Investing for charities - the tax dimension

Charities choose their investments carefully for a variety of reasons. The trustees’ primary concern will be to exercise their duty of care in making use of the charity’s assets to best serve its charitable objects. They will develop investment and risk management policies, to guide themselves and others who invest on their behalf. Increasingly, charities are taking public perception and ethics into account. But what about tax? The effect of tax law on the choice of an investment for a charity is often overlooked and can have a significant impact on the suitability of an investment for a charity.

What does the tax law say?

A UK charity qualifies for tax exemptions on most income and gains. However, these exemptions are restricted if a charity incurs ‘non-charitable expenditure’. Where a charity has exemptions restricted, this can result in a tax liability for the charity. ‘Non-charitable expenditure’ is expenditure which is not incurred exclusively for charitable purposes and includes investments or loans that are not classified as ‘Approved’.

What are Approved Charitable Investments?

Approved Charitable Investments are listed in tax legislation. You will find a useful summary in HMRC’s Guidance.The list is extensive and, with the exception of shares in an unlisted company, includes most ‘plain vanilla’ investments such as securities, gilts, cash deposits, units in a unit trust or common investment fund and real estate (save where this is held as security for a debt).

If the investment in question is not listed, it may qualify under the final catch-all category (Type 12). This category comprises loans or other investments which meet three criteria. They must be made for the benefit of the charity, they must be approved by HMRC and they must not be made for tax avoidance reasons.

When assessing a Type 12 investment, consider the following:

1. It is not possible to obtain clearance from HMRC in advance. The charity must invest first and obtain HMRC’s approval afterwards. This is a drawback for trustees seeking certainty. Charities which submit tax returns have the opportunity to declare their Type 12 investments there. For charities which do not submit returns a separate claim is required. In practice, most charities do not request approval and it seems that HMRC will not argue that an investment is not a Type 12 investment simply because no claim has been made.
   
   
2. Where the investment is a loan, it may yet qualify in its own right as an ‘Approved Charitable Loan’ (discussed below).
   
   
3. The charity must determine whether the investment is ‘for the benefit of the charity’. This is by no means an exact science and the particular circumstances of the investment, including the process by which it was chosen, are key.

What are Approved Charitable Loans?

If a loan is not an investment it will be an Approved Charitable Loan if it is:

1. a loan made to another charity for charitable purposes only
   
   
2. a loan to a beneficiary of the charity, and made in the course of carrying out the purposes of the charity, and
   
   
3. money placed in a current account at a bank (other than as part of an arrangement under which a loan is made by a bank to some other person).

Once again there is a sweep up category which includes ‘any other loan made for the benefit of the charitable company/trust, and not for the avoidance of tax.’

HMRC’s approach

In order to assess whether a given investment falls into the catch-all category, the vital consideration is the meaning of the phrase ‘for the benefit of the charity’. To assist charities, HMRC has published guidance on this concept. The guidance is useful in some areas and less so in others.

The position is clear with respect to loans to subsidiary trading companies which are made as an investment. The guidance states that HMRC will normally accept that a loan is for the financial benefit of the charity where the loan:

1. carries a commercial rate of interest which is paid and actively pursued
   
   
2. is adequately secured, and
   
   
3. is made under a formal written agreement which includes reasonable repayment terms.

HMRC recognise that the subsidiary may not be in a position to provide ‘normal’ security for the loan. If they investigate, they say they may require sight of the ‘business plans, cash-flow forecasts and other business projections’ which informed the decision to make the advance, but they do not specify what those documents should demonstrate. 

Recently, the guidance was updated to take into account so-called ‘mixed motive investments. Before this, HMRC viewed Approved Charitable Investments and Loans in a binary way. Approved Charitable Investments or Loans had to be uniquely either: for the ‘financial benefit’ of the charity (ie generate income or gains to enable the charity to carry out its objects), or for the ‘charitable benefit’ of the charity (ie funds used to carry out its charitable objects). HMRC now recognises that this rigid distinction is no longer appropriate and that charities need greater flexibility in making investment decisions. Provided the trustees have made a considered investment decision taking ‘properly qualified, and preferably independent, advice’ HMRC accept that a broader view can be taken as to how the charity benefits. Each case will be viewed on its own facts. The guidance states:

“For example, a commercial investment might yield a highly advantageous return for the charity, but be so contrary to the charity’s objects that it can’t be properly considered to be for the benefit of the charity. Conversely, an investment may yield a relatively modest rate of return, but may help directly carry out the charity’s objects. In such a case the trustees may be able to demonstrate that overall, there is an acceptable level of benefit to the charity for the amount invested.”

