Trading can be a taxing task

As donations fall, charities must look to other means of funding. But diversification can carry pitfalls, warns Helen Whymant. Helen Whymant is an assistant solicitor at Dickinson Dees.

As the impact of the fall in donations to charities hits home, more charities are boosting their income by becoming involved in an array of trading activities. These range from charity shops to more complex ventures, including credit cards and life assurance.

But charities are not always aware of the tax implications of their activities. More importantly, they are often unaware that if they trade at all they may lose their charitable status.

Trade carried out by charities falls into two main categories:

trades exercised in the course of the carrying out of a primary purpose of the charity, such as the provision of health-care services by a hospital in return for payment; and

trades which are not themselves part of the primary purpose of the charity but are designed to raise funds for charitable purposes, such as the sale of Christmas cards.

The distinction between these two means is vital. To qualify for an exemption from tax, the profits must be used solely for the purposes of the charity. Furthermore, either the trade must be a primary purpose trade or the work done in connection with the trade must be mainly carried out by beneficiaries of the charity. An example of the latter is the sale of goods manufactured by beneficiaries of a charity which exists to help people with disabilities.

Certain activities which are ancillary to the charity's primary purpose may also qualify for exemption, such as a college providing accommodation to students in return for rent. Some trades may be partly, but not wholly, primary purpose – for example, letting accommodation to students during term time and to tourists out of term time.

In certain circumstances these trades may qualify for exemption, but only if the non-primary element of the trade is small and the turnover of that part of the trade is less than 10 per cent of the trading activities as a whole. If these elements are not satisfied, all profits may be taxed.

Of course, if a charity decides to trade, it must first check its trust deed, memorandum and articles or constitution to ensure it has the power to do so. If not, the charity commissioners may be willing to sanction a change enabling it to trade. However, even if the power to trade is available, a charity must carefully monitor the anticipated level of its trading activity.

If trading dominates activities, the charity can fall outside its objectives. The Charity Commission may question whether the charity was established for exclusively charitable purposes.

Charities continuing with trading activities which dominate their other activities may therefore risk losing their charitable status. The charity must also consider whether the venture is in itself too speculative or risky for it to undertake.

More and more charities carry out their trading activities within a wholly owned non-charitable limited company, specifically formed to carry out trading for the parent charity.

Charity commissioners advise that a charity should trade through such a company where it wishes to benefit from permanent trading for the purpose of fund raising. By using a separate trading vehicle, the charity's charitable status would not be endangered.

Charities should therefore consider trading through a wholly owned non-charitable company, either where they are undertaking any form of non-exempt trading activity, or where they have no power to trade as they want, and the charity commissioners are unwilling to sanction the necessary change in those powers.

In addition, such a trading company should be used by a trust or constitutional charity where the trading carries any element of risk, or where there may be VAT advantages.

The company will donate its trading profits to the charity. In the hands of the charity, if used for charitable purposes, the donation will be tax free.

Although the Charities Commission encourages charities to set up non-charitable trading companies, it generally does not approve of the charity bearing the costs of establishing and financing the company. It prefers that such costs are met by way of a gift, or a commercial loan. The commissioners may sanction a loan, but there are rules which must be adhered to and a breach may result in the trustees being personally liable.

The commission will need to be satisfied that the charity has considered the viability of the company, and in particular the company's business plan, cash flow forecasts, profit projections and risk, to ensure that the loan is a reasonable investment.

The charity's investment powers must permit such an investment. The loan should be secured and should bear interest at a market rate, being paid rather than rolled over. Funds are there to be used for charitable purposes – a loan should not tie up funds indefinitely.

Charities need to diversify and find increasingly complicated and sophisticated ways of raising funds. But they should be advised of the difficulties they may encounter by venturing into such diversification.