University subsidiaries - are your arrangements compliant with charity law?

Why use a subsidiary?  

As institutions at the forefront of innovation and in a sector responding to financial pressures, universities are undertaking an increasingly diverse range of activities. A key compliance question for any new venture by a charitable university will often be: Can the activities be undertaken by the university itself within the scope of its charitable objects?  

This is an important question for a university's compliance with charity law (including the duty to apply assets and other resources only to advance its objects), which is ultimately capable of being a regulatory concern to the Office for Students as principal regulator.  It is also important to the corporation tax treatment of any income generated from the activities - this will normally be inextricably linked to an analysis of the charity law position and similar considerations will apply.

Most charitable universities are established for purposes framed around the advancement of education and research for the public benefit. Some ventures will clearly fall outside these objects (e.g. many arrangements involving the letting of university facilities for profit or the provision of consultancy). Other cases are not so clear cut, with some particular complexities around, for example, the public benefit of some research collaborations and contract research (as our earlier article explains).  

Structuring activities through a wholly-owned non-charitable subsidiary is the usual approach for charities, including charitable universities, to mitigate adverse charity law and tax implications associated with "non-primary purpose trading" (trading activities not directly or indirectly furthering a charity's objects, other than by generating profit). In line with Charity Commission guidance, a subsidiary must be used where non-primary purpose activities involve a "significant risk" to the charity's assets (the risk being that the income generated doesn't cover the corresponding expenditure, so that any shortfall has to be financed by the charity out of its own assets). 

Funding and resourcing a subsidiary

Some university subsidiaries operate on a significant scale with their own assets and staff teams. However, many require access to resources from their parent university in order to be able to operate. These might include:

• The time and expertise of university staff involved directly in delivering the relevant activities, as well as professional services for operational support.
• Access to university premises and facilities (including IT systems).
• Data and intellectual property rights.
• Working capital funding.
• Careful structuring of the provision of funding and other resources is needed to ensure compliance with charity law and guidance published by the Charity Commission and HMRC Charities on trading by charities. The guidance published by the British Universities Finance Directors Group (BUFDG) on the corporation tax treatment of universities (which has been agreed with HMRC) is also a very helpful sector-specific resource.

The rules are detailed and universities will need to refer directly to the guidance, but the key points are:

• Funding: Any funding provided to a subsidiary (whether by way of loan or a subscription for shares) must be justified by the university as an investment made for the benefit of the university, in line with the duties which apply to investment by charities. This requires an objective assessment of the subsidiary's trading prospects, financial viability and ability to provide a return on the investment, based upon a business plan, cash flow forecasts and profit projections. Loans must be on commercial terms, with a commercial rate of interest and clear repayment provisions, with consideration given to taking security. There are potential tax consequences of getting this wrong: an investment which cannot be justified as for the university's benefit could lead to a loss of tax relief.

Resourcing: Resourcing the subsidiary must not involve any element of gift or subsidy from the university. This is a requirement of charity law but subsidy control rules may be relevant too. This means appropriate charges must be made to the subsidiary for its use of university staff, premises and other resources. Charges must in fact be paid within a reasonable time to avoid indirectly subsidising the subsidiary via long term finance. Payment terms must be set out in a contractual arm's length agreement with consideration given to both the basis of re-charging and whether to structure as a cost-sharing arrangement or a contract for the provision of services (or an arrangement with elements of both).

Other tricky areas for charity law compliance

Beyond the initial set up and ongoing resourcing of a subsidiary, other issues may arise which raise questions of charity law compliance. These might include: 

• Can the university guarantee the liabilities/obligations of a subsidiary? For example, where the subsidiary is looking to access third party sources of working capital or a "performance guarantee" is required in relation to a significant contract the subsidiary may be entering into.
• What should a university do if a subsidiary is in financial difficulty?
• Can a loan to a subsidiary ever be written off?

These are not easy questions from a charity law perspective. Much will depend on the nature of the subsidiary's activities and whether they are activities the university could itself carry on. Generally, where a subsidiary is doing things a university could itself do as education or research, there may be greater scope to support and deal with a subsidiary otherwise than on arm's length terms. For example, universities may look to justify initial or ongoing investment as a "social investment" which directly furthers the university's objects as well as generating a financial return. The key point is that the university must always take decisions in its own best interests. Specialist advice is likely to be needed on these points which considers not only the charity law position but also the tax treatment.

Governance considerations 

• What level of control should the university exercise over its subsidiaries? A subsidiary's autonomy and agility of operations may be a key advantage of structuring activities through it. However, the university's shareholding is a charitable asset and any financial or governance failures could harm the university and its reputation. A parent university will therefore have a clear interest in ensuring there is good governance and strong financial management across its group, with a variety of constitutional and contractual mechanisms available to achieve that.
• Does the subsidiary need independent directors? How are conflicts managed? The Charity Commission's guidance says that, in line with good governance, there should be at least one independent member of the subsidiary's board - someone who is neither an employee nor board member of the university. Part of their role is to support with the management of conflicts between the interests of the university and those of the subsidiary. Finding "external" directors for some kinds of subsidiary can be challenging in practice, but the key point - and legal requirement - is that conflicts are in fact managed in relation to arrangements between the parent university and the subsidiary.

This article is part of a series looking at the practical implications for universities and their operations of having charitable status. Charity law can impact on a wide range of university projects, activities and decisions in ways that are not always obvious and sometimes overlooked. Drawing on our own experience of supporting universities with charity law and governance aspects of key strategic projects, income diversification and trading, research and innovation, spin-outs, investment, fundraising and much more, our aim is to prompt the question "Do we need to be thinking about charity law here?"

While this article looks at charity law only, there are a range of other legal, regulatory and governance considerations associated with establishing and operating university subsidiaries including corporate considerations around the choice of legal vehicle; procurement and subsidy control; tax and VAT; employment law; property; intellectual property and data protection.  

For more information or advice, please contact Rachel Tonkin or Morag Roddick in our Higher Education team.