It is common for charities to carry out trading activities for profit via their wholly-owned subsidiaries. The subsidiary company then donates some or all of its profits to the parent charity, reducing or eliminating completely its corporation tax liability for the period in question (as long as the donation is paid to the parent charity within 9 months of the end of the accounting period).

However, the Institute of Chartered Accountants in England and Wales (“ICAEW”) has recently provided some new guidance in this area following concerns that this practice may, in some circumstances, result in breaches of company law under the Companies Act 2006.

This is because there is a difference between taxable profits and distributable profits, and this means that a donation by the subsidiary company may be part donation and part distribution of reserves. Under the Companies Act 2006, a company cannot distribute an amount more than it has available in distributable reserves – so it may be that a subsidiary is making a distribution to its parent charity that it cannot make (in accordance with the Companies Act 2006).

Until the ICAEW released its new guidance, the Charity Commission’s approach to this area (guidance CC35, which has since been withdrawn for review and update) was that a subsidiary could pay to its parent charity as a gift aid donation an amount greater than its accounting profits – but this will now change following the ICAEW review.

Perhaps, this is best explained by way of an example.

Let’s assume a wholly-owned subsidiary makes accounting profits for the year of £500,000.

It has expenditure disallowable for tax purposes of £10,000, leaving it with taxable profits of £510,000. Let’s also assume it is subject to corporation tax at 20%.

Finally let’s assume the subsidiary company has historically made a donation to its parent charity of all of its profits, such that its profit and loss reserves have a token balance of, say, £1 only – and in this example, the subsidiary has made a donation of £500,000 in the current year.

Now, with taxable profits of £510,000, the donation of £500,000 reduces the taxable element to £10,000, giving rise to a £2,000 tax liability.

Therefore, the subsidiary has distributable reserves of £498,001 (£500,000 accounting profits less the £2,000 tax liability plus the £1 notional reserves balance).

The donation of £500,000 means that it has paid out more than its available distributable reserves – i.e. it has made an illegal distribution of £1,999.

Where this has happened, the parent charity will be liable to repay the excess amounts received (£1,999 in the above example) to the subsidiary and will need to make the necessary disclosures in its accounts.

There may also be a tax implication of such a situation, and HMRC are expected to publish their guidance on this area in due course.

Now it is unlikely that this situation will affect many charities, since the majority of subsidiaries make their payments to their parent charities out of the distributable reserves. However, charities should review their circumstances.

If you have any queries about this matter, or think that you may be affected, then please do get in touch for advice and guidance.