Sledgehammers and nuts
December 2008
Andrew Robinson outlines the latest rules on dealing with substantial donors...
If the substantial donor legislation, which was introduced in 2006,[1] was a sledgehammer to crack a nut, the review of the rules which HM Revenue & Customs launched earlier this year would seem to be an attempt to put at least some of the pieces of the nut back together again. There must be lessons that can be learned from all of this.
Why were the substantial donor rules introduced?
It‘s worth starting by reminding ourselves why the substantial donor rules were introduced in the first place. In the proverbial nutshell (prior to sledgehammer demolition), some wealthy individuals were in effect setting up their own charities to which they transferred cash or other assets, and claimed tax relief for the gifts to their charity. The charity would then pass value back to the individual, such as by way of a loan, so that the individual was left in no worse position than he or she was at the outset. Actually, the individual would be in a much better position as a result of the tax relief claimed in relation to the gift to the charity.
Clearly, this sort of arrangement is not what the charity tax reliefs are intended to encourage. It seems to have been big business. During the Standing Committee debates on the Finance Bill 2006 it was stated that £60m of reliefs were believed to have been accessed via this mechanism. The then Paymaster General, Dawn Primarolo, was clearly unimpressed, calling it ‘scandalous and despicable’.
The rules
The substantial donor rules seek to prevent the arrangements outlined above by charging the charity to corporation tax on an amount of income equal to the value passed to its substantial donors. So if a substantial donor receives, say, a loan from the charity, the charity would be charged to corporation tax on an amount of income equal to the loan.
Very broadly, a substantial donor is a person (which could be an individual or a company) who has claimed tax relief in relation to gifts to a charity, and the value of the gifts exceed £25,000 over a period of 12 months, or £100,000 over a period of six years.
One of the many problems with the substantial donor rules is that they are virtually impossible for most charities to implement. For example:
- When calculating the value of gifts received from a particular person for the purpose of working out whether that person is a substantial donor, the charity is required to take into account the value of gifts received from ‘connected persons’. These include spouses, relatives (including relatives of the spouses), spouses of the relatives, and persons with whom the individual is in partnership (and their spouses). So an individual, for example, could be a substantial donor in relation to a charity if their sister-in-law makes a gift to the charity – the individual might not have actually made a gift themselves. Without knowing the family tree and business interests of each donor, it is hard to see how a charity can possibly know for certain who its substantial donors are.
- A person may be a substantial donor in relation to a charity before he or she has even made a gift to the charity. For example, a person will be a substantial donor now, in relation to a charity with a 31 December year-end, if that person makes a donation of more than £100,000 to the charity in December 2014. Therefore, if the charity passes value to that person now, a charge to corporation tax will be triggered when that person makes the donation in 2014. How are charities meant to monitor this position? It would seem that they are required to keep records of value passed to anybody and everybody, just in case they become substantial donors at some point in the future.
- Owing to the way in which the substantial donor rules work, a single gift of £100,000 to a charity can result in the person being a substantial donor in relation to the charity for 18 years. That’s a long time for anybody to keep records!
A further problem with the rules is that they are so broad that they catch perfectly innocent transactions. For example:
- a charity could eventually be taxed on the value of dinners or concert tickets provided free of charge to wealthy individuals if those individuals make substantial donations to the charity at some point in the future;
- a school could be taxed on the value of scholarships or bursaries provided to a relative of a substantial donor;
- if a charity provides grants or other financial assistance to genuine beneficiaries, who happen to be related to a substantial donor, the charity could be taxed on the value of the financial assistance provided; and
- a charity could be subject to tax on the amount of remuneration paid to an employee of the charity, if the employee is related to a substantial donor of the charity.
Another problem with the substantial donor rules is that they have completely missed their target – they have crushed the wrong nut! As explained at the outset, the rules were introduced to prevent the avoidance of tax by wealthy individuals (i.e. substantial donors). Why, then, do the substantial donor rules impose onerous obligations and tax charges on charities, and not the substantial donors themselves? See also Kate Hand article, And another thing... where CFDG highlighted the problem prior to this year’s Budget.
More haste, less speed
These problems arise because the substantial donor rules were introduced in haste. They were announced as part of the Budget on 22 March 2006, and took effect from that date. They were enacted four months later, on 19 July 2006.
Clearly, the Government had got wind of aggressive tax avoidance arrangements, and wanted to stamp them out without delay.
What this meant was that there was no proper consultation on the issue and how it should be addressed, with the resultant sledgehammer smashing the wrong nut to smithereens through the introduction of draconian, unworkable legislation, with innocent charities having to pick up the pieces.
HMRC has said that these provisions are not intended to hamper legitimate activities of charities or their donors, and have made noises to the effect that it will take a reasonably common sense approach to the operation of the rules. This is all well and good, but enacting legislation which can only be interpreted through guidance from HMRC[2] is hardly the best way to operate a developed tax system. Charities need much more certainty that they will not be penalised under this legislation.
Consultation at last
To its credit, the Government has listened to the concerns of the charity sector, and in July this year it launched a review of the substantial donor rules.[3]
The consultation document issued by HMRC as part of this review recognises that a better balance needs to be struck between the need to deter the avoidance of tax and the need to enable charities to continue with their normal charitable activities with minimum administrative burden.
