HMRC has announced a 12-week open consultation on a number of key charity taxation rules, with a stated aim of tackling non-compliance and protecting the integrity of the sector.
The consultation identifies four areas of tax compliance in which the rules are currently “not working as intended”, gives examples of issues which arise in relation to each area, and makes proposals for reform in order to tackle abusive behaviour.
This is an early indication of possible reform and at this point HMRC is seeking views on policy design and potential alternatives before consulting on specific proposals. It is likely, therefore, that there will be some scope to influence HMRC’s thinking on the shape any reform ultimately takes.
HMRC has signalled that it intends to use feedback from the consultation to make proportionate legislative changes, so some adjustment of the rules in these areas seems likely.
- Generally speaking, the thrust of the consultation is towards making HMRC’s compliance and enforcement role easier. Potential downsides for the sector include a reduction in certainty for charities in key areas, and an increased need for effective decision-making and record-keeping as more decisions become open to review.
- For the small number of charities which fail to comply with their filing and reporting obligations the prospect of targeted sanctions is raised, although the need for a proportionate approach is recognised.
- Aspects of the proposals regarding the tainted donations rules may give rise to a lack of clarity as to whether arrangements could be caught by the revised rules and / or challenged by HMRC, with implications for donor confidence.
Which areas are under review?
The areas covered by in the consultation are as follows:
- The approved charitable investment rules
- The non-charitable expenditure rules
- The rules on filing tax returns and making payments to HMRC
- The tainted charity donations rules
What’s the issue?
Approved charitable investments
HMRC is concerned that the difference in treatment between different “types” of investment means that certain types of investment are not open to scrutiny where appropriate.
Income and corporation tax legislation currently lists twelve types of investment that are accepted as “approved charitable investments” for tax purposes.
Types 1-11 are automatically approved by HMRC and as such are exempt from rules on non-charitable expenditure. So-called “Type 12” investments (essentially, any investment which does not fall within Types 1-11, including investment loans) are subject to the requirement that an officer of HMRC must be satisfied, on a claim, that the investment is made for the benefit of the charity (rather than anyone else) and not for the avoidance of tax (whether by the charity or any other person).
HMRC suggests that in fact there are certain investments which fall into Types 1-11 (for example, certain types of investment in property) which should not automatically be waved through, and in relation to which charities should be prepared to show why they are for the benefit of the charity and not for the avoidance of tax. It therefore proposes that the Type 12 test should apply equally to Types 1-11. While it is not proposed that charities would need to make a claim in respect of Type 1-11 investments, where HMRC has concerns, charities would be expected to justify any investment by reference to this test. In effect, charities would need to be able to show that they had considered the Type 12 test in relation to all their investment activity. While this may be part and parcel of good decision-making in relation to more unusual investments (where a charity can be reasonably certain that it has considered any broader ramifications), compliance may be harder to evidence where, for example, investment is delegated to a third-party manager.
On the basis that significantly more investment decisions, and the thinking behind them, may become open to review by HMRC, charities are likely to need to consider how those decisions are made and the length of time for which records of such decisions should be retained.
HMRC is concerned that the nature of these rules is such that full recovery of tax which is payable in connection with non-charitable expenditure is not always possible.
When a charity incurs non-charitable expenditure (ie expenditure that is not in furtherance of its purposes, but also where relevant rules have, potentially inadvertently, not been complied with, such as rules for overseas payments and charitable investments) it loses tax exemption on an equivalent amount of its income and a tax charge is raised against its "attributable income and gains". This definition includes many but not all forms of income and, for example, excludes legacy income.
In some cases, the definition of “attributable income and gains” is insufficiently broad to permit full recovery of the tax which is due in connection with non-charitable expenditure. HMRC therefore suggests that this definition could be expanded, and also that its ability to reach back into earlier tax years could be extended beyond the current six-year period.
