Accounting

Taxing issues

Independent schools face a complex web of tax requirements, as Graham Batty reports

There is a popular myth that charities do not pay tax. Indeed Keith Moore, the head of HMRC (Charities), recently said that charities should pay no direct tax (corporation tax and income tax). What perhaps he should have said, of course, is that charities, including schools, should not pay any direct tax provided they work within a complex web of very specific exemptions.

What you also have to remember is that, although HMRC will not automatically request a tax return from a school every year, there is a legal requirement to submit a tax return and self-assess your tax liability if you have income that is outside the available exemptions. Failure to do this will result in the school being liable to penalties.

The exemptions
Most forms of investment income and capital gains are exempt provided that the resulting income and gains are applicable to and actually applied for charitable purposes. However, there are only very limited exemptions available for trading activities. Tax exemption is only given for trading activity carried on by the school in the actual execution of its charitable objects, or which is ancillary thereto. The charging of fees and running the school shop should not, therefore, usually be a problem.

What about activities that the school carries out to raise funds? The fact that the profits are used in furtherance of the school’s objects is irrelevant; these are taxable trading activities. However, provided that turnover from all of the school’s non-charitable activities is below £50,000 per annum the school can claim tax exemption on the profits under the small trades exemption. There is also an exemption for certain fundraising events such as fetes, concerts, firework displays, dinners and balls that can apply and although there is a limit on the number of such events that can be held at a particular location each year, there is no monetary limit on the amount raised by an event – pop concerts by big name pop stars have qualified.

Outside the exemptions
Of course, not all fundraising activities fall within the additional exemptions. Take a common example, a school charging an annual subscription to local residents to allow them to use the swimming pool, gym, tennis and squash courts when they are not needed by students. In effect, the school is running a sports club.

Before 2006 this might not have been much of a problem. On a marginal cost basis, that is taking the subscriptions and the additional running costs, the club makes a profit and so contributes to school funds. However, on a full cost basis, taking account of attributable overheads the school is committed to incurring come what may, the club makes a loss. In these circumstances, HMRC accepted that no tax was payable.

Following changes made in Finance Act 2006, any such loss in the school is now deemed to be non-charitable expenditure and results in a pound-for-pound withdrawal of the school’s tax exemption on its income. In most cases this will mean a tax liability unless the activity giving rise to the loss was carried out on a commercial basis with a view to profit, in which case a claim can be made to set this trading loss against the deemed income.

Any non-charitable activity that the school undertakes will need to show a budgeted profit on a full cost basis, rather than just a contribution on a marginal cost basis. Of course, if a substantial profit is likely the school should consider running the activity through a wholly owned non-charitable subsidiary company which can then gift aid the profit to the school, thereby eliminating the tax liability.

The funding of subsidiaries or related companies is an area where schools frequently encounter tax problems. Sums invested as share capital or advanced as loans must be appraised on their investment merits and meet stringent requirements relating to security, investment return and, for loans, repayment terms. HMRC must also formally approve the arrangements. Failure to do this will mean that the investment is deemed to be non-charitable expenditure which could result in a substantial tax liability for the school.

Under review
Finance Act 2006 also saw the introduction of rules which treat payments after 21 March 2006 made by a school to a substantial donor in the course of, or for the purposes of, certain specified transactions as non-charitable expenditure. This again entails the withdrawal of tax exemption from an amount of income equal to the non-charitable expenditure and a tax liability for the school. The rules are complex but schools will need to have procedures in place to identify substantial donors and review transactions with them.

The Finance Act 2006 changes are only just beginning to really bite and have made non-charitable expenditure a real and potentially expensive problem for schools. Make sure that you know where your risks are and get your tax governance in order. Failure to do so may leave you in trouble with the taxman.

Graham Batty is a senior manager for Baker Tilly Tax and Accounting Limited.

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