This article briefly explains why a charity may have one (or more) trading subsidiaries, common features of a trading subsidiary and a consideration of its tax status, and the key points for a charity to consider before deciding to support a trading subsidiary by providing it with funding.
What is a trading subsidiary, and why might a charity have one?
Many charities have one or more wholly owned subsidiary companies, most often used to carry out non-charitable trading, but also sometimes used to carry out charitable activities in a ring-fenced organisation, and so protect the charity’s assets. Such a company is often called a “trading subsidiary”.
A trading subsidiary will usually:
- be a private company limited by shares, as although other structures are available, they may limit some group tax reliefs.
- have a minimum of one director, although in reality there are usually several, and it is advisable to have a mixture of some (but not all) of the charity’s trustees, and some ‘independents’ who bring relevant expertise.
It is also usual for the parent charity to have a right to appoint and remove directors, in order to keep a level of operational control, and it is not uncommon for a trading subsidiary to receive some funding from its parent charity on its creation, often by way of a loan from the charity, but sometimes as a result of the charity’s buying share capital from its new trading subsidiary.
Charities enjoy certain tax advantages, but these are not generally shared by any trading subsidiary set up by the charity.
For tax purposes, the trading subsidiary is a normal commercial company. For this reason, great care is needed as regards tax and the relationship between the parent charity and its trading subsidiary.
If a charity can provide funding to its trading subsidiary on creation, can it simply provide more funding if the trading subsidiary is in financial difficulties?
It is possible for a charity to provide further funding to a trading subsidiary, and it is indeed common for charities to have to fund their trading subsidiary regularly, particularly its working capital, due to the operation of the gift aid rules which promote a subsidiary shedding as much profit to its parent charity as possible.
As a trading subsidiary is not charitable, however, but a normal commercial company, any funding by the parent charity must be considered an investment by the parent charity.
The aim of an investment by a charity in a non-charitable organisation is to obtain the best level of financial return within the level of risk considered to be acceptable. This return can then be used by the charity to achieve its charitable purposes.
The trustees of a charity must consider an investment in its trading subsidiary in the same way as they would consider any other investment. The trading subsidiary cannot receive “special treatment” because of its operational links to the charity.
And, because of those operational links, trustees of a parent charity must be alert to possible conflicts of interest when taking decisions as to whether or not to provide further funding to the charity’s trading subsidiary, and manage those conflicts properly.
They must also be mindful of their legal duties:
- to act in the charity’s best interests alone, and
- to make sure the charity’s assets are only used to support and carry out its charitable purposes.
The Charity Commission’s guidance on investments is key, and should be read by all charity trustees considering investment in a trading subsidiary.
What does the parent charity need to consider if it wants to make an investment to support its trading subsidiary?
Before making any further investment in a trading subsidiary, the parent charity’s trustees must consider it as they would any other investment of the charity’s resources.
This means that they must:
- consider whether the investment is suitable, having regard to its other investment options
- consider the diversification of the parent charity’s investments
- consider the trading subsidiary’s business prospects, and be satisfied of its financial viability (based on business plans, cash flow forecasts, profit projects etc.)
- obtain and consider appropriate expert advice on the above points
- and, based on all that information, resolve that it is in the charity’s interests to make the investment
Where a trading subsidiary is struggling financially, the Charity Commission would usually consider it to be more appropriate for the parent charity to provide further funding by way of loan rather than by buying share capital in the trading company.
This is because the charity should be more likely to receive repayment of a formal loan in case of the insolvency of the trading subsidiary, in particular if the loan is secured on the assets of the trading subsidiary. In contrast, if the trading subsidiary becomes insolvent, shareholders will be the last to be repaid (if at all).
It may still, however, in some cases be more appropriate for a parent charity to buy share capital in its trading subsidiary as a way of providing it with additional funding.
Whether this is the case for any particular parent charity will very much depend upon the individual facts of the situation concerned, and external professional advice from both lawyers and accountants should be obtained to allow the parent charity’s trustees to come to a decision about whether to invest in the charity’s trading subsidiary in this way.
Where a loan may be the most appropriate way to provide further funding to a trading subsidiary, what must the parent charity’s trustees consider before reaching a decision?
Let’s look at the considerations for making a loan in more detail, given the Commission’s preference for this approach when the trading subsidiary is in financial difficulties, and bearing in mind that any loan from the charity to a trading subsidiary must be treated by the trustees of the charity as they would a loan to any non-charitable third party.
The parent charity’s trustees must consider:
- whether the charity has the required investment and lending powers (which may require an update to the charity’s constitution)
- whether the trading subsidiary will be successful and able to repay the loan (to include a review of the business plan and detailed profit and cash flow forecasts)
- the current commercial rates appropriate for a loan to such a company
- whether it is appropriate to register a charge over the trading subsidiary’s assets (to ensure first option on any assets should the trading subsidiary become insolvent)
- a formal loan agreement
It is crucial that the parent charity’s trustees are able to justify financial support for the trading subsidiary as a suitable way of investing the charity’s resources, as if the funding does not represent an approved charitable investment or approved charitable expenditure by the parent charity, the charity may have to pay tax on the funding provided.
It is therefore very likely that a charity will need external professional advice about the appropriateness of any investment in the subsidiary and the terms of that investment – such as the return on amounts invested, risks of default, and so on, when compared with an investment by the charity of its funds elsewhere.
All of the above would need to be considered at a properly constituted meeting of the trustees, and the decisions made documented appropriately.
Once an investment is made in the trading subsidiary, what should the parent charity’s trustees do to monitor the investment?
If the trustees of a parent charity decide that investment in the charity’s trading subsidiary is a suitable way of investing the charity’s resources, then, as with all investments, it will be necessary for them to review the investment in the trading subsidiary regularly - and to decide whether it is in the best interests of the charity to maintain or to withdraw the investment.
If it appears, on review, that the trading subsidiary will make financial losses, the parent charity’s trustees must act to minimise any loss to the charity, as it is their duty to safeguard the assets of the charity. Failing to take appropriate steps to minimise any loss to the charity could be considered the result of a breach of trust, and the trustees may be personally liable for the consequential loss.
What if the parent charity’s trustees decide they aren’t able to justify financial support for the trading subsidiary as a suitable investment for the charity?
The Commission sets out in its guidance that a charity must not subsidise a failing subsidiary, and it has not changed that position even in light of the coronavirus pandemic.
A parent charity’s trustees must consider its trading subsidiary’s viability carefully when deciding whether to make an investment, and when reviewing a charity’s existing investment, in its trading subsidiary.
It is not appropriate to ‘prop up’ an insolvent trading subsidiary with charity funds, as that would be a breach of trust on the part of the parent charity’s trustees.
If a trading subsidiary is insolvent, it is vital that professional advice is sought as a matter of urgency. In that scenario, it may be appropriate to wind-up the trading subsidiary.