Charities are likely to be concerned by the prospect of any changes which would enable HMRC to claw back greater amounts of tax, particularly where incurring non-charitable expenditure may have been inadvertent. The proposals again raise the prospect of charities needing to retain records for longer periods of time and extend the period during which charities may be obliged to regard their tax affairs as open to review by HMRC.
Filing and payment obligations
HMRC is concerned that charities which fail to submit a tax return when requested to do so can still claim reliefs such as Gift Aid even if it later emerges that they do not qualify.
The consultation reminds charities that they should file annual tax returns to HMRC, both to confirm that their tax affairs are in order and to enable HMRC to monitor activities in the sector. In practice, however, many charities are not required to file a return annually.
According to HMRC, some charities are failing to meet their reporting and filing obligations when a notice to file has been issued and continue to claim reliefs while in default. HMRC takes the view that this is unfair on the majority of charities which do comply with their obligations, and puts the Exchequer at risk of paying out Gift Aid, or giving reliefs, to charities that do not qualify for them. The consultation therefore proposes withholding Gift Aid payments and disapplying other reliefs for defaulting charities, while acknowledging that any sanction should be “carefully targeted” and accompanied by appropriate guidance to help educate the sector about its obligations.
The availability of a broad range of tax reliefs underpins the operating model of many charities. The possibility of having these suspended is therefore significant. While some form of sanction for deliberate or reckless non-compliance does not seem unreasonable (see for example the Charity Commission’s approach to so-called “double-defaulters”), it remains to be seen how this would be put into practice. Ensuring that any concrete proposals are both appropriately targeted and proportionate to the scale of the problem will clearly be key.
The tainted charity donations rules
HMRC has found the tainted donations rules to be overly complex to apply to certain types of abusive behaviour, particularly due to the “purpose test” element of the rules.
The tainted donations rules are anti-avoidance measures which aim to deter the abuse of tax reliefs through charitable giving. In essence, they target situations in which:
- A donation is made to a charity and connected “arrangements” are entered into by the donor (Condition A), or
- The / a “main purpose” of entering into the arrangements is for the donor to receive a financial advantage (directly or indirectly) from the charity (Condition B).
A third condition excludes qualifying trading companies and relevant housing providers from the scope of the rules.
The consultation highlights circular arrangements whereby funds are donated to a charity, attract tax relief, and are then passed back to the donor or a party which is connected to or controlled by the donor. Notably, both the examples cited in the consultation concern scenarios where the “arrangement” involves the charity investing the donation: either in providing loan finance to the donor or a connected person, or in making an equity investment in an entity controlled by the donor.
The consultation acknowledges that investment can be a legitimate way for charities to generate additional income on excess funds, but notes that in some cases a donation may be made solely to claim relief, with little "real" benefit to the charity. Such arrangements may well also fall foul of the rules on approved charitable investments (see above) and / or the Gift Aid rules; for example, the requirement that a gift is not part of an arrangement for the charity to acquire property (eg shares) from the donor or a connected person. In these cases, much will turn on the facts. Indeed, much of the complexity which has been identified by HMRC appears to stem from applying Condition B (the purpose test) which is likely to be fact-sensitive. Unsurprisingly, the proposals in this area are largely concerned with removing or modifying Condition B, or replacing the rules entirely.
The focus on investment-related “arrangements” suggests that they may have been a particular area of regulatory interest for HMRC (see for example Reb Moishe Foundation v Revenue & Customs (2020) UKFTT 303, on which we have previously commented). As such, it is a reminder to charities to ensure that they give careful consideration not only to the tainted donations rules but also to the rules on approved charitable investments and the general requirements of the Gift Aid regime.
Charities will also wish to consider whether proposals for reform in this area, particularly the proposal simply to remove Condition B, risk creating a chilling effect amongst donors due to a lack of clarity around whether an “arrangement” may be caught by the revised rules and / or challenged by HMRC.
The consultation closes on 20 July 2023. If you have any observations on the proposals that you would like to share with us, please do get in touch with Laetitia Ransley or your usual contact at the firm.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, June 2023