A case in the First-tier Tribunal (Tax Chamber) has offered helpful clarification on the tests applied in assessing so-called “Type 12” investments by charities. While it may be a legislative “sweep-up” provision, Type 12 is often relied upon by charities to provide loan finance to trading subsidiaries and group companies, and to make certain types of social investment. The case also sheds light on the role of the Tribunal and its willingness to challenge decisions made by an officer of HMRC.
What was the case about?
The case concerned a donation and loan-back arrangement between a charity, the Reb Moishe Foundation (RMF) and a commercial property finance company called Gladstar. RMF had objects which were broadly connected to the Jewish faith and planned to build schools in Israel. One of the two elderly trustees of RMF was also the company secretary for (and from 2010 an employee of) Gladstar.
Between 2005 and 2007, Gladstar made donations to RMF of approx. £2.5 million; in 2006, RMF made a loan facility of £2 million available to Gladstar on terms which included payment of 24 per cent interest pa and repayment of the principal on demand or in the event of default. The purported reason for the loan-back was that RMF did not have an immediate use for the donated funds, one of its school-building programmes having been delayed, and that in the meantime it could make a substantial return in this way.
The Tribunal considered whether the loan to Gladstar qualified as an “approved charitable investment” for the purposes of sections 543 and 558 of the Income Tax Act 2007. It concluded, agreeing with the overall ruling of HMRC, that it was not, and that it was therefore non-charitable expenditure in respect of which tax relief was not available. The quantum of the alleged non-charitable expenditure for the relevant tax year was also considered but is not discussed here.
The statutory test
A Type 12 investment is defined as: “A loan or other investment as to which an officer of Revenue and Customs is satisfied, on a claim, that it is made for the benefit of the charitable trust and not for the avoidance of tax (whether by the trust or any other person).”
The judgement makes it clear that these two requirements should be considered separately and cumulatively: in this case, the Tribunal and HMRC determined that the first limb (benefiting the charity) was satisfied, but the second (not tax avoidance) was not.
Notably, the parallel Charity Commission regulatory inquiry took a different view on the first limb, concluding that the governance failures in relation to decision-making concerning the loan were sufficiently serious that it was not possible to be satisfied on this front: the trustees had failed to manage conflicts, take advice or articulate the rationale for the loan and were consequently unable to show that, at the time, the loan was made for the benefit of the charity. The difference of views highlights the different perspectives of the two regulators: while HMRC (and latterly the Tribunal) viewed the matter in terms of the financial benefit to RMF, the Commission regarded the governance of the decision as integral to the assessment.
One of HMRC’s principal objections was the circularity of the arrangement, such that some of the funds ended up back where they had started in a matter of days. The Tribunal also found that this arrangement possessed no obvious “commercial logic”.
Coupled with that, the transactions facilitated two tax deductions which benefited Gladstar: first, the Gift Aid on the donation; and second, the interest paid on the loan (which was a deductible business expense). This “double dip” led the Tribunal to conclude that the motivation for the donation and loan-back was in fact the avoidance of tax by Gladstar, being “any other person” for the purposes of the statutory test.
Too close for comfort?
Many features of the Charity Commission’s inquiry report will be familiar to charity practitioners: unmanaged conflicts of interest; failure to take professional advice; failure to keep adequate records of decisions; and the failure to identify and distinguish between the interests of two closely connected but fundamentally differing entities.
In particular, RMF failed to carry out adequate due diligence or an assessment of creditworthiness on Gladstar, or to take independent advice on the suitability of the investment – either when it was first made or when Gladstar later proposed dropping the interest rate to 10 per cent, due to adverse trading conditions following the 2008 financial crisis. In addition, non-payment of interest did not trigger prompt action for recovery, as it should have done had the arrangement been at arm’s length; indeed, the balance of the loan was only repaid following the issue of two orders of the Charity Commission to recover the funds.
A number of these failings arguably flowed from the close relationship between RMF and Gladstar, and a failure to view the arrangements purely in terms of RMF’s best interests. It was noted that one of the directors of Gladstar was “very much the controlling mind behind these transactions” and exerted considerable influence over one of the two trustees of RMF.
A charitable reading of the judgement might suggest that the individuals involved devised a scheme which delivered the best financial outcome for both RMF and Gladstar, but failed to identify and distinguish adequately between the charitable best interests of RMF and the commercial interests of Gladstar. The case thus highlights the importance of ensuring that trustees are able to take informed, independent decisions, and to consider the matter purely in terms of the charity’s best interests.
The Tribunal and HMRC
The Tribunal made it clear that its role in such cases is supervisory, and so it could only review the reasonableness of the HMRC officer’s decision. While it appeared that the officer in question had taken into account irrelevant information and had ignored relevant information, the Tribunal concluded that he was likely to have reached the same conclusion had this not been the case.
The Tribunal was clear that the statutory test was the one which should be applied, rather than compliance with HMRC’s published guidance, and criticised HMRC’s focus on that guidance rather than the legislation. This may be a useful marker for future challenges to officers’ decision-making: the guidance remains relevant in the sense that it is likely to inform how an officer applies the statutory test, but trustees may be able to point to the judgement if they feel that the officer has relied too heavily on the guidance and has not properly considered the underlying legislation.
That said, the Tribunal’s supervisory jurisdiction means that anyone whose challenge is unsuccessful is unlikely to be able to ask the Tribunal to consider the matter afresh, unless it can be shown that the officer failed to make a reasonable decision. Even if there are shortcomings in the decision-making, such as taking into account irrelevant factors or failing to take into account relevant factors, this will only be relevant if the Tribunal concludes that consideration of the correct factors would have resulted in a different decision.
Loans to trading companies: cause for concern?
Charities frequently offer loan finance to subsidiaries when they are set up in order to provide the subsidiary with working capital to begin trading; once the subsidiary becomes profitable, its distributable profits are gifted to the parent charity via corporate Gift Aid. In recent months, however, charities may have been asked to consider providing additional loan finance to their subsidiaries. Some of these subsidiaries may fairly recently have Gift Aided their last year’s profits to their parent charity. Many will have close relationships with their parent, including shared trustees and directors. Should these charities now be concerned about making further loans to their subsidiaries?
The fact pattern in such a case is likely to be clearly distinguishable from the one considered by the Tribunal, but the case highlights the importance of giving proper consideration to the statutory test and to principles of good governance. Clearly any decision to invest further in a trading subsidiary (and indeed to make any other Type 12 investment) must be taken having regard to trustees’ duties in relation to investment (and considering the need for professional advice), and more generally to protect the charity’s assets.
- This ruling emphasises the importance, when considering a Type 12 investment, of thorough due diligence and assessment of creditworthiness, effective management of conflicts of interest and careful recording of the decision-making process, even where the counterparty is well known.
- Trustees might reasonably ask themselves who is driving the transaction and what their motivations may be, as well as considering the “commercial logic” and overall tax effect of the arrangement for the parties involved.
- Once in place, trustees must be prepared to enforce arm’s length terms, including action to recover funds in the event of breach.
- HMRC’s guidance on approved charitable investments continues to be a helpful guide to how an officer is likely to view an arrangement, but the statutory test is the ultimate decider.
- That said, the Tribunal’s supervisory jurisdiction makes it unlikely that an officer’s decision will be reversed, unless it can be shown to be unreasonable.
If you require further information about anything covered in this briefing, please contact Laetitia Ransley, or your usual contact at the firm on +44 (0)20 3375 7000.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, October 2020