December 30, 2002

1. Meaning of "income"

The question sometimes arises as to what is the "income" of a charity and whether any particular receipt is "income". This question arises in various circumstances:

(1) The identification of "income" for accountancy purposes.

(2) The identification of "income" for charity law purposes, e.g., requirements of registration and auditing may depend on the amount of a charity's income; a charity=s constitution may require income to be dealt with in a different way from capital.

(3) The identification of "income" for tax purposes.

It is submitted that accountancy principles govern the definition of "income" for charity law purposes: contrast Threllfell v Jones [1993] STC 537.

1. Are gifts "income" of a charity?

The accountancy rule is that "voluntary income" is generally to be included in the income and expenditure account. See Sorp 2.

Nevertheless the general rule for income tax is that simple donations and legacies are not "income" and are not subject to income tax. Thus Rowlatt J. in Graham v Green 9 TC 309 at 312:

"a mere gift is not a profit or gain, and I hardly feel any doubt about that."

The expression "profits or gains" in an income tax context is synonymous with "income." How does one reconcile what appears to be a contradiction between income tax and accountancy principles? Very easily. The word "income" is imprecise and bears different meanings in different contexts. On this point tax and accountancy concepts simply differ.

Thus sums paid to a charity under the payroll deduction scheme are not subject to income tax. Such sums are simple gifts. Again, government grants will not usually constitute income. (Where a charity is carrying on a trade, grants may exceptionally be treated as trading receipts.)

Three special rules apply to treat simple gifts as income for tax purposes.

2. Donations from individual or companies

Gift Aid donations from an individual are deemed to be income of the recipient charity: see 13.33 (Position of recipient charity).

Gifts of money from companies are deemed to be income of the recipient company: see 17.5.10 (Position of recipient charity).

3. Inter-charity payments

Section 505(2) provides:

Any payment which B

(a) is received by a charity from another charity; and

(b) is not made for full consideration in money or money=s worth; and

(c) is not chargeable to tax apart from this subsection; and

(d) is not, apart from this subsection, of a description which (on a claim) would be eligible for relief from tax by virtue of any provision of [section 505(1)];

shall be chargeable to take under Case III of Schedule D but shall be eligible for relief from tax under subsection (1)(c) above as if it were an annual payment.

The section does not require that the payment is to be treated for all purposes as if it were an annual payment; so the donor charity is not required to deduct tax at source on making the payment. The Revenue accept this view: see IR75 para 4. The payor charity does not enjoy any tax relief from making the payment; except where a charity makes annual payments to charity.

The rule only applies when both payer and payee are income tax charities; so the section does not apply if a charity established out of the UK makes a donation to a UK charity; or if a UK charity makes a donation to an overseas charity. (But see 2.25.7 (Payment to a Foreign Body) below for tax considerations in the latter case.)

It is considered that the transfer of an asset other than cash would not constitute a "payment".

 

2. What income of a charity is taxable

A charity may be subject to tax on its income in two circumstances. The charity may fail to satisfy some of the conditions for exemption, such as application for charitable purposes only. There are also some forms of income which do not qualify for tax relief. Examples are:

(1) Trading income outside the statutory exemptions.

(2) Schedule E (employment income).

(3) Income of various kinds taxable under Schedule D Case VI and in excess of the statutory exemption.

Charity income which does not qualify for tax relief is subject to tax in the following manner:

(1) A charitable trust would be subject to income tax at the basic or lower rate. A charitable trust is not subject to the additional rate of income tax in any circumstances: see s.686 ICTA 1988.

(2) A charitable company would be subject to corporation tax at the appropriate rate.

In practice most charitable income does qualify for the income tax reliefs discussed below.

3. Tax exemption: claims and appeal procedure

1. Claims

It is necessary to make a claim to qualify for exemption:

(1) under s.505 (which contains the main income tax exemptions);

(2) under s.46 FA 2000 (Small trades, etc.).

The time-limit for a claim is as follows:

(1) A charity which is a trust must make any claim within five years from 31 January in the year following the end of the tax year to which the claim relates.

(2) A charity which is a company must make any claim within six years from the end of the accounting period to which the claim relates.

(3) There are different time limits for claims to Tax Credit Transitional Relief. For charities which are trusts for tax purposes the time limit is two years from the end of the tax year in which the distribution was made. For charities which are companies for tax purposes the time limit is two years from the end of the accounting period in which the distribution was made.

If a charity receives income from which tax has been deducted at source (e.g. Gift Aid income) then the charity will make a claim for repayment of tax; that necessarily implies a claim for relief under s.505. A formal claim for relief would be needed if a charity receives income without deduction of tax; such as rental income or trading income. But simply submitting accounts to the Revenue showing receipt of (otherwise taxable) income received gross should be sufficient to amount to a valid claim.

2. Jurisdiction over appeals

The claim must be made to the Board of Inland Revenue. The main significance of this is that appeals lie only to the Special Commissioners: see s. 46C(1) TMA 1970. One wonders why exclusive jurisdiction was given to the Special Commissioners. Charity tax cases do not in principle call for different treatment from other cases.

The current position is also anomalous since:

(1) A claim is not required for minor income tax reliefs outside s.505; or for CGT relief. In these cases appeals may be made to the General or Special Commissioners in accordance with the usual principles.

(2) Although a charity's claim to recover tax on a Gift Aid donation must be adjudicated by the Special Commissioners, an individual's claim for higher rate tax relief on the same payment may be made to the General or Special Commissioners.

