As funders over the years have responded to the need for greater scrutiny and accountability for the use of their funding, the underlying agreements have become increasingly complex. What in the past might have been a simple summary of a voluntary donors’ wishes can now be a comprehensive contracted arrangement with commercial terms. In the transition what was a grant or donation may now be a comprehensive contractual agreement. As this can have very significant implications for the recipient of funding, this guidance seeks to highlight particular areas in relation to VAT and accounting implications.
In broad terms VAT is a tax on transactions which are carried out by way of business but where grants and contracts are concerned it is not always easy to determine if there is a business transaction and therefore whether VAT is due.
Grants, in the appropriate hands, are not business transactions and as such are outside the scope of VAT. Contracts, however, are treated as business transactions and the VAT liability, and the consequences needs to be considered.
Why does it matter?
The main difficulty associated with VAT is that HMRC will typically carry out an inspection some time after a transaction has taken place and, more often than not, when the money has all been spent. Having to correct errors and pay VAT after the event is troublesome in itself but when there is no money left, it can be disastrous. In addition HMRC is inclined to add interest and penalties these days.
There are a number of aspects which affect the VAT position for the recipient:
- Accounting for VAT – if the consideration received by an organisation is deemed to be subject to VAT, often the VAT must be declared out of gross receipts, reducing the level of funding and making it difficult to seek more funding.
- Claiming VAT – VAT may only be reclaimed on taxable business activities. If the consideration is deemed to be outside the scope of VAT or exempt, VAT incurred on the activity may not be recoverable. Getting it right at the outset allows for appropriate modelling.
There is often a balancing act between the needs of the recipient and the donor as to the correct VAT position.
How are they accounted for?
The terms on which income is received governs how and when it is recognised in the Statement of Financial Activities and whether trust or contract law applies.
There are three key recognition criteria for income: entitlement, measurement and certainty. Whether or not it can be recognised it also needs to be analysed as either restricted or unrestricted in nature.
A grant is voluntary income to further a charity’s objects rather than to secure goods or services. It is a form of a donation, held on trust by the recipient to be used only for the purposes for which it was given. If those purposes are no narrower than the objects of the charity then when recognised it is analysed as unrestricted income. If those purposes are narrower (for example, for one particular activity or project) then when recognised it is analysed as restricted income and may only be applied to that narrower purpose.
Unless grant income is specifically for a future period, it should be recognised as soon as the charity is entitled to the income – all conditions have been met or are within the charity’s control, it can be measured reliably and its receipt is virtually certain. It should not be deferred merely because it hasn’t been spent. Until it falls to be recognised as income it should be carried forward in the balance sheet within creditors, restricted as necessary. If it is recognised as income before it is expended, it is carried forward within reserves, restricted as necessary.
A performance related grant is a grant with terms requiring performance of a specified service and payment is conditional on specified outputs and deliverables. It is still a grant because the payment is voluntary in nature and is accounted for as a grant except that it is only recognised on performance.
A contract is a binding agreement for the supply of goods or services or the performance of a service, at a specified price. A contract may be entered into by a charity because the contract activity furthers the charity’s objects (incoming resources from charitable activities) or as a means of income generation usually via a trading company (activities for generating funds). Unless a contract says otherwise, any retained surplus on the performance is retained by the charity and the income is always unrestricted. Entitlement to recognise the income is “earned” as the contract is performed. Income received before entitlement is a payment in advance held within creditors.
A performance related grant can be difficult to distinguish from a contract. To do so one should consider whether Trust or Contact Law applies if something goes wrong – and this may require legal advice. Money held on trust can only be applied to the purposes for which it was given. In the event of a breach of trust the grant may have to be repaid and the trustees may be personally liable to do so. Under Contract Law the aggrieved party may have wider remedies for breach of contract, such as a claim for damages. Such terms are indicative of contractual rather than voluntary arrangements.
The imposition of conditions does not preclude a payment from being treated as a grant for VAT purposes but advice should be sought where the conditions appear more than just good housekeeping. HMRC will often look to the accounts to consider the VAT position based on the accounting treatment.
It is important to know what type of income your organisation receives and how it should be accounted for. The VAT position for grant funding is complicated and careful attention needs to be paid in circumstances where it appears that the donor is receiving benefits in exchange for their money or there are onerous conditions.
RSM advises a large number of not for profit organisations and carry out reviews to determine the VAT treatment of income received. If you would like to discuss your VAT or accounting treatment please contact your local RSM contact.