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Company Law

Q: Incorporating charity status to existing companies

We should like to establish a charitable arm to the theatre production company that we are in the process of incorporating. What are the implications to establishing a two-tier or a parent structure? If we do charitable and community work, can we draw a wage?

A: There are a number of important reasons for setting up a subsidiary trading company which will be wholly owned by the charity (even if the charity is itself incorporated):

1. Avoidance of risk to charitable status.
A charity can lawfully carry on a trade in furtherance of the primary charitable purpose it was set up for. Thus, a charity set up to foster and promote the education of the public in the performing arts can, if its Memorandum of Association permits, carry on the business of producing stage productions. On the other hand, engaging in merchandising, running bars and catering or other fundraising ventures which are not technically in furtherance of its primary charitable purpose, although unlikely to attract the censure of the Charity Commissioners if modest, risk loss of charitable status if allowed to develop into a major part of the charity's operation. For this reason, the constitutions of some charities prohibit trading directly but allow investment in trading companies.

2. Avoidance of personal risk to the trustees of the charity.
The trustees of a charity may wish to distance themselves from involvement in trading activities and the con-sequential personal risk to themselves in the event, for example, of the charity trading while insolvent, or they may simply not wish to be involved in running a business they do not understand. In such event they will ensure that trading is carried out by a subsidiary company of which they are not themselves directors or managers.

3. Limited Liability.
If a trading charity goes bust, its entire assets will be sold to pay creditors and the charity will have to be wound up. However, if trading activities are carried on through a separate trading company then if the trading company goes bust the charity and its separate assets will survive. Thus, if, for example, the charity (or a separate rights-owning company belonging to the charity) owns the rights to a particular stage play and licenses its production company to produce the play, the stage rights can be preserved in the ownership of the charity if the trading company (production company) becomes insolvent.

4. Administrative convenience.
It may be desired to separate the running of a charity from its trading operations so as to enable the charity and the trading company to be run by different people, while retaining overall control and supervision by the charity. Furthermore, with very limited exceptions (such as in the case of professional trustees) the trustees of a charity cannot in law be paid for their services as charity trustees but, if they are working directors of a trading subsidiary, they can be paid reasonable remuneration for their services to that company, although it is considered desirable that they should not hold both offices simultaneously in case conflicts of interest arise or it becomes difficult to separate, for remuneration or other purposes, what they are doing as trustees of the charity and what as directors of the trading subsidiary. This answers your question about drawing a wage.

5. Tax benefits.
The trading income of a charity is exempt from income tax and corporation tax in so far as such trade is regarded by the Revenue as carried out for the primary purpose of the charity. Within certain specified limits a small amount of non-primary purpose trading can be carried on without liability to tax, depen-ding upon the proportion of such peripheral trading to annual turnover and total income. But if all the charity's trading activities are carried out through a separate trading subsidiary which is wholly owned by the charity, and if the entirety of the trading subsidiary's profits are paid over to the charity by means of a Deed of Covenant or Gift Aid, then there is total exemption from corporation tax on all the subsidiary's trading profits.

It should be noted, however, that having a separate trading subsidiary obviously involves additional administrative expense, and care has to be taken to keep the financial structures of both bodies separate. The names of both bodies should be distinguished, and the separate identities of the charity and trading company must be made clear in all publicity material. Investment in trading companies has to be specially justified to the Revenue as being for the benefit of the charity and not just for the avoidance of tax. The Charity Commissioners will also need to be satisfied that the establishment of a trading company is not being used merely as a device for paying remuneration to individuals who are both trustees of the charity and directors of its trading company, or as a means of paying them more than what is reasonable. Further, the trading company must be made financially independent as soon as practicable without continual funding from the charity (five years is the usual period allowed), unless for special reasons the Charity Commissions otherwise expressly permit, or such funding is adequately secured. Both the Charity Commission and the Revenue will be concerned to ensure that the charity is not continually funding the losses of its trading subsidiary, and in any event the charity must not settle any debts of the subsidiary direct.

It is also worth mentioning that there may be conse-quential VAT benefits by setting up a trading subsidiary. For example, if the charity distributes free literature, if it has set up a trading subsidiary for other reasons and arranges for the production of the literature to be carried out by the trading subsidiary, and sold to the charity for full value, the charity will purchase it as a zero-rated VAT input.

However, setting up a separate trading subsidiary may be counter-productive for smaller charities. If undertaken the above factors should be considered carefully and professional advice taken.

First published May 2001