It is submitted that the matter should be reformed by providing that claims should be made to the Inspector; or, better still, that claims are not required at all. But the point is not of much practical importance.

3. Repayment claims and returns

The Revenue practice is explained in the Guidance Note Chapter 6. The Revenue are prepared to repay tax provisionally without awaiting the results of their verification process (which takes some time). They will only do so if they are satisfied that the affairs of the charity are in order.

4. Schedules F, D III, IV, V: general conditions for relief

2. Then, assuming that you get over that hurdle in one way or the other, it has to be shown that the income was Aapplied to charitable purposes only@: see 2.13 (Application for Charitable Purposes).

Requirement 1(a) depends on whether or not there is an Aincome tax charity@, a question discussed in 1.4 (Income tax definition).

1. Schedule F: UK dividends

The rules for charitable trusts and charitable companies are distinct, though the end result is broadly the same.

Take first the case of a charitable trust which receives dividends (or other distributions) from a UK resident company. The income of the trust for tax purposes is the amount of the dividend and the tax credit, but the income will be exempt from tax provided the dividend is applied for charitable purposes only: ss.20, 505(1)(c)(iii) ICTA 1988. (In any event the tax credit would frank the charge.)

If a UK resident charitable company receives a dividend from a UK resident company, the charity is not normally taxable on the dividend: s.208 ICTA 1988.

 

1. Tax credit: transitional relief

When a charity receives a dividend from a UK resident company, the charity is notionally entitled to a tax credit. From 1999/00 the tax credit is not repayable to the charity. S. 35 F(No. 2)A 1997 confers transitional relief: on a claim, a charity will receive:

Fraction of Distribution	Date of Distribution
13%	2001/02
8%	2002/03
4%	2003/04

These payments are not Atax credits@ and are not income for the qualifying expenditure rules. They are treated as a repayment of tax for the specific purpose of section 703 ICTA 1988 (cancellation of tax advantages) see F(No. 2)A 1997 s.35(5).

The relief is not payable if the dividend is received from a residuary estate via personal representatives: see 28.5.5 (Income Tax). For an anti-avoidance provision see 10.3 (Pre-Acquisition profits).

The claim is made on form R68 (TCTR) available from IR charities.

2. Tax planning for Schedule F income

The current law has a number of remarkable consequences. As far as tax is concerned, it may be preferable for a charity to invest in investments other than UK shares, yielding income not taxable under Schedule F. It is better for an individual to retain shares and give his dividend income to a charity (under Gift Aid) rather than to give the shares to the charity. On tax planning for companies the situation where a charity owns all or a substantial part of a company, see 10.2.1 (Gift Aid).

2. Interest

Section 505(c)(ii) provides exemption for interest. This exemption applies to "short" interest as well as "yearly" interest. The exemption applies to foreign source interest as well as UK source interest: section 505(1)(c)(iia).

3. Annual payments

Annual payments are also exempt from tax by virtue of s.505(1)(c)(ii) and (iia). The exemption applies to annual payments having a UK or a foreign source.

Royalties are annual payments for this purpose: see Lawrence v IRC 23 TC 333.

Profits of a trade are not "annual payments", and so a charity's trading income is not exempt from tax under s.505(1)(c). See Trustees of Psalms and Hymns v Whitwell 3 TC 7, the principle of which (despite some criticism) was upheld in R v Special Commissioners of Income Tax ex parte Shaftesbury Homes and Arethusa Training Ship 8 TC 367.

4. Rent and other receipts from land

Section 505(1)(a) provides:

(a) exemption from tax under Schedules A and D in respect of any profits or gains arising in respect of rents or other receipts from an estate, interest or right in or over any land (whether situated in the United Kingdom or elsewhere) to the extent that the profits or gains--

(i) arise in respect of rents or receipts from an estate, interest or right vested in any person for charitable purposes; and

(ii) are applied to charitable purposes only.

The requirement that land must be vested in a person for charitable purposes is satisfied when land is vested in any charity, whether a trust, company or an incorporated association. The requirement is also satisfied where the land is vested in a nominee for a charity. The income arises from an equitable interest vested in the charity.

Rent to a charitable trust for the use of furniture in a furnished letting is (in the absence of a trade) charged under schedule A. See Schedule A, para 4. Section 505(1)(a) does not strictly provide exemption since such rent is not from land. The Revenue may not take the point. The Guidance Note Annex I.3.2 states that the exemption includes income from furnished lettings.

The exemption extends to land outside the United Kingdom (which would otherwise be subject to tax under Schedule D Case V).

As to the borderline between a letting income and trading income see 6.2.2 (Profit from lettings).

1. Lease premium provisions

It is considered that the exemption is wide enough to cover any charge under the lease premium provisions (sections 34 to 39 ICTA 1988).

2. S.776 ICTA 1988: transactions in land

Section 776 ICTA 1988 imposes a tax charge under Schedule D Case VI on a wide variety of gains arising from a disposal of land. Section 776 can apply in many cases where there is no intention of tax avoidance. See, for instance, Page v Lowther 57 TC 199. Since:

(1) s. 776(3) directs the gain to be treated as Aprofits or gains chargeable to tax under Schedule D Case VI@, and

(2) s.505(1)(a) provides exemption from tax under Schedules A and D in respect of "profits or gains" arising in respect of rents or other receipts@ from land

the better view is that a s.776 gain on a disposal of land could qualify for the charity exemption for land. However, the Schedule D Case VI exemption is drafted on the basis that the exemption does not apply: see 2.11 (Schedule D Case VI). Strictly this is irrelevant but in practice it may lead a Court to hold that the charity exemption for land does not apply to income within section 776.

