A better regulatory framework?
Reza Motazedi reviews the tax and financial reporting implications of converting to new charitable incorporated organisations
KEY POINTS
- The CIO provides a simpler incorporation option for charities
- There are two types – ‘foundation’ and ‘association’
- Consider HMRC notification issues
- Proportionate approach to accounting requirements likely
- Likely to be of more use to the ‘smaller’ charities
For the first time in 400 years there is now a legal structure designed exclusively for registered charities. The charitable incorporated organisation (CIO) is intended to provide charities with a practical and effective corporate vehicle and is expected to become available once Parliament approves the final CIO regulations. The Charity Commission has recently published its CIO guidance and model constitutions so there is now an opportunity for people to review whether the CIO will work for them.1
As charity trustees become increasingly concerned about the personal financial risks associated with running charities there has been a growing trend towards the use of limited liability companies to try and mitigate personal liability not only for the trustees, but also for any members that a charity may have.
A simpler framework
Charities that have adopted the limited company structure have, however, discovered that the legal framework within which companies operate was never intended for charitable organisations, and there is a constant tension between the regulations which charities face under the Charities Acts, and the obligations which are imposed on companies by company law.
Under these two legal regimes charities are required to file separate sets of annual returns and accounts with the Charity Commission and Companies House. Although this dual regulatory burden has generally not proved problematic for larger charities, for many smaller charities it has been cumbersome.
The CIO is intended to provide the benefits of incorporation to registered charities within a more attractive legal framework that is regulated purely by the Charity Commission.
Many charities that have held back from incorporating will now wish to adopt the CIO structure in order to take advantage of the benefits of incorporation, while some existing incorporated charities will also wish to become CIOs in order to simplify their regulation and save cost.
Types of CIO
A CIO is an incorporated body with a constitution and a legal identity that is quite separate from its trustees or members, but it is not a company and it is therefore not (on the face of it at least) subject to UK company law or EU regulations affecting companies.CIOs come in two ‘types’:
- ‘foundation’ CIOs where the same people are both the trustees and members; and
- ‘association’ CIOs which may have a body of members which are quite distinct from the trustees.
Although CIOs are a new type of legal entity the tax rules that will apply to them are the same as apply to charities in general, and therefore this commentary is of general application to all charities. However, given the ability to convert from an existing charity structure (for example, limited company, unincorporated association or trust) into a CIO, we first need to consider the direct tax and VAT consequences of conversion.
For existing charitable companies limited by guarantee, the process of converting to a CIO should be relatively straightforward, although the detailed regulations in this area are awaited. However, it should not be done without professional advice. It is envisaged that a charitable company converting to CIO status will continue in existence and simply re-register under a different part of charity legislation.
It is important to note, however, that unlike a company, the CIO will have no way to offer a debenture or secured charge over its assets as a security for any borrowing. This means that if a CIO wishes to borrow money the individual trustees may be called upon to give a personal guarantee, which defeats the purpose of operating through an incorpoarated entity. As a result, the Charity Commission has already acknowledged that larger charities are likely to continue to use the limited company structure.
General tax issues
A deemed transfer of assets may take place for VAT purposes and although existing registrations with HMRC for corporation tax and Gift Aid claims should remain the same, a new VAT registration may be required.
If you are converting an unincorporated association to a CIO, HMRC will need to be informed for direct tax purposes and a new VAT registration obtained. At present HMRC becomes aware of any new incorporated company as it is automatically informed by Companies House. CIOs do not need to register at Companies House so it is anticipated that there will at some point be a mechanism in place between the Charity Commission and HMRC to inform HMRC of new CIOs. Otherwise the CIO will not be prompted to inform HMRC of its existence and activities. Trustees will need to make sure that in any event they do not overlook this.
Perhaps more importantly, the new CIO will have to re-register for Gift Aid. Hopefully re-registration will be quick to ensure no gap in Gift Aid recovery from HMRC.
