Recent changes to the accounting standards applicable to charity trading subsidiaries may see the resurgence of deeds of covenant.
Up until around the year 2000, it was common practice for trading companies owned by charities to have in place deeds of covenant, under which they undertook to pay their trading profits up to their parent charity. The introduction of the current regime for corporate charitable donations in 2000 rendered deeds of covenant unnecessary.
However, new accounting rules (FRS102 / FRED 68) are likely to change that, because in the absence of a deed of covenant (or something akin to it) there could be a mismatch between the accounting and tax treatment of some donations made by the trading subsidiary.
For tax purposes, a subsidiary that is wholly owned by a charity can make donations either during the relevant accounting period or up to nine months thereafter, giving enough time for its profits to be calculated.
Importantly, those later post-period donations can be carried back to operate as deductions for the earlier accounting period, and this means they are deductible against the taxable profits of that period.
The new accounting rules do not change that tax treatment. However, they do change the accounting position.
This is because they alter the level of certainty which has to exist regarding an intended post-period donation in order for it to be reflected in the accounts of the subsidiary – even though the donation has not actually been made by that point.
In the past, auditors were often willing to rely on the expressed intention of the company’s directors, or an historic fact pattern of making donations. This is no longer sufficient. There has to be an obligation to make the payment – otherwise the trading subsidiary’s accounts can only recognise the donation in the accounting period in which it is actually made, not the earlier period.
It is generally understood that a properly drafted deed of covenant creates the necessary obligation for these purposes.
The changes to the accounting treatment will probably see charities either dusting off old deeds of covenant - perhaps never formally revoked? - or considering the drafting of new ones, to ensure that the tax and accounting position for their subsidiaries remains consistent.