A UK charity, whether new or established, faces an increasingly complex regulatory environment. One consequence of this is that without an understanding of the regulations that apply and careful planning, a charity can contravene direct tax or VAT regulations and face an unexpected and unwelcome tax charge.  There is also an ever-expanding and unavoidable body of rules on charity accounting and charitable governance with which a charity must comply.

Dixon Wilson is a specialist provider of audit, accountancy and advisory expertise to UK-registered charitable companies and trusts and other not-for-profit organisations.  During all stages of development, from formation and funding to operation and expansion, we enable our not-for-profit clients to maximise the funds they have available for charitable purposes.  We often act as a useful sounding board for management and trustees.

Many of Dixon Wilson’s private clients have established charitable trusts to support their philanthropic objectives.  We work closely with the charity’s trustees, including advising on their responsibilities and, on occasion, we act as professional trustees.  We assist with accounting matters, and advise on how to make the best use of the various tax exemptions available to charities.

Some of the most important questions for those creating and operating charities are set out in the sections that follow.  Below that, we provide further information on how Dixon Wilson advises on the specific issues relevant to our clients in this sector.

Taxation
    •    Sponsorship income and donations received
    •    Substantial donors
    •    Trading income
    •    Fundraising events
    •    Other income and gains

Gift Aid

VAT
    •    Business activities
    •    Donations
    •    Exempt activities
    •    VAT reliefs for certain purchases made by charities

Charity Accounting
    •    Restricted and unrestricted funds
    •    Analysis of expenditure
    •    Charities’ SORP

Other points to consider
    •    Payroll
    •    Legislation

Questions that those involved with the charities must often address include:-

Taxation

    •    Are all funds raised being spent in order to meet charitable objectives? If not the receipt may be taxable.

    •    Are all loans and investments "approved charitable investments or loans" if not a tax charge may arise.

    •    Is the charity carrying on any type of trade?  If so, does this trade fall into a specific exemption or is it potentially taxable?

    •    Is there a way of restructuring activities to prevent the tax charge on trading income arising?

    •    Could HMRC look to tax corporate donations as trading income?

    •    Are fundraising events held? If so do they meet the requirements to be exempted from tax and VAT?

    •    Are there large donors? If so might any benefits provided to them give rise to tax charges for the charity?

Gift Aid

    •    Can the charity reclaim gift aid on donations received?

    •    Are the appropriate records being maintained to support these reclaims, or is there a risk that HMRC might find the documentation is insufficient to allow gift aid repayment?

VAT

    •    Is the charity carrying on business activities? If so, are they of a size that means the charity needs to register for VAT?

    •    Is VAT being charged on all taxable activities where required?

    •    What proportion of VAT on expenditure can be reclaimed? Is there a way of increasing this amount?

    •    Does VAT need to be charged on corporate donations?

    •    Is the charity making purchases which can be exempted from VAT due to the charitable status? Is VAT at present being paid on these?

Accounting

    •    Is restricted income and expenditure being separately recorded – to ensure a clear record is maintained of how much is received and how the restricted income is employed?

    •    Are adequate records being maintained to allow preparation of the year end accounts in accordance with the Charities SORP (the charity accounting guidelines)?

Other issues

    •    Is payroll being properly prepared and PAYE paid over on time to HMRC?

    •    Are trustees’ remuneration, benefits and expenses reasonable and in line with the legal requirements?

    •    Is the charity complying with Charities Commission and other guidance, for example on public benefit issues and HMRC regulations governing ‘fit and proper persons’?

Dixon Wilson advises extensively in the following areas:-

UK TAXATION

The UK tax system offers numerous exemptions and other tax reliefs for UK registered charities.  However, there is a common misunderstanding that charities need not concern themselves with taxation at all.  Unfortunately, this is far from the truth: is it often vitally important to structure activities in a manner that ensures the various available exemptions apply.  