Finally, with regard to social investment HMRC endorses the Charity Commission guidance which recognises that a charity may legitimately wish to make sustainable or socially responsible investments, which benefit the charity in other ways, for example by having a positive impact on its supporters’ perceptions.

Investment funds

An interesting question arises in relation to investment funds. Must a charity investor ensure that the underlying investments of a fund in which it is invested are comprised entirely of Approved Charitable Investments? Ostensibly no, since the unit of a unit trust is itself an Approved investment (likewise for a share in a UK-incorporated Open-Ended Investment Company) and there should be no need to analyse the investments at the level beneath. Nonetheless, a grey area exists for funds in which the income and gains from the underlying assets arise directly to the fund’s investors, rather than to a manager or trustee who then makes distributions, as is the case with so-called Baker Trusts.

Another point of interest concerns charitable funds.  Where the fund is itself a charity (such as a common investment fund) its constitution may confine the investment powers to making investments which are immediately recognisable as Approved Charitable Investments. The extent to which a new-style Charitable Authorised Investment Fund (CAIF) need be concerned to do this is less obvious.

A CAIF is a hybrid entity because it is an FCA authorised investment fund which is registered as a charity. As such, CAIFs must comply with both the authorised fund regulations and charity law. For the reasons below, it is considered that CAIFs should, in practice, restrict themselves to Approved Charitable Investments and Loans.

1. CAIFs are registered with HMRC as charities rather than as collective investment schemes. Thus, from HMRC’s perspective, a CAIF is taxed by reference to charity tax provisions rather than those governing authorised investment funds.
   
   
2. As part of the registration of a CAIF the Charity Commission makes an order to bring the CAIF within the definition of ‘common investment fund’ thus deeming it for all purposes to be a charity.

In practice, this issue is unlikely to affect CAIFs which are established as UCITS (Undertakings for Collective Investment in Transferable Securities) schemes because the applicable investment restrictions mean that these funds are unlikely to invest in Type 12 investments. For a CAIF established as a QIS (Qualified Investor Scheme) this is potentially more of an issue.  

The trading risk

A further risk to the tax efficiency of an investment made by a charity is where participation in the investment is treated by the tax code as a trading activity.  Something which is described as an investment may, for tax purposes, be a participation in a trade. For anyone other than a tax specialist this is difficult to spot and is an area where some vigilance is needed.

This is because, unless specifically exempted, a charity’s trading profits are subject tax. Broadly speaking, the exemption only covers profits which arise from trading activities which contribute directly to the furtherance of charitable objects.

So, for example, a charity with a partnership interest in an investment partnership, which for tax purposes is considered to be trading, may itself be trading.  This is because each partner, by definition carries on the activity of the partnership. Private equity funds and hedge funds are examples of partnerships that may (depending on the specifics of the fund) be regarded as carrying on a trade such as long-term equity or debt trading. Similarly, participation in an underwriting market could be viewed as carrying on the trade of underwriting. Another common trading risk arises with respect to property development where there may be a deemed trade. The tax effect of making investments of these kinds needs to be considered carefully. A tax liability is not necessarily a reason to avoid an investment, but it can make it much less ‘suitable’ than other forms of investment, particularly if it leads to the charity having to go to the expense of making a tax return.

Foreign taxes

Finally, it is important to look beyond the UK and consider the international aspect of investment activity. Where a charity makes foreign investments, it should ascertain whether the jurisdictions in question have equivalent tax reliefs for UK charities. Some do – particularly (and subject to the impact of Brexit) in Europe. If there is no exemption, the investment return may be reduced by foreign taxes. This can be the case with transfer taxes and withholding taxes.

Conclusion

Charities and their investment advisers need to tread carefully when it comes to choosing investments which will preserve the all-important charitable tax reliefs. For anything out of the ordinary, professional tax advice can be money well spent.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, December 2018