This section does not apply in relation to VAT as the VAT system is based on taxable sales turnover rather than profit or loss. A charity can offset the VAT it has to account for on its taxable sales by claiming back, on its VAT return, subject to the normal rules, VAT incurred on its costs.
Charities may make trading losses. In the past, HMRC guidance has stated that if trading activities are not within the charitable objects, losses 'may' be regarded as non-charitable expenditure. This has given scope for a discretionary approach, but recent decisions of the courts have made it impossible for this discretionary approach to continue.
If the trading is within the charitable objects of a charity, losses will be regarded as charitable expenditure. If the losses arise from non-primary purpose trading they will be regarded as non-charitable expenditure. For detailed guidance about non-charitable expenditure please see Annex II paragraph 3.2.
All non-primary purpose trade losses must therefore be treated as non-charitable expenditure, and tax exemption is not available on that amount of the charity's income. For more information about primary purpose and non-primary purpose trading please refer to the guidance starting at paragraph 12.
However, the fact that a loss arising from non-primary purpose trading is treated as non-charitable expenditure may not result in a net tax liability. The trading loss itself may be available for set off against the amount chargeable under S505 (4) ICTA 88. The effect can therefore be self-cancelling, as shown at B in the table below. The trading loss will only be unavailable for set off against the amount chargeable if the trading is not on a commercial basis and there is no reasonable expectation of gain (CT)/not with a view to the realisation of profit (IT)*.
The table below gives an overview of the main possibilities, though each case depends on its own facts:
| Tax profit/ loss |
Basis of Trading | Is it charitable expenditure? | Tax position |
|---|---|---|---|
| Loss | Not on a commercial basis: No reasonable expectation of gain (CT). Not with a view to the realisation of profit (IT) | No. Loss is Non Charitable Expenditure (NCE) |
NCE leads to a charge under S505(4) ICTA 88 that is not cancelled by loss relief * |
| Tax profit/ loss |
Basis of Trading | Is it charitable expenditure? | Tax position |
|---|---|---|---|
| Loss | On a commercial basis: Reasonable expectation of gain
(CT) With a view to the realisation of profit (IT) |
No. Loss is (NCE) |
NCE leads to a charge under S505(4) ICTA 88 typically cancelled by loss relief * |
| Tax profit/ loss |
Basis of Trading | Is it charitable expenditure? | Tax position |
|---|---|---|---|
| Profit | On a commercial basis: Reasonable expectation of gain
(CT) With a view to the realisation of profit (IT) |
N/A | Profits are taxable |
Paragraph 52 above covers the need to ascertain whether trading is on a commercial basis, with a reasonable expectation of gain (Corporation Tax) or with a view to the realisation of profit (trusts - Income Tax). This ‘commerciality test’ should initially be applied to the taxable deemed trade, after the split created by S505 (1B) (a) and (b).
If the taxable trade is, on the facts of the case, uncommercial, it is then necessary to consider whether the ‘larger undertaking’ of which it is a part is both commercial and ‘with a view to gain (Corporation tax) or ‘profit’ (Income Tax) S393A (3)(b) and S384 (1) ICTA 1988.
HMRC guidance on the meaning of larger undertaking can be found in the Company
Taxation Manual for Corporation Tax and BIM
75720 for Income Tax.
If the taxable trading source is part of a ‘larger undertaking’,
then it may be that the commerciality test is applied before the split created
by S505 (1B) (a) and (b), so that the loss is allowable. Each case must, however,
be decided on its own merits.
In paragraph 53 Type C scenarios, the charity is being taxed just like any other person or business which carried on the same trade and should fill in its tax return accordingly.
For Type B, assuming that an equivalent amount of tax-exempted income has been received, charities might show in their computations
| Income liable to assessment by virtue of S505 (4) ICTA 88 | XXX |
| Relief for trading losses* | -XXX |
Profit |
Nil |
This would be reflected in their tax return. The loss has been used and should therefore not be shown on the return as available to carry forward. This may cause difficulties if a charity's loss making non-primary purpose trade later moves into profit. However, if charities wish to pursue such trading, this can be conveniently done using a subsidiary company, which mitigates tax liabilities by gift aiding its profits to the parent charity. The use of subsidiaries can have other advantages.
The paragraph 53 type A scenario may present the most difficulty. The charity may find that its non-primary purpose trading creates a cash surplus over direct costs but there is no realistic expectation of tax profit or gain. The loss cannot be set off against the S505 (4) ICTA 88 charge, because the trading is not carried on on a commercial basis and with a reasonable expectation of gain/ with a view to the realisation of profits.
What constitutes non-charitable expenditure is, however, as much a matter of charity law as of tax law, and charities may wish to obtain professional advice if they find themselves in this situation. In general, non-charitable trading is better situated in a trading subsidiary.
In all cases, it should be noted that it is up to the charity whether or not to claim capital allowances in relation to its non-charitable trade. This flexibility can be helpful. However, in reviewing whether a commercial basis and a ‘view to the realisation of profits’/ a ‘reasonable expectation of gain’ exists, HMRC Charities will take into account depreciation (apportioned on reasonable grounds) on assets purchased wholly or partly for the non primary purpose trade. If an asset was originally bought wholly for use for the primary purpose, then it is not taken into account.
It should also be noted that, for any given charity, the facts can change and as a result the tax treatment of the losses may also change. For example, scenario A may apply - a charity may have a non-charitable activity which yields a cash surplus over direct costs, but which, year after year, shows losses for tax purposes once overheads are allocated. In these circumstances, the loss could not be set off against the S505 (4) ICTA 88 charge but it could be carried forward and set off against later year profits of the deemed trade. However, from the date that a realistic approach to putting the activity on both a commercial and profitable basis is adopted, scenario B would then apply and the loss could be set off against the S505 (4) charge. It is recommended that in such a case an explanation is provided with the return.
When Section 505 (1B) ICTA 1988 becomes effective, see the guidance at paragraph 48 charities will pool unused non-primary purpose losses brought forward. These losses will be available to carry forward against profits from non-primary purpose trading. Computations and returns can be completed on this basis.