Where income falls outside the exemptions, it may be possible to adopt an alternative operating structure, which does not alter the underlying nature of activities but does protect the charity from UK taxation.  

The first step to be taken by most UK charities is to register with the UK Charities Commission.  This is usually a requirement for access to the various UK tax exemptions available to charities.  It is also necessary before donors to the charity can obtain the tax benefit of their donations.  

Although UK charities are generally able to limit the taxation that they are required to pay, they will remain within the corporation tax or income tax regime, depending on whether they are an incorporated charity or an unincorporated charitable trust.  

HMRC can require charities to submit tax returns, and the normal practice is to ask for a tax return at least every few years, even when there is no taxable income arising.  In the past it has not been necessary to specifically register with HMRC as a charity, but this is now a requirement for all new charities.

The overriding principle which covers the various tax exemptions is that any income must be applied for charitable purposes, in line with the charity's objectives as set out in its governing documents.  

This point always needs to be considered when a new activity is embarked upon, to ensure the activity is in line with the stated objectives and therefore that income expended on it will attract tax exemptions. 

There are also a number of tax pitfalls associated with the main sources of income which charities receive, and some of these are outlined below:-

Sponsorship income and donations received

It is generally the case that pure ex-gratia donations received are exempt from taxation, as long as the funds are applied for charitable purposes.  

However, problems can arise where a charity receives donations from businesses and provides goods or services in return for those donations.  Most commonly this would be some form of corporate sponsorship arrangement where the charity is seen to be advertising the donor.

There is a fine line between carrying on a trade generating corporate sponsorship and receiving pure donations and there is a body of a case law and HMRC guidance which can be used to help distinguish between the two.

Where the services provided by the charity to the donor are insignificant, the sponsorship retains the nature of a charitable donation and the charity need not concern itself unduly about the taxation of the income.

The position can be distinguished where significant benefits are provided in return for the donation.  These may include use of the charity’s logo by the sponsor, endorsement of the sponsor’s products by the charity or access to the charity’s mailing list. In these cases the donations may then become taxable trading income in the hands of the charity.

It can in certain circumstances be possible to restructure donations to move them away from sponsorship towards pure donation.  Though the question will always be decided on the true nature of the arrangement, the documentation surrounding the income will also be important.
 
Substantial donors and Tainted Charity Donations

Charities have struggled for some years with the substantial donor rules under which charities can potentially face a tax charge when they enter into certain transactions with 'substantial donors'. The key criticisms levelled at the current rules are the administrative cost of complying with them, and the possibility that they deter genuine donations which have no tax avoidance motive.

In 2010 draft legislation was published for comment, which replaces the substantial donors rules with the concept of 'tainted charity donations' ('TCD'). The 2011 budget introduces amendments to the draft legislation, and confirms that the TCD legislation will be included in Finance Bill 2011.

The TCD rules can apply to a donation of any size, but include a purposive test designed to catch only those donations which are part of an arrangement which aims directly, or indirectly, to provide a benefit to a donor and would not have been made had those benefits not been expected. The primary target for recovery of tax under these rules is the donor, though the charity can remain liable in some circumstances.
Trading income

It is perfectly possible for a charity to carry out trading activities and very many charities do so.  It may not always be immediately apparent that the activities taking place amount to a trade, but this needs to be carefully monitored in order to ensure an unexpected tax charge does not arise.

Trading income is exempt from tax to the extent that it amounts to a ‘primary purpose trade’: where carrying out the trade fulfils a primary purpose of the charity as stated in its governing documents (for example, a charitable school charging pupils to attend).  

Any intended trading activity should be considered in light of this exemption to establish whether or not it will qualify.  There are other exemptions for trades carried on by the beneficiaries of the charity, or for small trades.

Where a specific exemption does not apply, trading income can be fully taxable on the charity.

The most common area of difficulty is trading for fundraising purposes.  As the fundraising purposes do not constitute the primary purpose of the charity, income from this type of trading will be taxable.  