5. Life policies, annuities and capital redemption policies

1. Introduction

This section considers gains from:

(1) a policy of life insurance,

(2) contract for life annuity, or

(3) capital redemption policy.

These are together referred to in this section as A policies@. They fall within the scope of Chapter II, Part XIII, ICTA 1988, known as the Achargeable event provisions@. A full discussion of these provisions needs a book to itself. The provisions are not clearly drafted and a continual process of amendment has created a fine tangle even by the standards of UK tax legislation.

In outline, there are three stages to the application of these provisions. The first is to ascertain whether there is a Achargeable event@. The second stage is to compute the gain arising on the chargeable event. These aspects are not discussed here. The third stage is to ascertain the method of charging the gain to tax.

Charities enjoy no exemption from the charges imposed on policies.

A "qualifying policy" (elaborately defined) will not normally give rise to a chargeable event, unless it has been acquired for consideration. The return on the funds invested in the policy or annuity will reflect the fact that the life company (if UK resident) will itself normally be subject to tax on its investments. Accordingly, policies are not appropriate investments for a charity.

2. Qualifying expenditure rules

Policies are not qualifying investments (for the qualifying expenditure rules) unless a claim is made under para 9 Sch 20 ICTA 1988. The Revenue Guidance Note Annex VI.2 provides:

VI.2 Premiums paid

VI.2.1 The Inland Revenue cannot accept premiums paid by charities on insurance policies (including policies assigned in favour of charities) as qualifying investments within Paragraph 9(1) Schedule 20 ICTA 1988. Further, we do not accept such payments as qualifying expenditure within the definition in S506 ICTA 1988. That is, we regard the payment of premiums by a charity as non- charitable expenditure.

VI.2.2 While Paragraph 9(1) gives the Board the power to consider investments other than those specified in Schedule 20, such investments should be of the same kind as those specified. We do not consider that premiums paid under an insurance policy have the same character as those specified investments. Such premiums are payment of consideration for entering into a contractual relationship. Further, regular premiums are paid in discharge of obligations under such a contractual relationship. The policyholders acquire or maintain rights under the contract; they do not acquire any entitlement to an interest in the underlying investments. The underlying investments remain the property of the insurer.

VI.2.3 We do not consider amounts paid as premium under insurance policies to be qualifying expenditure within S506 ICTA 1988, as they are not laid out in furtherance of a charity's charitable objects.

We cannot altogether agree: in our opinion a policy may in principle be an Ainvestment@ which falls within para. 9. The fact that the relationship with the Insurance Company is contractual is neither here nor there. As we note above, a qualifying policy is, however, not an appropriate investment for a charity, so in practice it does not matter.

3. Method of charging gain to tax

The method of charging the gain to tax is set out in s.547, and depends on the nature of the charity which realises the gain. They may be summarised as follows:

1. The charity is a company or an unincorporated association. The gain is subject to tax under Schedule D Case VI. (This applies, in general, to policies made after 13th March 1989.)

2. The charity is a trust created by a single company. The company is subject to tax on the gain and is not entitled to recover the tax from the charity. (This applies, likewise, to post 13th March 1989 policies.)

3. The charity is a trust created by a single individual. If the individual is living and UK resident at the time the gain accrues, he is in principle charged to tax on the gain; he may recover the tax charged from the charity. (This applies in general to policies issued after 19th March 1968.) If the individual is not UK resident or living at that time of the death or other event giving rise to the gain, the trust is subject to tax at the rate applicable to trusts.

4. The charity is a trust created by two or more persons. There is an apportionment under section 547A ICTA 1988.

The Revenue view is set out in the Guidance Note Annex VI.5 to VI.8. This is not set out here as in practice it should not arise.

The rules are capricious and the imposition of this tax charge on charities was probably an oversight and not intentional. However the Revenue Guidance Notes Annex VI makes it clear that the Revenue will take the point and no informal concession is available. A charity could take steps to avoid the tax charge, in a similar manner to the arrangements taken to avoid tax on trading income. But these questions should not arise because, as noted above, these policies are not normally appropriate for charities.

 

6. Trading income

Trading income is discussed at 6.1 (Charitable Trades).

7. Schedule D, Case VI

Section 46 FA 2000 provides a modest exemption from tax under Schedule D Case VI. The exemption is discussed in paragraph 6.12 (small trades). The exemption does not apply to Schedule D Case VI income under the following categories

(1) Recovery of relief wrongly given under:

(a) Section 30 Taxes Management Act 1970 (recovery of overpayment of tax).

(b) Section 214 ICTA 1988 (refund of group relief).

(c) Sections 788, 790 and 804 ICTA 1988 (recovery of double taxation relief wrongly given).

(d) Paragraph 14 Schedule 4 F(No. 2)A 1997.

(e) Paragraph 52(4) Schedule 18 FA 1998 (recovery of excessive repayments of corporation tax).

(2) Section 214 ICTA 1988 (chargeable payments connected with exempt distributions).

(3) Section 547(1)(b): see para. 2.9 (life policies, life annuities and capital redemption policies).