The conversion of an unincorporated charity to a CIO should attract so-called ‘incorporation reliefs’. Charities do not typically pay tax on capital gains (which could potentially arise on incorporation, as strictly transactions to transfer assets to a corporate body should be effected at market value). There should therefore be no additional tax arising as a result of transferring an unincorporated charity’s activities and assets to a new CIO which has compatible charitable objects.
If an existing charitable company is converted to a CIO there is no actual transfer of assets involved so this similarly should not result in the crystallisation of a tax liability in respect of any chargeable gains.
If a charity holds any assets which are not applied for charitable purposes, then the situation may be slightly more complex. However, the taxes acts specifically provide relief for other unincorporated activities which incorporate.
Charitable companies
A charitable company may be carrying on one or more taxable trades in addition to its normal non-taxable charitable activities, and so consideration will need to be given to the tax effect of transferring these to the new CIO. The general tax rules for charitable companies will similarly apply to CIOs.
Exemptions and reliefs
There are some very specific exemptions and reliefs from tax for all charities which will also be applicable to CIOs. Where the trade is exercised partly in the course of carrying out a primary purpose of the charity and partly otherwise, each part is treated as a separate trade. Similarly, where the work is carried out partly – but not mainly – by beneficiaries, the part carried on by the beneficiaries and the other part are treated as separate trades. Expenses and receipts are to be apportioned between the separate trades. Any profit arising from the non-exempt trade is then taxable, subject to the further exemptions outlined below.
Turnover limits for the small trading tax exemption
Most charities could be expected to carry out activities of a trading nature which do not meet the work done or the primary purpose tests. However, provided the income is applied for the purposes of the charity and does not exceed certain limits, such income will not be taxable.In this context it is the charity’s annual turnover which is relevant (see Figure 1).
Partial exemption is possible even where the above limits are exceeded. The qualifying and non-qualifying activities are treated as two separate trades and exemption granted on the profits of the notional qualifying trade, the income and expenditure of the whole trade being apportioned between the two notional trades on a reasonable basis.
Trades that do not qualify for exemption
It can be fairly difficult for the exemption regarding trading income to apply, and a large number of charities will not meet the specific exemptions.
HMRC actively promotes one method of tax avoidance where a non-qualifying trade is carried on by a non-charitable company which then donates its profits from that trade to the charity via a gift aid donation or deed of covenant. The donation is deductible from its taxable profits and therefore effective tax exemption is achieved.
Under the CIO regime, it will therefore be possible for a similar structure to be used so that a non-charitable company may donate this income to the CIO which is then exempt from tax on the donated income. This is best achieved by the non-charitable company being a subsidiary of the charity (CIO). The subsidiary company then has nine months following its year end to make the donation of profits and obtain the deduction. Otherwise, the donation will have to be made in the accounting year, and that could cause practical difficulties.
Gift Aid
The detailed rules regarding Gift Aid claims will also operate under the CIO regime.
Charities (and CIOs) receiving Gift Aid donations can reclaim basic rate tax on the donations, provided they were in receipt of a valid certificate from the donor and can demonstrate a clear audit trail linking the donation to the donor.
In order to operate the Gift Aid scheme, charities need to keep detailed records to show how much has been received from each donor who has made a declaration and sufficient records to show that their tax reclaims are accurate.
Since 1 April 2010, the window available to make Gift Aid claims has reduced from six years to four years. This has largely gone unpublicised, and the time limit will also apply to CIOs.It is recommended that before a charity transfers its activities to a CIO, it ensures that its Gift Aid claims are brought up to date.
VAT considerations
Depending on whether the conversion to a CIO constitutes the creation of a separate legal entity, a new VAT registration is likely to be required as the conversion is treated as the transfer of a business as a going concern, otherwise known as a ‘TOGC’. There will be some administrative issues to consider, in relation to the VAT registration, particularly if a VAT group registration is required and there are any property assets transferred. It will be important to avoid administrative errors that may prove to be costly.
VAT registration and property interests
Provided the CIO has taxable business activities over the VAT registration threshold,2 it will have to apply for VAT registration.
