Charities & Trading Subsidiaries Part 4

As highlighted in part 3 of this series, a charity must adhere to the qualifying investment criteria if it wishes to avoid the potential tax penalties incurred by non-charitable expenditure. It cannot simply give a certain amount of money to a trading subsidiary as a goodwill gesture. Any investment must be commercially sound. This underlying requirement will therefore dictate the type of investment which a charity can make to the trading subsidiary.

Part 4

TYPES OF INVESTMENT

The two main types of investment are the acquisition of share capital and/or the provision of loans.

Share Capital

It may sometimes be prudent to subscribe only a nominal sum for the issue of share capital so as to satisfy company law. If a parent charity does subscribe a greater sum as a means of investment then that investment will be subject to risk if the trading subsidiary ultimately fails. This is because the repayment of share capital has a lower priority than the repayment of loans in the event of liquidation.

On the other hand the capitalisation of the subsidiary by loan carries its own risks. The provision of loans may expose the subsidiary to the risk of insolvency if it cannot repay its borrowings. It must be remembered that any loan by the charity must be on a commercial basis and offer commercial returns. the subsidiary would be obliged to pay a reasonable rate of interest in addition to the capital and this could cause some difficulties for a newly established subsidiary with marginal profit margins.

Therefore in this instance where profit margins are likely to be marginal it may be reasonable to pay more than the nominal amount for share capital.

Of course a trading subsidiary does not have to rely on the parent charity for sole funding. outside financiers can play a role in capitalising the enterprise. However, investment through the acquisition of shares is unlikely to prove attractive to such persons or organisations as they would be motivated by profit. This would sit uncomfortably with a trading subsidiary which gives all or most of it profits to the charity, leaving little or no dividend.

The charity could market the acquisition of shares to wealthy supporters who would be willing to invest and possibly fore go a commercial return.

Loans

HMRC guidance stresses the requirement that any loan from the charity to the trading subsidiary must be at arms-length and bear a commercial rate of interest with suitable repayment terms. It is highly unlikely that HMRC would tolerate a loan agreement with no rate of interest and a repayment schedule over a 1000 year time period!

The loan must also ordinarily be secured against any assets of the trading subsidiary. Where this is not possible, because the trading subsidiary has no assets, then HMRC will likely scrutinise the loan through an assessment of the business projections, cash-flow forecasts etc.

A trading subsidiary is of course under no obligation to obtain a loan from the charity. it may approach commercial entities in-order to acquire finance. This obviously puts the trustees of the charity at less risk as they wouldn't have to grapple with the many issues surrounding charitable investments as has been previously discussed.

However banks and other lenders may require guarantees/security from the charity itself as part of any loan agreement. This would expose, both the charities assets and the trustees themselves to risk if the subsidiary got into difficulty. Such commercial lenders may also stipulate repayment terms which would be in excess of what the charity would be obliged to charge under any loan agreement with the subsidiary.

Therefore loans from commercial lenders may not always be a viable option. Well-wishers and supporters of the charity could offer loans to the subsidiary on more favourable terms.