(4) Sections 660C or 677 ICTA 1988 (charge on settlor under Part XV ICTA 1988). It is unlikely that this would, or indeed could, ever apply to a charity.

(5) Section 703 ICTA 1988 (transactions in securities).

(6) Section 776 ICTA 1988; but see paragraph 2.8.2 (transactions in land).

(7) Paragraph 13(7) Schedule 19 FA 1988.

(8) Any other enactment specified in an order made by the Treasury.

8. Miscellaneous minor exemptions

A miscellany of minor charging provisions make a specific exemption for charity.

(1) Certificates of Deposit. Charities are exempt from the special charges relating to certificates of deposit if the profits or gains are applied to charitable purposes only: s.56(3)(c) ICTA 1988.

(2) Offshore Funds. Charities are exempt from the offshore funds legislation if the gains are applicable and applied for charitable purposes. If a temporary charity ceases to be charitable there is a special clawback charge: s.761(6) ICTA 1988. This section is analogous to the CGT provisions: see 3.8 (Property Ceasing to be Subject to Charitable Trusts).

(3) Accrued Interest Scheme. Charities are exempt from the accrued interest scheme: see s.715(1)(d). There is once again a clawback provision if a temporary charity ceases to be charitable: see s.715(3) ICTA 1988, and 2.7. There is no requirement that any sum should be applied for charitable purposes; though this is of little practical significance if the view which we have taken of this expression is correct; see 2.13 (Application for Charitable Purposes).

(4) Charity Pension Schemes. The 40% charge on the repayment of a pension fund surplus to an employer does not apply when the employer is a charity: s.601(4) ICTA 1988. There is no requirement that the sums repaid must be applied to charitable purposes only.

(5) Guaranteed Returns on Futures & Options. The charge does not apply to a charitable trust: ICTA 1988 Sch 5AA para 7.

(6) Non-trading gains on intangible fixed assets. The charge (in FA 2002 Sch 29) does not apply: see s.505(1)(c)(iic) ICTA 1988.

 

9. Application for charitable purposes only

It is usually a requirement for charity tax exemption that the income concerned must be applied to charitable purposes only. The trading exemption uses a variant form of words: see 6.9 (Application for Purposes of the Charity). Exceptions to the rule include s.715 ICTA 1988 (accrued income scheme) and s.601(4) ICTA 1988 (repayment from pension funds).

1. Misapplication of charitable funds

If a charity applies its income in a way not permitted by its constitution, then the income will not usually be Aapplied for charitable purposes@. It is not possible to give a complete list of circumstances where charity income is mis-applied; but we will supply a few examples.

An obvious example is if the trustees themselves consume the charity funds: (amongst other consequences) the charity will not be entitled to tax relief.

A charity which expends income on political activities would also forfeit its tax exemption. Political activities are not charitable (unless merely incidental to other truly charitable activities).

A charity which made a grant to a non-charity will be mis-applying its income unless it has a specific charitable purpose in making the grant. (For an example, see Nuffield v IRC 28 TC 479).

Misapplication of charitable income may be of a more subtle nature. For example, the concept of charity generally requires that money must be spent for public benefit; a trust for the benefit of a private class of individuals (such as employees of a company, small or large) is not normally charitable. So, in one case when a charity spent money on a playing-field open only to employees of the Electrolux Co. Ltd, the money was not applied to charitable purposes, any more than if the trustees had pocketed the money themselves: see Werner's Charitable Trust v IRC 21 TC 137. Likewise, in IRC v Educational Grants Association 44 TC 93, the charity concerned applied most of its income for the education of the children of senior employees of the Metal Box Co. Ltd. This was education by way of private benefit, not public benefit; that money was not applied for charitable purposes and tax relief was lost. It is submitted that the test is an objective one: the fact that a charity believes it is acting properly is not sufficient if in fact the funds are not applied for charitable purposes.

Investigation into charitable malpractice may be carried out by the Charity Commissioners or the Revenue. In practice this is more the concern of the Charity Commission, as the consequences go beyond tax. The Charity Commissioners may inform the Revenue of their investigations; and the Revenue (in derogation of the usual confidentiality rule) may inform the Charity Commissioners: s.10 Charities Act 1993.

2. Acts with consent of Charity Commission

There are many uncertain questions in charity law. It is possible for a charity quite innocently to apply its income in a way which may subsequently be held to be non- charitable, and so entirely innocent mistakes may give rise to a tax liability as well as bringing personal liability on the trustees. The only answer is that trustees should be quick to seek professional advice. Where the professional adviser is in doubt, he may seek confirmation from the Charity Commission. The Charities Act lays down two ways to proceed:

(1) The Charity Commission may sanction an action by Order under s.26 CA 1993. If this is done, the act is deemed to be proper. No tax problems can arise, since even if the Charity Commissioners were wrong to grant the order, income applied pursuant to the order is deemed to be applied for charitable purposes only.

(2) Alternatively, the trustees may seek the advice of the Charity Commissioners under s.29 CA 1993. The trustees may rely on such advice and act without risk of personal liability. The position here is unlike that where there has been an Order under s.26. Section 29 does not deem an act in accordance with the Commissioners' advice to be proper for all purposes. Thus the Revenue are in theory free to seek to raise tax on the basis that the Charity Commissioners' advice is wrong, and charitable income has been misapplied. In practice it seems most unlikely that the Revenue would take this course. In the authors' view, therefore, a charity acting in accordance with the Charity Commissioners' advice under s.29 may not in practice be at risk of losing its tax relief even if the Charity Commissioners' advice is wrong.

