24 January 2023
Many charities have recently tried to diversify their funding streams – mostly through various trading operations – and some now have complex group structures. As we come out of the pandemic, charitable groups are reviewing their operations and concluding that:
- some trading activities are now creating a drain on the charity;
- the activities can be carried out within the charity with no tax impact (e.g. because income from the trading activities would fall within the exemption from tax for profits of small-scale trades, or the trading activity is consistent with the charity’s objects); and
- the administrative costs of running a complex group are escalating.
As a result, a lot of charities are deciding to simplify their group structure. While this may be the right decision in the long term, charities need to ensure that any group reorganisation is carefully planned. It is important that charities seek the right advice at the right time.
By way of example, take the fictitious organisations 'Charit Able' (a large charity established as a company limited by guarantee) and 'Trade Able Ltd'. Charit Able acquired all of the shares in Trade Able two years ago, because it saw potential in a platform that Trade Able had started developing. Two years on:
- the platform is ready for use;
- Trade Able owes Charit Able £2.5m in a long-term loan; and
- Trade Able has expensed all development costs and has significant negative reserves.
Having confirmed that Trade Able’s activities could be performed by Charit Able with no adverse tax consequences, Charit Able’s board has decided that Trade Able’s trade and assets is to be transferred to the parent charity, and for Trade Able to be wound down and struck off the Register in due course. Charit Able and Trade Able are part of a VAT group.
What happens to the long-term loan between Charit Able and Trade Able? Should this be forgiven by Charit Able?
Provided the forgiveness of the debt is structured correctly using a formal deed of waiver, any resultant credit of £2.5m to Trade Able’s statement of comprehensive income should not be subject to corporation tax.
If a claim to the effect that Charit Able’s loan to Trade Able can be regarded as an approved charitable loan or investment was accepted by HMRC, any charge to Charit Able’s statement of comprehensive income, which results from the waiver of the debt:
a)should not be regarded as non-charitable expenditure; and
b) should not result in the restriction of any of Charit Able’s corporation tax exemptions.
If no such claim was made to HMRC at the time the loan was advanced, consideration should be given to doing so before the loan is waived – along with full disclosure of the charity’s intention to release Trade Able of its obligations under the terms of the loan agreement.
Alternatively, the loan could be converted into additional share capital in Trade Able. However, because this additional share capital is not distributable a capital reduction may be necessary in order to create enough distributable reserves to transfer the net assets from Trade Able to Charit Able.
A case would need to be made to HMRC that the investment by Charit Able in Trade Able’s additional share capital is being made for the benefit of Charit Able, and not for the avoidance of tax.
What value should the net assets be transferred at?
If net assets are transferred at net book value, this will mean that the net assets of Trade Able will be recorded at a value significantly below fair value in the accounts of Charit Able.
If net assets are transferred at their fair value, then it may be difficult to assess the fair value of the intangible fixed-asset given its nature. A valuation exercise may require experts and prove costly. Thought would also need to be given as to whether any gain generated by this transaction would form part of Trade Able’s distributable reserves.
The transfer of the assets to the parent may be deemed to be a distribution by Trade Able. Given the negative reserves in Trade Able, various steps would need to be taken to ensure that there are sufficient distributable reserves so that an illegal distribution is not made.
The value for which the intellectual property is transferred should not be of consequence from a corporation tax perspective. The costs incurred by Trade Able in developing the platform will be treated as having been incurred by Charit Able. Any future gain realised by Charit Able on the sale of the platform should, in principle, be exempt from corporation tax.
How is this transaction reflected in the financial statements of Charit Able?
Merger accounting could apply in this case, where the results and cash flows of all the combining entities are brought into the financial statements of the combined entity from the beginning of the financial year in which the combination, adjusted so as to achieve uniformity of accounting policies.
Practically, this means that Charit Able would restate its charity-only financial statements to show Charit Able and Trade Able as a combined entity from the date of acquisition.
Although merger accounting is the method suggested by the Charities SORP, the use of acquisition accounting is not forbidden. However, in order to be termed ‘acquisition accounting’ it is essential that the consideration paid for Trade Able demonstrably equates to its fair value. This would mean that a full fair value exercise would need to be undertaken on the net assets acquired from Trade Able.
Hybrid accounting may also be an option. This allows the transfer of the assets to be brought into the acquiring entity at their book value at the date of the transfer, and no restatement of previously reported results is required.
As can be seen from this example, there is a number of financial and tax-related areas that need to be carefully considered when undertaking (what would seem to be) a relatively simple transaction to transfer trade and assets around the group. In addition, it might be necessary to novate customer contracts and supplier agreements (including insurances), and to transfer employment contracts.
When undertaking a transaction like this, it is important for charities to seek advice from legal, tax and financial reporting experts. All three areas are needed to create an effective scheme of reconstruction.
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