It will be particularly important here to consider any property interests that may be transferred to the CIO. These should be capable of being transferred without any VAT issues, but it will be important to consider if there are any options to tax in place, whereby the charity has made an election to charge VAT on its properties and notified HMRC.
Care should be taken with any opted to tax property interests to ensure, these will qualify as a part of the transfer of the deemed business to the CIO. The CIO will be required to provide a specific VAT anti-avoidance statement that it will not use the opted property for any exempt activities to avoid a VAT charge arising on the transfer of the opted to tax property interest by the transferee (the previous entity). Also the new CIO, will, where there is an option to tax in place, be required to notify to HMRC prior to conversion of its own option to tax; otherwise an irrecoverable VAT charge at 20 per cent of the total value of the opted properties could be triggered.
Where appropriate, if the property interests are within the VAT Capital Goods Scheme, then the transferor (the newly created CIO) will take over responsibility for any unexpired period for the Capital Goods Scheme (Notice 706/2 explaining what this is can be downloaded from the HMRC website). So the new CIO will be required to retain the details of the VAT previously recovered in case there will be a future requirement to repay any of the VAT previously recovered by the previous existing entity. Professional VAT advice must be obtained where any property interest will flow with the conversion to a CIO to ensure any major VAT issues are averted.
VAT grouping
At this stage we are not aware of any consideration by HMRC in respect of possible trading subsidiaries and whether the new CIO can or will be required to set up trading subsidiaries.
The VAT grouping rules allow a body corporate to form a single VAT group registration with its trading subsidiaries. Many charities benefit from forming a VAT group registration to enable increased VAT recovery and simplified VAT administration of submitting a single VAT return for all trading businesses. It is quite likely that a CIO will qualify for VAT grouping purposes but HMRC may require persuading that the CIO and associated trading entities should qualify for this beneficial structure.
It would appear reasonable to assume that some form of branch or further CIO subsidiary may be required.
Reports and accounts
The current proposal is for all CIOs to submit annual accounts and reports to the Charity Commission.
The most important point outlined in the initial consultation paper issued by the Cabinet Office/Charity Commission relating to the accounting provision was the decision on the right accounting framework for CIOs.
The issue arose as company and non-company charities have different accounting frameworks; smaller unincorporated charities can opt to prepare accounts on a receipts and payments basis rather than an accruals basis. However all companies must prepare accrual accounts.
After receiving responses to the consultation, the majority favoured a proportionate approach to the accounting requirements of CIOs based on the level of the charity’s income. In other words, up to a level of income, the CIOs could prepare accounts on the receipts and payments basis – thereafter on accruals basis. This approach has now been adopted. However, there is still a question to be discussed – the current level of preparation of accrual accounts for unincorporated charities is £250,000 – should this remain unchanged for CIOs? It is the government’s intention to keep this level initially but assess its effectiveness or otherwise after a review period which has yet to be determined.
The other important issue is the accounts on conversion to a CIO. As it stands, regulations make it clear that it would not be appropriate to grant an application for conversion where relevant documents for complete financial years have not been filed. Where a CIO is registered, following conversion, the trustees must send the conversion financial statements to the Charity Commission within six weeks of conversion. In addition, the CIO trustees will be required to submit a closing financial year report and return to the Charity Commission.
The policy aim is to ensure continuity of accounting and reporting for organisations that use the conversion process to become a CIO. Immediately prior to conversion, the trustees of a charitable company are required to comply with the Companies Act – from the date of conversion it is charity law that will apply to CIOs. However, the government is considering several options that may enable a converting entity to continue its annual reporting cycle without the need for a conversion statement.
1. See: www.charitiesdirect.com/caritas-magazine/the-cio-has-landed-new-options-for-incorporation-954.html
2. www.hmrc.gov.uk/vat/forms-rates/ rates/rates-thresholds.htm
Author: Reza Motazedi
Reza Motazedi is the head of charities and not for profit group at Deloitte.
He has specialised in the sector for 20 years and assisted clients across a wide range of financial and strategic issues including restructuring, mergers and governance.
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