3. Stolen income

Is income applied for charitable purposes if it is stolen from a charity, or obtained by deception? Technically, it does seem hard to say that such income has been applied for charitable purposes. However, it seems unjust that a charity which is the victim of theft or fraud should then lose its tax relief. The authors consider it possible to argue that income is applied for charitable purposes wherever a charity has taken reasonable care in the handling and application of its funds. This view is perhaps supported by the approach of s.506(3) ICTA 1988.

Another difficulty which might arise if property is stolen is that the charity would lose the opportunity to incur qualifying expenditure, so possibly leading to a forfeiture of tax relief if the charity has incurred non-qualifying expenditure: see 2.21 below (the qualifying expenditure rules). Nothing short of an extra-statutory concession could solve that difficulty.

4. Ex gratia payments

A charity may make an ex-gratia payment out of motives of enlightened self- interest. It may, for instance, be good business for a charity to give a member of its staff on retirement a pension in excess of that to which he or she is contractually entitled. Again, one can imagine a case in which the relations subsisting between the charity and the person who is asking that the voluntary payment be made to him are such as to make it expedient for the charity with a view to its future prosperity to comply with the request. It is considered that such payments are applied for charitable purposes.

A charity may make payments out of moral considerations, and not out of pure self-interest. A standard example is where a testator fails to comply with the rules regulating wills, so that his estate passes to a charity whereas he clearly intended it to pass to another person. The charity may be under a moral obligation to make an ex-gratia payment to that person. Such an ex-gratia payment is permitted with the consent of the Charity Commission or Attorney-General: s.27 Charities Act 1993.

Is this sort of ex-gratia payment applied for charitable purposes? At first sight one might think not. Indeed, s.27 clearly envisages that the payment would normally be a breach of trust by the charity: see s.27(1)(i). On further consideration the matter is less clear. In Re Snowden [1970] Ch 700 the ex-gratia payment was justified as being in the true interest of the charity. Cross J observed that charities depend for their continued existence on the recognition by members of the public of a moral obligation to give to charity, so they should have regard to moral obligations themselves. It is significant that he referred to Re Clore [1966] 1 WLR 955, where a payment to a charity was held to be for the benefit of an individual. It is difficult to see why a charity which complies with its moral obligations and with the terms of s.27 should lose its tax relief. So while the matter is not free from doubt, the authors prefer the view that proper ex-gratia payments are also applied for charitable purposes. For a possible IHT problem in this context see 21.30 (Charity transfers asset to disappointed beneficiary under moral obligation).

5. Income used to repay loans

What is the position when a charity uses income to repay a loan? The authors suggest that the income is applied for charitable purposes where the funds were borrowed for proper charitable purposes; but where the funds were not borrowed for charitable purposes, the repayment of the loan is not an application of income for charitable purposes. This view is supported by Guild & others (trustees of the William Muir (Bond 9) Ltd Employees Share Scheme) v IRC [1993] STC 444.

6. Legitimate application of charitable income

If a charity applies its income in any manner permitted by its articles or trust deed then the income is, in the authors' view, applied for charitable purposes only.

"If the first requirement is satisfied [i.e., income accrues to a charity] then ... the second requirement [that the income be applied for charitable purposes] must equally be satisfied if the application is within the powers of the charity."

Pennycuick J in IRC v Educational Grants Association 44 TC at p 107.

A body established for charitable purposes only, which applies income according to its constitution, must, in the authors' view, apply that income for charitable purposes. Any other view requires that the word "charitable" has two different meanings in the same section. A charity's income is then always applied for charitable purposes unless:

(i) it is applied for non-charitable purposes (as discussed above) or

(ii) it is not "applied" at all, i.e., surplus income is left uninvested.

In either case the charity is acting in breach of its constitution.

The Revenue have often challenged this view but without success. In Campbell v IRC 45 TC 427 payments covenanted to a charity were applied in the purchase of a business from the covenantor. The Revenue argued that the income was not applied for charitable purposes only because there was an incidental benefit to the donor; or because the charity was obliged to use the income in this way. Both these arguments (though accepted by the Court of Appeal) were rejected by the House of Lords.

In IRC v The Helen Slater Charitable Trust Ltd 55 TC 230 one charity transferred funds to another. The Revenue contended that this did not constitute "application for charitable purposes only" because (i) the money was not spent "in the field"; or (ii) because the money passed without change of "beneficial ownership". Both these contentions were rejected by the Court of Appeal.

It follows that any money properly spent in the administration of a charity (including expenses of preparing accounts, dealing with tax and fundraising) is applied for charitable purposes only.

If the authors' view is correct, it follows that no assistance in this context can be derived from the rating cases, such as Oxfam v Birmingham City Council [1976] AC 126 where the Courts have adopted a stricter interpretation of the words "wholly or mainly used for charitable purposes" in the rating legislation.