The most common way of dealing with this problem is to establish an incorporated trading subsidiary to carry out the fundraising activities.  

Put simply, the trading subsidiary donates its profits up to the parent charity, this donation is then offset against the subsidiary’s taxable income and neither the subsidiary nor the parent is subject to tax on the profits.

There are administrative costs associated with this sort of structure, but for many charities these are far outweighed by the tax savings achieved.
Fundraising events

The comments on trading income above might lead one to the conclusion that income raised from fundraising events will be taxable as non-primary purpose trading.  

This would be the case, except that there is a specific tax exemption for profits from fundraising events.  This applies when all the profits of the events are used for charitable purposes and the events qualify for exemption under the rules laid out by HMRC.  These are broadly as follows:-

    •    The event must be of a non-recurring nature.  They can occur more than once, but this should not be regular or continuous, for example the operation of a shop or a bar;

    •    The limit on the number of events which can be held in one place in one year is 15.  Most significantly the events should be clearly organised and promoted primarily to raise money for the charity and people attending must be aware of its primary fundraising purpose.  Social events which incidentally make a profit do not fall within the exemption.

It is important to consider the tax rules when organising this sort of event, in order to avoid an unpleasant surprise on discovering that the hard-earned funds might now be subject to taxation. The VAT rules and the tax rules are aligned in this area – so a tax saving might also be a VAT saving.
Other income and gains

Other income and gains should generally be exempt from tax as long as they meet the general requirements outlined above for the application of the funds.  This covers interest and other investment income, as well as property income. 
Gift Aid

Donations made in the UK by individuals are treated as being made after deduction of 20% tax. Charities receiving these donations are then able to reclaim the additional 20% tax from HMRC. Higher rate taxpayers can also claim additional relief through their tax returns.

This is not available where benefits in excess of set limits are received by donors in return for donations.

At present allowable benefits are 25% of donations of £0 - £100, £25 donations of £101-£1,000 and the lower of 5% of the donations & £2,500 for larger gifts (with effect from April 2011).

In order to reclaim the additional tax on gift aid donations it is vital that a charity receives the appropriate gift aid declaration from the donor.  There is specific information which is required to be included on this declaration and it needs to be retained.  

Record-keeping around gift aid is important, as it is possible for HMRC to declare that a gift aid declaration is invalid if the records supporting it are insufficient.  This could have a very real cost to the charity.

Income tax on such donations is currently reclaimed from HMRC via a claim form, and a charity will need to establish a system for reclaiming repayments due to them. HMRC can be slow to make repayments and planning for cash flow should reflect this.

A charities application form has to be submitted to HMRC before gift aid repayments can be claimed.
VAT

Charities are subject to the VAT rules in a similar way to other organisations, and will often need to consider their VAT position carefully in order to minimise the real VAT cost to the charity and ensuring they comply with the VAT legislation.  VAT for charities is a notoriously complex area, and one which can be costly if it mishandled.

Two of the most important points to consider when planning a VAT strategy for a charity are:

    •    how to minimise the VAT chargeable to those individuals for whom it is a real cost, that is private individuals and businesses who cannot reclaim all their VAT, and

    •    how to maximise the VAT that the charity can reclaim on its expenditure.

Often these two aims conflict with each other and so the primacy of one of them or a compromise between the two has to be found to limit VAT cost born by the charity.
Business activities

Charities are required to charge VAT on all their business activities, as soon as they pass the VAT registration threshold.

The question of what constitutes a business activity is a complex one, but the definition is drawn widely and many activities will qualify as business in nature, particularly where there is some form of consideration received and/or they are carried on in a regular manner on business principles.

Where an activity is held not to constitute a business activity, no VAT will be chargeable on any income, although one would not expect a non-business activity to generate much in the way of income in any case.

VAT cannot be reclaimed on expenditure relating to non-business activities.  It is therefore often desirable to argue that an activity is a business activity, to ensure that maximum VAT can be reclaimed.

