The Best Interests of a Charity are not Always the Same as its Trading Subsidiary
As many charities are finding increasing pressure on their traditional sources of income, there is a need for charities to find new and innovative ways of funding the charity.
This can give rise to an increased amount of trading activities and the main reason a charity sets up a trading subsidiary is if these activities are non-primary purpose (i.e. the trading activity does not directly advance the charity’s charitable purposes) and in excess of the HMRC small trading exemptions. Trustees need to carefully consider whether to set up a trading subsidiary and how to manage this relationship between the charity they are ultimately responsible for and the trading subsidiary in a way that avoids conflict.
Setting up a Trading Subsidiary
As a charity trustee, the main consideration should always be ‘what is in the best interest of the charity?’ The creation of a trading subsidiary, in theory, shields the charity assets from the risks associated with trading, but care must be taken that the charity’s assets are not put at risk from the need to support the subsidiary. The Charity Regulator may open an investigation if they do not consider the support the charity is giving to the subsidiary to be in the best interests of the charity. Establishing and managing the relationship, responsibilities and transactions between the charity and subsidiary is key and there are several key points to consider:
There needs to be a clear line of responsibility to the charity for the trading subsidiary operations. The trading subsidiary should have its own separate board of directors and should include at least one person with experience of commercial activity. Whilst it is usual that there are some trustees/ directors in common, it is recommended that the charity has trustees who are not directors of the trading company and the trading company has directors who are not trustees of the charity. This helps trustees put the interest of the charity first, particularly where there may be conflict with what is best for the trading subsidiary. It can facilitate healthy debate between the trustees of the charity and the directors of the company to ensure conflicts are resolved in a way that is appropriate for all parties and it also eases separation if the trading subsidiary was to fail and can help mitigate the reputational risk of a failed subsidiary.
It is very common for charities and their trading subsidiaries to share resources, such as staff, premises and equipment. It is important where there are resources shared that the trading subsidiary pays a fair rate for the resources and there is a formal arrangement in place. For staff where payroll is paid by the parent charity, this can simply be recharged on an apportioned basis if they spend time working on both entities. The regulator has, in cases we are aware of, made clear that where the trading subsidiary has use of space in the charity’s building, there should be a formal lease agreement in place and rent should be charged at open market rate.
There are costs and time associated with setting up a trading subsidiary. The Charity Regulator would only expect a charity subsidiary to be set up after charity trustees have considered the risks of the trading subsidiary and that costs do not outweigh the benefits.
The Charity Regulator is likely to recognise that initially a trading subsidiary requires funding and support. However, it should always be kept in mind that the aim of the trading subsidiary is to generate income for the charity.
When a charity chooses to invest in a trading subsidiary, this is no different to an external investment made by the charity and should only be undertaken if there is expectation of a profit in the long term. Initial finance may be provided by the charity through issuing of share capital or a loan. It is critical if there is a loan that there should be a formal loan agreement in place between the entities. The loan should be on a commercial basis and include both appropriate repayment terms and a market level of interest charged. If the subsidiary manages to obtain external funding, the charity trustees need to consider the risk to their own assets if they are asked to provide a guarantee and if this is in the best interest of the charity.
Even with the best intentions and plans, not all trading subsidiaries succeed. If there are extended periods where the subsidiary is operating at a loss, charities should consider the best action for the interest of the charity. It is important to remember that the reason the trading subsidiary was set up was to both protect the charity’s assets in the trading venture and generate additional funds for the charity. In instances where the only reason the subsidiary is surviving is because the charity is heavily supporting it and getting no benefits, this can cause issues with the regulator as there is a lack of evidence to demonstrate keeping the subsidiary open is in the best interests of the charity and that trustees are sufficiently fulfilling their legal duties with care and diligence. It is vital in these instances that charity trustees focus on minimising any losses to the charity.
There can be conflict between what is best for the charity and what is best for its trading subsidiary. Charity trustees have a legal duty to act in the interest of the charity and we have seen instances where the Charity Regulator has opened investigations where this has not been clear. The trustees in these cases have had to spend time dealing with the enquiry and ultimately putting in place arrangements such as commercial rent, formal and commercial loan agreements and separation of the board which should have been in place. Therefore, it is better to set up on a proper basis in the first place!
What to do to Avoid Harmful Conflict:
- Take careful consideration prior to setting up a subsidiary to ensure there is enough assurance to demonstrate that the rewards and benefits outweigh the risks and costs;
- Appoint a different board of trustees to board of directors;
- Put agreements in place for any shared resources at market rate;
- Ensure loans provided by the charity are under a loan agreement with repayment terms and market rate interest;
- Regularly scrutinise and consider the trading subsidiaries’ results.
If you would like to discuss this in further detail then please contact our Not for Profit team on 01772 821 021.
This article is from our Using Conflict as a Catalyst for Change report, a guide to help you embrace, manage and mitigate conflict within your charity.