7. Deduction at source

There is a theoretical difficulty in satisfying the applicable for charitable purposes requirement when a charity receives income from which tax has been deducted at source. Suppose a charity receives a Gift Aid payment of ,78 (,22 being deducted at source assume 22% basic rate). The charity can only claim a complete refund on the basis that the entire ,100 has been applied for charitable purposes only. How can the charity comply with this requirement when it has only received ,78? The answer, in the authors' view, is that ,22 is deemed (provisionally) to be applied for charitable purposes, since the ,22 is treated as income tax paid by the charity: see s.348(3) ICTA 1988. The ,25 has then been applied for charitable purposes just like any other administrative expense of the charity, such as the payment of rates. Comparable reasoning may apply when a charity receives a dividend and claims a refund of the tax credit. In practice the Revenue make repayment to charities in good standing provided the charity makes a declaration that the income has been or will be applied to charitable purposes only.

10. Accumulated income

This section considers whether income is applied for charitable purposes if:

(1) it is accumulated; or

(2) it is retained for future use, without being Aaccumulated@ in the trust law sense of being added to trust capital.

For convenience we refer to both (1) and (2) as Aaccumulation@.

It has been suggested that accumulated income would not be "applied for charitable purposes" since it was not "applied" in any way. In some circumstances accumulation is obviously necessary for sensible charity administration (e.g., to raise funds for a specific project). The Court of Appeal in Helen Slater favoured the view that accumulated income is applied for charitable purposes. Oliver LJ, giving the judgment of the court, said this:

"Charitable trustees who simply leave surplus income uninvested cannot, I think, be said to have `applied' it at all ... But if the income is reinvested by them and held, as invested, as part of the funds of the charity, I would be disposed to say that it is no less being applied for charitable purposes than it is if it is paid out in wages to the secretary."

This statement, though strictly obiter, carries highly persuasive authority. The authors consider that the law is settled: income lawfully accumulated is applied for charitable purposes. This view was adopted by the Special Commissioners in Nightingale v Price [1996] STC (SCD) 116 and Sheppard v IRC (No 2) 65 TC 724 at 731. This view is confirmed by the fact that Gift Aid payments and inter-charity payments are treated as income for tax purposes: see 2.1.1 (Are gifts or donations Aincome@ of Acharity@). No-one could contend that these payments (if retained by the donee charity) are not Aapplied for charitable purposes@ so as not to qualify for tax relief. This view is also consistent with the CGT position.

This is accepted by the Revenue. Guidance Note Annex II.3.2 provides:

AIR (Charities) will not challenge accumulations of income except in the rare cases in which it is:-

[a] not invested at all but kept in cash or in a current account

or

[b] where it becomes apparent that accumulated income is being invested in some project in which there is a potential conflict of interest between the interest of the charitable trust and the interest of the trustee or provider of the trust funds.@

1. Accumulation in breach of trust

This is already hinted at in the passage from Helen Slater cited above. The law is correctly stated in the Charity Commissioners report for 1992 para 98:

"If trustees have a power to accumulate income, that power must be consciously exercised in a proper way and with the good of the charity's beneficiaries in mind. A failure to consider the matter and simply to allow the income to accumulate without good reason amounts to a breach of trust. There are also possible tax consequences. Where we have reason to believe a charity may be pursuing that course, we shall seek explanations from the trustees and will then take appropriate action if we are not satisfied by the responses received."

It seems likely that income retained without proper reason is not "applied for charitable purposes" and tax relief may therefore be lost. But see 2.17 (when must income be applied for charitable purposes).

Income accumulated with a view to committing a breach of trust later is likewise not applied for charitable purposes and example [b] from Guidance Note II.3.2 is an example of that.

11. Income invested in breach of trust

Suppose income is invested in breach of trust. Is the income applied for charitable purposes? The answer depends on the breach of trust involved.

Suppose a charity uses its funds for charitable purposes but not those specified in its constitution, e.g., a charity for the advancement of education expends its funds on the relief of poverty. The income is nevertheless applied for charitable purposes.

Suppose charity trustees make an investment in an asset which is outside the range of their powers of investment. It is considered that the income is still applied for charitable purposes, being retained and invested for future charitable use, even though the trustees are in technical breach of trust.

Suppose trustees invest in assets within a category of permitted investments, but the trustees failed to take proper care in choosing the investments, or the investments are unduly speculative. The breach of trust may well lead to losses to the charity. It is submitted that as long as the trustees act in good faith, the income is applied for charitable purposes. The purposes of the trustees are wholly charitable, even if the manner of application is wrong.

Suppose the trustees invest in a transaction in which they are interested. The charity might purchase an asset of the trustees, or lend to a company in which they are interested. This is in principle a breach of trust but if the terms of the transaction are favourable to the charity, no-one may object. No tax problem arises. This is now confirmed by a Special Commissioners decision, Nightingale v Price [1996] STC (SCD) 116. This case concerned (inter alia) a loan (on terms which favoured the charity) from a charity to a private company connected with a charity trustee. The Revenue argued that the loan was a benefit to the private company, so the loan was not an application of funds for charitable purposes only. The argument was rightly dismissed. The loan was not a benefit at all; if it was a benefit, that was merely incidental, and the loan was still for charitable purposes only. A similar conclusion was reached by the Special Commissioner in Sheppard v IRC (no 2) [1993] STC 240 at 245; no appeal was made on this point.

Contrast the position where a charity applies its income by investing in a manner which is not a technical, but a substantive breach of trust. For instance, a loan on unfavourable terms to a private company in which the trustees are interested. Here the income is not applied for charitable purposes at all (eg an interest free loan) or is not applied for charitable purposes only (eg a loan giving charity less than commercial rate of interest.)

