A review undertaken by the Institute of Chartered Accountants in England and Wales (ICAEW) has brought into question the position regarding donations made by for-profit subsidiary companies to their parent charities.

Since 2000, these payments have gone largely unquestioned by HMRC and have been outside the ambit of what is now the Companies Act 2006 (CA 2006) and the Corporation Tax Act 2010 (CTA 2010). However, the revised guidance from ICAEW changes this position and the accounting treatment of Gift Aid payments.

No rules

Being a charity comes with considerable advantages in the tax treatment they receive. However, due to the benefits received by charities in terms of relief from taxation, they are normally barred from trading in areas outside their charitable objects. It is for this reason that many charities decide to set up a subsidiary company which can carry out non-charitable trading in their place, whilst also donating its profits back to the parent charity under the Gift Aid scheme, thereby escaping any tax liability on its profits.

As this is a fairly complex area of the law (and imperative to get right in order to reap the rewards), there has been plenty of guidance on these Gift Aid payments. Under previous guidance, Gift Aid payments were not seen as distributions by the subsidiary and could, therefore, be made in excess of a company’s taxable profits. For any regular commercial company, any payments made to the shareholders (in this case the parent company) would be considered a distribution. Distributions are not legally allowed to be paid out in excess of the taxable profits of the company. Subsidiary companies of charities were, therefore, an anomaly in that they could donate more than their taxable profits, ensuring nothing was left on which they would be liable to pay Corporation Tax.

This practice was endorsed by HMRC and remained common practice until the ICAEW issued its technical guidance in 2014. The ICAEW had sought legal advice to clarify the position of the Gift Aid payments as to whether they should, in fact, fall under the rules attributable to distributions within the Companies Act 2006. The new guidance confirmed the payments were distributions and would, therefore, be illegal if paid in excess of distributable profits. This became a serious issue, as unlawful distributions are liable to be repaid to the subsidiary company and would also not be considered a qualifying donation, leaving the subsidiary open to Corporation Tax liabilities.

Introduction of the FRS 102

This revised treatment of Gift Aid payments remained the status quo until 2017 when the Financial Reporting Council (FRC) made its amendments to the Financial Reporting Standard 102 (FRS 102), as part of its triennial review. These changes are due to be implemented for accounting periods beginning on or after 1 January 2019. However, some of the adjustments should be implemented before this date as they are simply clarifications of the initial guidance.

The amendments seek to clarify significant differences arising from accounting treatment commonly in practice. Unless there is a legal obligation to make a payment, no liability for expected Gift Aid payments can be recognised at the reporting date and accounted for in the subsidiary's accounts.

In summary, as they are now recognised as distributions, Gift Aid payments can only be accounted for once there is a legal obligation to make the payment or if the payment has actually been made. If the subsidiary needs to make use of the additional nine months permitted for subsidiaries wholly-owned by charities to make Gift Aid payments then the payment will now be recognised in the following year’s accounts.

The solution

Deeds of Covenant used to be the standard method for subsidiary companies to shelter taxable profits. This changed in 2000 when charitable donations became deductible as qualifying Gift Aid payments. However, the practice of creating a Deed of Covenant has been suggested for trading subsidiaries to make their upcoming Gift Aid payment a legal obligation. To be able to account for a Gift Aid payment in relation to profits in the year in which they are accrued, it is important to note that the guidance specifically states that a decision of the board of the subsidiary to make a Gift Aid payment, taken prior to the reporting date, is NOT sufficient as this will not be considered a legal obligation. If a charity decides not to institute a Deed of Covenant, the donation can only be recognised at the time of payment. Taking advantage of the nine months, to ensure there is enough capital to make the payment legally, would mean that the donation has to be recognised in the subsidiary’s accounts for the following year.

Whether a Deed of Covenant is required will therefore depend on when the subsidiary wants to reflect the payment in its accounts. If the subsidiary would like to reflect the payment in the year the profits were accrued, then a Deed of Covenant will be necessary. However, if the payment can be recorded in the following year’s accounts when the Gift Aid payment is actually made, no Deed of Covenant will be required. In either case, the tax position will remain unaffected if the accounts are presented correctly.

For more information

For more information on this issue or for any queries concerning the relationship between a charity and its trading subsidiary, please contact Phil Watts.