The role of trading subsidiaries in independent schools

Independent schools are currently in a challenging position. Growing economic pressures are making it increasingly difficult for parents to afford school fees. Meanwhile, the potential application of VAT to these fees within the next 12 months is becoming a very real possibility. Given these circumstances, it’s crucial for each school to explore income maximisation strategies, such as the implementation of a trading subsidiary.

Why consider setting up a trading subsidiary? 

You may be considering implementing a trading subsidiary or perhaps you’ve already set one up at your school but are unsure of its purpose. A trading subsidiary can be set up for several reasons, including to protect your school’s assets from commercial risks or to shelter profits from non-charitable trading. 

It’s important to be aware that a trading subsidiary set up to minimise corporation tax could inadvertently lead to costly implications across other taxes and could pose a risk to maintaining strong governance. 

What do independent schools pay tax on?

Due to their charitable status, most independent schools are exempt from corporation tax on any income arising from their ‘primary purpose’ activities. These activities are those set out in the charity’s objects. Note that the school’s charitable objects may not have been reviewed for several years and could be restrictive in what is permitted. They could be limited to a particular geography or class of beneficiary, so it’s important to check what falls within them before starting a new venture.

Likewise, corporation tax is not due on income from activities that are ancillary to the primary purpose, such as student accommodation, books, uniforms, etc. Income from property held by the school, such as rental property, will not be subject to corporation tax if the profits are reinvested back into the school’s primary purpose and no additional services (like the provision of staff) are provided to the tenant. 

Non-primary purpose trading turnover of up to £80,000 per year can remain within the school without adverse tax implications. However, for risk management or governance reasons, the charity may still want these activities to be ringfenced into a separate company. 

What happens if you need, or want, a trading subsidiary?

An alternative way of trading would be to establish a trading subsidiary that could carry out the non-primary purpose activities. The profit that the trading subsidiary realises from these activities can then be paid up to the school under charitable donation provisions. The trading subsidiary does not pay corporation tax on any profits donated to the school, and the charity will not owe corporation tax on the donations it receives.

What about other taxes?

Although a trading subsidiary may result in corporation tax savings, it will not benefit from all of the same charitable exemptions that the school currently does, such as those related to VAT.

Typically, a charity is an eligible body for the provision of education and provision of sport for VAT purposes. Therefore, it can treat such supplies as exempt, and no VAT needs to be charged on the income under the current rules. Depending on the outcome of the forthcoming general election, schools may be required to account for VAT on fee income. This may be legislated by removing independent schools from the definition of an ‘eligible body’.   

An off-the-shelf trading subsidiary is generally not considered an eligible body for the provision of sport or provision of education in the same way. This means that VAT typically needs to be charged by the trading subsidiary. It should be noted that a common example of trading in a subsidiary is the provision of sports facilities to third parties. These facilities will likely be supplied to organisations and individuals who cannot recover VAT. Therefore, moving these types of activities out of the school could have commercial implications.

However, with proper planning, it’s possible to extend the VAT exemption to many of the income streams generated by a trading subsidiary. This typically requires a thorough review of the subsidiary’s memorandum and articles of association, as well as its operational practices. Regular reviews are crucial to ensure that the initial planning remains effective over time. This often forms a central part of any HMRC compliance checks.

How will the school and trading subsidiary interact? 

To protect the charitable assets, the trustees will need to be confident that there is a robust rationale for allowing the subsidiary to use the charity’s premises, staff, resources, etc. This means they need to consider the school allocating and recharging relevant direct and indirect costs to the subsidiary. For instance, this could be by entering into formal lease agreements for the use of property. 

Charges to the trading subsidiary from the school for use of its facilities, staff and other assets are, by default, subject to VAT unless specific planning arrangements (such as dual contracts of employment) are put in place. This applies regardless of whether any profit is realised or intended. However, if a profit is realised, under the corporation tax rules this is likely to be taxed as non-primary purpose trading profit in the hands of the school.

A potential solution to the additional VAT costs is to set up a VAT group registration that includes both the school and the trading subsidiary. This would allow charges between the entities to be disregarded for VAT purposes. It’s important that both entities properly consider this before implementation to ensure no unintended consequences, such as reducing the trading subsidiary’s right to recover VAT that it incurs.

Whilst VAT has been a significant factor when considering whether to incorporate a trading subsidiary in the past, its importance in this area will decrease if VAT becomes due on school fees. This is because schools are likely to have a right to recover the VAT incurred on charges from the trading subsidiary. Although corporation tax or risk issues usually drive the use of a trading subsidiary, there may be instances where there are VAT benefits to using a trading subsidiary. Specialist advice should always be taken before implementing these types of arrangements.

Are there any non-tax issues?

Several governance issues must be considered before setting up a trading subsidiary. A few of these are noted below, but this is by no means an exhaustive list.

The charitable donation payments from the trading subsidiary must be actually paid over to the school. Therefore, it is important that the school and trading subsidiary have separate bank accounts so that the transaction can be seen to have taken place.

Under the Companies Act, it is unlawful to make distributions more than distributable reserves. Thus, the trading subsidiary must have sufficient distributable reserves at the time the charitable donation payments are made. This has proved to be a challenging issue during the lockdown period when subsidiaries have not been able to generate income.

The Charities Act reiterates that the trading subsidiary must be financially viable in its own right. The school cannot support the trading subsidiary through donations, gifts or services in kind, or by settlement of debts. Particularly during the initial set-up, you will need to pay attention to how the subsidiary will fund its cashflow requirements to ensure they comply with charity law and to ensure you do not fall foul of unexpected tax consequences. 

In summary, not every school will need a subsidiary company. If you determine that you do, you should employ a holistic approach to its operation needs to ensure that charity law, tax and governance issues are proactively addressed.