12. Tax avoidance motive

The authors' view is that every intra vires application of income by a charity is an application for charitable purposes. This rule should apply even in the context of a tax avoidance scheme; IRC v Campbell was such a case. Moreover, Sch 20 ICTA 1988 clearly envisages that payments made with a tax avoidance motive may be "applications for charitable purposes"; otherwise paragraphs 9(i), 10(d) of that Schedule would not be necessary. Nevertheless, it is understood that the Revenue have argued the contrary and the point might one day come to the Courts.

13. When must income be applied for charitable purposes?

Statute does not lay down a time limit within which the income must be applied for charitable purposes. It is submitted that that income must be applied for charitable purposes by the time the claim for exemption is determined. See 2.3.1 (Claims). This (seemingly generous) rule would not cause difficulties to the Revenue, since a charity's income is taxable until a valid claim is made.

14. Properly invested income later applied for non charitable purposes.

Suppose trustees invest income is sensible and authorised investments; and at a later date apply it for non charitable purposes. It is submitted that the position would be as follows:

(1) The income is not applied for charitable purposes if the non charitable application was intended at the time the investment was made;

(2) The income has been applied for charitable purposes if at the time of the investment it was intended to apply the funds for charitable purposes, and there was some change of plan.

The effect of the qualifying expenditure rules would need to be separately considered.

15. Which funds must be applied for charitable purposes?

The application for charitable purposes rule only requires that a charity must apply its income (and chargeable gains) on charitable purposes. The rule is not broken if a charity applies any of its funds on non-charitable purposes, so long as all its income of the year (and chargeable gains) is so applied. The question may arise whether any particular funds which have not been applied for charitable purposes only represent the income of the year. There is no reported case on this point, but it is thought that tracing rules must be applied, similar to those developed in relation to the remittance basis.

Where capital has been applied for purposes which are not charitable, and income is used to replenish the capital, it is considered that the income has, technically, been applied for charitable purposes. Where, however, there is a close link between the expenditure of capital and its replacement by income, there is a risk that the sums misapplied might be held to represent income ("in reality") and not capital, so that income tax relief will be lost.

Similar considerations apply where income is used to repay a debt owed by the charity. The income is certainly applied for charitable purposes so long as the debt is incurred for charitable purposes. If the money borrowed has been applied for non-charitable purposes, income used to repay that debt might be held not to be applied for charitable purposes. This is even more likely to be the case if the borrowing and repayment were part of a pre-planned arrangement.

16. Avoiding the application for charitable purposes rule

A charity may wish to apply funds in a way which might, conceivably, be held not to be for charitable purposes only, even though the charity is not acting unlawfully. In this case, the funds should not constitute income or chargeable gains of the charity, nor should they be funds which can be traced to such income or gains. The most suitable funds for the purpose would be legacies or donations to the charity. (Not, of course, qualifying donations or gifts from other UK charities, which are treated as income.) The funds should be held in a separate account, preferably in a separate bank, from any funds representing a charity's income or gains. If the view which we have taken above is correct, it would also be permissible to use income from previous years which has been properly invested. The charity will also need to consider the qualifying expenditure rules.

17. The qualifying expenditure rules

A complex code of restrictions on tax relief for charities was enacted in 1986. Charity tax relief was already restricted by the rule that a charity's income or gains must be applied for charitable purposes only. That rule was of limited application. The concept of "application for charitable purposes" was a wide one, as such cases as Campbell and Helen Slater indicate. Moreover, the rule only affected a charity's income or chargeable gains. If a charity misapplied its other funds then tax relief would be unaffected. The purpose of the 1986 reform was to deal with these problems. The central restriction is contained in s.505(3); and it is supplemented by s.506(6) and Part III Sch 20. Section 506 and Parts I and II of Sch 20 contain elaborate definitions. We refer to this code (for which the statute does not supply a name) as "the qualifying expenditure rules".

The central concepts employed in these rules are "qualifying expenditure", "non-qualifying expenditure" and "relevant income and gains". These are elaborately defined terms: but in short:

(i) "qualifying expenditure" is the charity's expenditure of which statute

approves; other expenditure - especially expenditure with a tax

avoidance motive - is non-qualifying expenditure:

(ii) "relevant income and gains" means a charity's taxable income and chargeable gains.

We must first of all consider these definitions in detail.

18. Meaning of "relevant income and gains"

"Relevant income and gains" is defined in s.505(5) and means:

"(a) income which apart from [s.505(1)] would not be exempt from tax together with any income which is taxable notwithstanding that subsection; and

(b) gains which apart from [s.256 TCGA 1992] would be chargeable gains together with any gains which are chargeable gains notwithstanding that section."

The definition is capricious. All chargeable gains of a charity are relevant gains. Almost all of a charity's income is relevant income. Most of a charity's income is either taxable or exempt from tax under s.505(1). In particular, income from Gift Aid payments and inter-charity payments constitutes relevant income. However, income from certificates of deposit is exempt by a provision other than s.505(1) and does not constitute "relevant income".

Simple gifts to a charity (including donations under the payroll deduction scheme) are not "income" in the tax sense and do not form part of its relevant income. See 2.1 (Meaning of AIncome@).

19. Franked investment income

In the case of a charitable company, resident in the UK, does a Schedule F distribution from another UK resident company ("franked investment income") constitute "relevant income"? Section 208 provides:

"Except as otherwise provided by the Corporation Tax Acts, corporation tax shall not be chargeable on dividends and other distributions of a company resident in the United Kingdom, nor shall any such dividends or distributions be taken into account in computing income for corporation tax."