The consultation proposes various measures to achieve this. It seeks to reduce the number of transactions between a charity and its substantial donors which could be caught by the rules, and which would result in the charity being charged corporation tax. Under the proposed new rules, the following transactions would not be caught:
- the payment of remuneration to employees of charities, provided the remuneration is at a market rate;
- charitable grants made in the charity’s ordinary course of business; and
- payments made or benefits given by a charity to a substantial donor of less than £500.
In terms of identifying substantial donors, the proposals seek to assist charities by suggesting that the relevant thresholds might be increased so that a person will be a substantial donor if that person, or persons connected with him, makes gifts of more than £50,000 in a 12-month period, or £125,000 over a three-year period (currently £25,000 over 12 months or £100,000 over six years). In addition, the proposals suggest that gifts to the charity of less than £1,000 per annum might be ignored for the purpose of determining whether a person is a substantial donor.
Any changes that are made to the substantial donor rules will be backdated to 22 March 2006 – the date the rules originally took effect. So having well and truly cracked the nut, the Government is indeed trying to put some of it back together again and pretending that the sledgehammer incident had never happened.
Clearly, these proposed changes are a welcome step in the right direction. The proposals to take additional transactions by charities outside the scope of the substantial donor rules, so that they are no longer caught, is particularly good news, as is the proposal to backdate any changes to 22 March 2006.
As is always the case, however, the proposals could and should go further. Additional transactions by charities could be taken outside the scope of the substantial donor rules (for example, legitimate loans made by a charity on commercial terms to a person connected with a substantial donor would continue to be caught by the substantial donor rules, even following the proposed amendments). Also, the de minimis limit of £500 below which payments made by a charity will not be caught does not seem particularly generous (see also Ernese Skinner article, Balancing the books). The proposals also do nothing to address the requirement for charities to know the family history and business interests of all its donors in order to establish the total donations made by ‘connected persons‘.
Little benefit is likely to be gained from the proposal to increase the thresholds which must be exceeded before a person becomes a substantial donor (i.e. the increase in the aggregate value of gifts to £50,000 in a 12-month period, or £125,000 over a three-year period). Charities will still need to go through the process of identifying all gifts by each person (and connected person) to establish whether these limits have been reached. Similarly, the proposal to ignore gifts of less than £1,000 per annum is unlikely to yield much benefit for charities, as they will still need to keep track of individual gifts throughout the year in order to determine whether this limit has been exceeded.
More fundamentally, the consultation does nothing to address the issue that the substantial donor rules are aimed at the wrong target. It is the relatively few individuals who seek to abuse the tax breaks available to charities that should be affected by these rules, not every single charity that operates in the United Kingdom. One can’t help feeling that a better approach may be to step back and look at this issue afresh rather than repaper over the cracks.
The consultation closed on 7 October 2008. A summary of the responses to the consultation should be available on the HMRC website by the end of the year.
Learning points
Firstly, it is abundantly clear that the abuse of the tax reliefs that are available to the charity sector will not be tolerated by the Government. The reliefs are there for a specific purpose – to encourage charitable giving and to promote genuine charitable activity for the benefit of the public. The moment the tax reliefs are exploited, the Government can be expected to crack down on the abuse with a very heavy hand.
All those involved in the sector, from advisers to donors to charities themselves, must therefore play by both the letter and spirit of the legislation. The activities of a few, who seek to abuse the tax reliefs that are available, can all too easily result in a great deal of pain for everybody.
Secondly, the Government could certainly learn from this experience. It is a lesson in how not to introduce new legislation. The substantial donor rules in their current form are not targeted at the people who perpetrate the mischief that the rules are seeking to prevent. They impose obligations on all charities, when it is the actions of relatively few individuals that resulted in the rules being introduced. The rules are simply not workable in practice and, worst still, they can actively discourage charities from entering into perfectly acceptable charitable arrangements.
While hindsight is a wonderful thing, could the Government not have announced a consultation back in 2006 on proposed legislation aimed at tackling the immoral abuse of the tax reliefs and incentives that are available to the charity sector?
There is little doubt that the Government would have received the full co-oporation of the charity sector – indeed the Charity Directors Finance Group said at the time that it was essential that the charity brand is protected and not tainted by association with tax-avoidance schemes.
Surely, working together, the Government and the charity sector could have come up with more targeted, effective legislation that did not impose such onerous administrative obligations on innocent charities. It must be better to get it right first time, rather than rush through legislation only to have to revisit it two years later, and make changes that are backdated to when the legislation was first introduced.
The charity sector can take lessons from this experience too, though. Facilitating charitable activities is high on the Government’s agenda – the measures announced in Budget 2008 to help charities maximise the benefit of charitable giving is evidence of this. Charities have a collective voice, which the Government is prepared to listen to. The introduction of transitional relief for Gift Aid following the reduction of the basic rate of tax shows this to be the case. So those involved in the charity sector can and have played a part in the development of relevant tax legislation, and it must continue to do so if the substantial donor experience is to be avoided in the future.
Let’s make sure we crack the right nut next time – the first time around.
[1] Section 54 of the Finance Act 2006: www.opsi.gov.uk/ ACTS/acts2006/ ukpga_20060025_en_1
[3] Details in the ‘lapsed consultations’ area of www.hmrc.gov.uk/ consultations/index.htm
Author: Andrew Robinson
Andrew is a tax director with Grant Thornton UK LLP. He specialises in advising housing associations, universities, regulatory bodies, membership organisations as well as charities generally, covering issues such as maximising the availability of Gift Aid, non-primary purpose trading, the use of non-charitable subsidiary companies, mitigating tax on property disposals and housing regeneration projects.
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