Calculating the profits of the trade

Contents

36. VAT: does this section apply for VAT purposes?

This section does not apply in relation to VAT. VAT liability relates to taxable supplies and is not based on profit or loss.

Read about how VAT affects charities

37. Direct tax: what profits are taxable?

Trading receipts should be allocated to the sources listed in paragraph 4 above on a reasonable basis. The profits of taxable non-charitable trading, including capital allowances if applicable, should be calculated in the same way as for any other trader. This may involve apportioning what was originally charitable trading expenditure to a non-charitable or deemed non-charitable trade. Any such apportionment will apply only for tax purposes.

For most charities the challenge will be to maintain adequate accounting systems to properly identify the separate charitable  and non-charitable deemed trades, in order to allocate and, where necessary, apportion costs to each. Charities are strongly recommended to do this. The approach may vary. For example, there could be a ‘high level’ approach of identifying the trading activity of a particular department, division or building, etc. as charitable or non-charitable. Alternatively, there might be a 'middle level' approach of, for example, identifying particular contracts or projects, or the work of individuals as charitable or non-charitable. At the most detailed level, charities might identify each individual piece of work done, flag it charitable or non-charitable in the accounting system, and allocate costs accordingly.

HM Revenue & Customs' (HMRCs) view is that a high or medium level approach may be justified on the facts - a department or a project may be identifiable as wholly charitable or wholly non-charitable. However, this approach would be inappropriate for mixed charitable/non-charitable activity. In HMRCs view, a detailed or 'low level' approach to accounting for charitable and non-charitable activity will be more appropriate. This will give the greatest accuracy and take the least risks with charity law, which places a responsibility on trustees to identify charitable trading carried on by the charity for which they bear responsibility.

There are further factors, discussed below, that may be particularly relevant when calculating the profits of a trade carried on by a charity.

38. Direct tax: allocation of indirect overheads and costs

For a non-charitable trade, section 479(4) CTA 2010 and section 525(4) ITA 2007 requires that there be a 'reasonable apportionment of expenses and receipts'. This will involve taking into account direct expenditure and a reasonable proportion of indirect expenditure such as overheads, whether or not these were originally incurred for charitable purposes.

For example, if a non-charitable trading activity is the charity’s only trading activity, is carried on in the charity's premises and takes 30 per cent of the floor area, it might be proper to allocate to the non-charitable trade 30 per cent of the costs of the premises such as:

  • heat and light
  • rent
  • building repairs and maintenance

Apart from the use of premises, other indirect overheads that may be partly attributable to the trade are:

  • employee salaries
  • computer costs
  • telephone charges
  • postage costs
  • accountancy and legal fees
  • general administration

The proper basis of apportionment of indirect costs will depend on the facts. In the case of the use of premises, the apportionment might be based on:

  • the size of floor space allocated to the trade
  • where student accommodation is let to tourists out of term, the number of days in the year when the premises are allocated to the trade, and actively marketed
  • in the case of employee salaries, the amount of employee time devoted to the trade compared to total employee time

39. Direct Tax: goods or services provided at undervalue

It is common for charities to receive goods or services in their trades at no cost, or at less than their full market price. For example:

  • a supplier might sell trading stock or equipment to a charity at cost price
  • a professional adviser might provide services for no charge
  • helpers and beneficiaries might do work on a voluntary basis

Where a charity (but not a charity subsidiary company) receives goods or services free, or at less than their full market price, the charity may deduct a notional cost/market price when computing the profits of the trade. Notional costs/market price should be calculated on a reasonable basis. For example, were a celebrity to act as a volunteer waiter at a gala dinner, the notional cost would need to be restricted to the going rate for the employment of a waiter, not that of the celebrity. Market price will be the wholesale or trade price at which the charity could reasonably have expected to buy the goods or services in, not the retail value of those goods or services.

There is guidance about charities and transfer pricing in the International Manual at INTM 412030 and INTM 440260.
There can be adverse tax consequences for a charity if it has a transaction or transactions with a 'substantial donor'. A 'substantial donor' is a person making gifts to a charity of at least £25,000 in a period of 12 months, or £150,000 in a period of six years.

Transactions with Substantial Donors