Many higher education institutions (HEIs) establish and use subsidiary companies in the course of managing their day-to-day operations
Non-Primary Purpose Trading
In general, an HEI will establish a subsidiary company in order to carry out trading activities which do not directly further its charitable educational purposes (usually referred to as ‘non-primary purpose trading’).
Trading of this kind cannot generally be carried out by an HEI, without raising a risk for the HEI in relation to breach of the general duty under charity law, to ensure that its assets are only applied for its charitable purposes.
Common examples of non-primary purpose trading include:
- providing conference facilities to third parties, including hotel-type accommodation
- providing ‘closed’ courses for commercial companies
- carrying out research commissioned by commercial companies
There is a tax aspect to this which is important. Although trading activities which directly advance an HEI’s charitable objects and which generate a profit are exempt from corporation tax, the same is not true of profits generated by a non-primary purpose trade. While some non-primary purpose activities, which are essentially ancillary to primary purpose activities (eg selling educational material to students of the HEI) are exempt from tax, many are not and can therefore give rise to a liability to tax for the HEI.
- The solution to these issues is often to establish a wholly-owned subsidiary company to carry out the non-primary purpose trade.
- To the extent that the subsidiary makes profits from the trade, it will have a liability to corporation tax which can be reduced or eliminated by the trading subsidiary making a ‘gift aid’ donation to its parent HEI. The donation is free of tax in the hands of the HEI and is deductable by the subsidiary in calculating its tax liability.
- HM Revenue & Customs regard arrangements of this kind as acceptable recommended practice, notwithstanding that they may in some respects appear to be a rather artificial solution to the problems posed by non-primary purpose trading.
- HMRC’s approach is very clearly articulated in a guidance note on the corporation tax treatment of UK HEIs which is produced by the British Universities Finance Directors Group.
- It is worth noting that, although establishing a subsidiary will generally be driven by tax considerations, there may be some circumstances in which an HEI concludes that it would prefer to carry out a particular trading activity via a subsidiary in order to ensure that any liabilities and risks associated with the trade are ring-fenced from the HEI’s other assets and activities.
Arm's Length Relationship
- Many of the key issues in this area derive from the principle that, notwithstanding that it may be wholly-owned by an HEI, a subsidiary is treated for the purposes of charity and tax law in the same way as any other unconnected third party. In other words, it must deal with the subsidiary on an ‘arm’s length’ basis.
- In line with the arm’s length principle, an investment in a subsidiary must be treated by the HEI in the same way as it would treat any other proposed investments of the HEI’s assets.
- In practice, this means that the HEI should be able to conclude that an investment in the subsidiary is (whether by way of equity investment or loan) commercially sound. HMRC’s own guidance makes it clear that, depending on the size of the proposed investment, any decision to invest should generally be based upon a business plan, cash flow forecast, projection of future profits etc.
- There is an associated tax risk in relation to investments made by an HEI in a subsidiary. If not an ‘approved investment’ for tax purposes, the amount invested can give rise to a tax charge on the HEI as ‘non-charitable expenditure’. This emphasises the importance of ensuring that any funding provided to a subsidiary can be justified as an investment which is in the HEI’s best interests.
- Given that shareholders in any company rank behind its lenders, HMRC’s general approach (which is supported by Charity Commission guidance on charities generally) is that HEIs should look to lend money to a subsidiary rather than invest by way of equity. A loan of this kind would need to be charged at a proper rate of interest and include clear repayment terms. HMRC’s guidance also suggests that any loan should be secured, although taking security may obviously have no real value in the context of a start-up company which may have few fixed or other assets.
- The repayment of a loan by a subsidiary is not always straightforward from a tax perspective. This is because, while the payment of interest is a tax deductible item for the purposes of calculating taxable profits, repayment of the capital of a loan is not tax deductible and must be paid out of the trading subsidiary’s retained taxed profits.
- HMRC and the Charity Commission do acknowledge that there may be circumstances in which equity investment is to be preferred, particularly where investing in a trading subsidiary by way of a loan may have the effect of making it potentially insolvent.
- HEIs should be aware of the guidance published by the Institute of Chartered Accountants in England and Wales in relation to donations made by a subsidiary to its parent charity. The guidance highlights the issue that can arise in some cases where the amount of taxable profits being donated by the subsidiary to its parent, in order to eliminate a liability for corporation tax, exceeds the amounts that are available for distribution for company law purposes. This is often because certain expenses are disallowable for tax purposes, but are allowable for accounting purposes.
- Such donations are potentially unlawful under the Companies Act 2006 and can create an obligation on the parent HEI to repay the donations received. An unlawful distribution of this kind may also create negative reserves in the subsidiary, which will prevent it from making lawful (and tax efficient) distributions to the parent, with a potential impact on the way in which its financial standing is perceived by suppliers and others.
- There are some options in terms of rectifying the position, but these will, themselves, have potential implications in respect of both charity law and tax. While the Charity Commission has already revised its guidance in the light of the ICAEW guidance, HMRC are understood to still be considering the position. Further guidance is expected from them in due course.
- There are a range of other issues that an HEI will need to consider in establishing a relationship with a subsidiary. Apart from its governance arrangements, a subsidiary will often rely on the provision of services by the HEI, eg back office support or the services of the HEI’s employees. From the HEI’s perspective, the key point is that such arrangements are made on an arm’s length basis and that the HEI does not subsidise the cost of the subsidiary’s operations or receive payments for its services, which are in excess of the cost of providing them (potentially generating a taxable profit for the HEI itself).
- Subsidiary companies are an important part of the day-to-day operations of many HEIs. They can be very beneficial arrangements, but care needs to be taken in the way they are set up and managed. Regular reviews of how subsidiaries are operating should be part of an HEI’s risk review processes.
For more information, please contact Con Alexander on 0117 314 5214 or Emma-Jane Dalley on 0117 314 5465.
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This article was first published in the February issue of University Business.