Where a charity has a split between business and non-business activities, the proportion of its input tax that can be reclaimed is split on a basis agreed with HMRC.  There is often scope to significantly increase the VAT reclaimable by negotiating a favourable method of apportionment.
Donations

The VAT position of corporate donations or sponsorship is a particularly thorny issue.  The rules for VAT are considerably more rigorous than those for direct taxation, so that although sponsorship income may be held not to be trading for tax purposes, it  can be subject to VAT if there is any small benefit provided in exchange for the sponsorship or donation received.  

This may not be a problem in many cases where corporate donors can fully reclaim their VAT. However, it is vital to get this right from the beginning in order to avoid creating a VAT liability which may not be able to be reclaimed from sponsors if the spectre of it is not raised at the time the donations are received.  

Where sponsorship is held to be VATable, this is a real cost to the sponsor, and may therefore reduce the amount donated to the charity after VAT, there are a number of ways of dealing with the issue.

It may, for example, be possible to split the donation into a VATable and non-VATable portion, so that only part of the income is subject to VAT.
Exempt activities

A number of the activities undertaken by a charity, although business in nature, may, be specifically exempt from VAT.  One common example is the provision of education. VAT will not need to be charged on this exempt income.

It is important to bear in mind that carrying out these sorts of supplies reduces the VAT the charity recovers on its expenditure as VAT on expenditure is reclaimable only to the extent that the expenditure relates to taxable and not exempt supplies.  

Again, there may be scope for negotiating a method of apportioning VAT on general expenditure between exempt and taxable supplies so as to get the most beneficial result for the charity.
VAT reliefs for certain purchases made by charities

Certain purchases made by charities are exempt from VAT, where they would be VATable if made by a non-charitable organisation.  This is a helpful method of reducing VAT, which all charities should be aware of to ensure they are minimising the VAT they pay.

Notable examples of the areas where this may apply are advertising costs, costs associated with the construction of buildings and costs associated with donations.
CHARITY ACCOUNTING

Restricted and unrestricted funds

Charities are required to account for restricted and unrestricted income and expenditure separately.  

Restricted income is income where the donor has specified the purpose for which the funds are to be spent.

A charity needs to be able to demonstrate that those restricted funds have been spent appropriately, in line with the restrictions imposed by the donor.  

This is not something that can be dealt with entirely at the final accounts preparations stage.  It is vital that records of the restrictions placed on donations and the expenditure on which they have been employed are maintained on an ongoing basis. 
Analysis of expenditure

The statutory accounts prepared by the charity must allocate the charity’s expenditure between support costs, charitable activities and governance costs.  A split of activities in this way must be genuine and can have a great impression on the reader of the accounts and it is therefore vital to ensure that costs are appropriately split between the activities undertaken.  

There are a number of further disclosures which are specific to charities, for example additional disclosures relating to staff and director remuneration. 
Charities’ SORP

The accounting rules are largely contained in the Charities’ SORP, which is a comprehensive document governing how charity accounts should be produced.  Preparation of statutory accounts requires familiarity with the SORP in order to ensure appropriate accounting treatment is applied and adequate disclosures are made.
OTHER POINTS TO CONSIDER

Payroll

A charity employing staff needs to operate a payroll system in order to collect income tax and national insurance through the PAYE system and pay this over to HMRC, in the same way that any other organisation would. There are strict time limits on the making of payments and the provision of information to HMRC. Benefits must be carefully monitored and appropriate reporting exemptions claimed just as for other organisations.

Any charity employer should look to have this well in hand in order to avoid penalties for non-compliance.
Legislation

Charities are subject to a raft of legislation and guidance, much of which is issued by the Charities Commission.  It is necessary to comply with guidance and legal requirements on matters such as public benefit, trustee remuneration and benefits, fit and proper management and other areas.

This will involve an assessment of the charity’s initial activities and organisation against these requirements, familiarity with the guidance as it exists and remaining up-to-date with changes as they emerge.