenario, their trustees are likely to be acting in breach of their duties.
Setting up a subsidiary trading company is a perfectly legal way to avoid this problem. The subsidiary carries out trading activities that the charity can't, and then passes its profits up to the charity. No corporation tax is payable, as the profits are gifted to the charity rather than retained by the trading company.
That sounds easy…
Sadly it isn't as easy as it sounds. Charities must also keep in mind that a trading company is an entirely separate entity that must exist at arm's length from its parent charity.
This means that, while it makes sense for the charity to want trustees and staff to sit on the board of the trading company, the charity and trading company must not be run by the same set of people. Each needs enough independent board members to be able to operate separately from the other.
Trading company directors need to run their company with separate board meetings. And, while parent charities understandably want to provide the resources a trading company needs to get off the ground (like staff, office space and working capital), a charity can't provide free support for its subsidiary. Arrangements between the two must be at arm's length.
At the root of this is the fact that the charity's stake in the subsidiary is an investment. Charities that have subsidiaries must keep in mind the fact that the subsidiary should be generating a profit to support the charity – just like any other investment.
This isn't straightforward at the best of times, but current economic conditions pose additional challenges.
Trading activities come with commercial risks. Some subsidiaries make a lot of money for their parent charities. Others don't. Many subsidiaries aren't generating the profits they were four or five years ago.
When a trading subsidiary gets into financial difficulty, it is likely that the directors will turn to the parent charity for help. This is where it's really important that the charity and trading company are run as entirely separate entities making their own, independent decisions.
That doesn't mean the charity can't help. If a subsidiary has generated profits for a charity over a period of time, but has got into a sticky patch and needs working capital, it might be appropriate for the charity to provide a secured loan. Most trading companies don't own their own property, but it is usually still possible for there to be security in the form of an "all-monies" debenture.
What is most important is that any assistance should be provided with the charity's interests in mind. A charity must not simply prop up a struggling subsidiary that is losing money and has no realistic recovery plan. To do so would risk a breach of trust by the trustees and a hefty tax bill for the charity.
The trading company's directors also need to understand the insolvency rules to avoid wrongful trading. If they get this wrong, they can become personally liable.
See James speak at the 'Charity Trading: Cashing in?' event on Monday 12th December.
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