The schedule F distribution is given in some respects the same status as a gross payment of income from which tax has been deducted. Nevertheless, the payment is not technically income for any tax purposes unless there is in the particular context some express provision overriding s.208.

Section 505(5) defines "relevant income and gains" to include only "income which apart from subsection (1) above would not be exempt from tax together with any income which is taxable notwithstanding that subsection". Franked investment income in our opinion falls within neither limb. It is not relevant income, indeed, it is probably not "income" at all, as that term as used in a taxing act prima facie means "taxable income".

The conclusion obviously weakens the effect of the anti-avoidance provisions considerably. It could conceivably be argued that tax credits are mere machinery to impose a charge on dividends. But although in many respects the effect is the same, the distinction is real, and is applied, for instance, for double tax treaties. On this view, a dividend is not "exempt" unless the tax credit can be reclaimed, even though it is not (technically) chargeable. This argument is very strained. It involves the proposition that franked investment income is income which is not exempt even though it is not chargeable. To our mind, franked investment income is not "relevant income" either because it does not constitute "income" at all or, if it does, because it is exempt from tax.

20. Meaning of "qualifying" and "non-qualifying expenditure"

The central concepts of the statutory restrictions are qualifying and non-qualifying expenditure. Section 506(1) provides that:

"' qualifying expenditure' ... means, subject to subsection (3) below, expenditure incurred ... for charitable purposes only; and

`non-qualifying expenditure' means expenditure which is not qualifying expenditure."

It is considered that the phrase "incurred for charitable purposes only" has exactly the same meaning as "applied to charitable purposes only", (see 2.13 (Application for Charitable Purposes)).

21. Expenditure

The definition rests on the term "expenditure". If an item of a charity's funds is applied in a way which is not "expenditure" then that application is neither qualifying nor non-qualifying expenditure. "Expenditure" is not defined. The word normally means "that which is expended or spent". One might think that every application of a charity's funds must then constitute "expenditure" by the charity. However, s.506(4) sheds light on the meaning of the term in its context and shows that that extreme view cannot be maintained. The subsection provides:

"If ... a charity -

(a) invests any of its funds in an investment which is not a qualifying investment ...or

(b) makes a loan (not being an investment) which is not a qualifying loan ...

then, ... the amount so invested or lent ... shall be treated ... as being an amount of expenditure incurred by the charity, and, accordingly, as being non-qualifying expenditure."

1. Making Loans

Let us first consider the status of loans. Section 506(4)(b) directs that if a charity makes a non-qualifying loan it is treated as incurring expenditure equal to the amount so lent.

What is the position if a charity makes a qualifying loan? Since the qualifying loan is not non-qualifying expenditure, one might have thought that it must be qualifying expenditure. That would be wrong. It is considered that a qualifying loan is not "expenditure" at all. One might not normally describe a simple loan - such as a bank deposit - as "expenditure". Two particular features show that a qualifying loan is not "expenditure" for the purposes of these rules. First, s.506(4) assumed that loans are not "expenditure". It directs that the amount loaned should be treated as expenditure. (The same language is used in s.505(3): "If a charity incurs or is treated as incurring non-qualifying expenditure...".) Secondly, if a loan constituted expenditure, then the definition of qualifying expenditure in s.506(1) should be expressed to be subject to the exception in s.506(4) for non-qualifying loans. For these reasons it seems clear that a qualifying loan is an item of "non-expenditure".

2. Making investments

Normally a person who purchases an investment might be said to have incurred expenditure. However, the arguments set out above (showing that qualifying loans do not constitute "expenditure") also apply to investments. It is therefore considered that a charity which invests its funds in qualifying investments does not incur any "expenditure". In short, any income accumulated and invested, or capital gains reinvested, do not constitute "expenditure" (unless the investment is a non-qualifying investment).

By contrast, of course, making non-qualifying investments is treated as non-qualifying expenditure. Suppose a charity exchanges non-cash assets in return for non-qualifying investments. Section 506(4) normally deems an investment in a "non-qualifying investment" to be non-qualifying expenditure; but that section only applies when a charity invests any of its funds in that way. "Funds" arguably connotes cash or that which is as good as cash, such as money in a deposit account or, perhaps, gilt-edged securities. If a charity exchanges (say) land for shares can one say that that charity has "invested its funds"? The anomaly suggest that the answer is, yes.

3. The Revenue view

The Revenue agree. Guidance Note Annex II.7.1 provides:

AIt is important to remember that qualifying expenditure does not include investments that the charity has made or loans which are accepted as qualifying loans or investments for the purposes of Schedule 20 (see Annex III).@

(Emphasis original)

Likewise at Annex III.7:

AIII.7 Qualifying loans and investments are not expenditure

III.7.1 An investment or loan is not an item of expenditure since it is not paid away irrevocably. A qualifying investment or loan is not an item of qualifying expenditure to be taken into account for any restriction of relief computation.@

4. Repaying Loans

Section 506(4)(b) only applies when a charity makes a loan. If a charity repays a loan then in the authors' view it incurs "expenditure". If the liability to repay the loan was properly incurred by the charity, then the expenditure is incurred for charitable purposes only; and so the sum expended in repaying the loan is qualifying expenditure. This is so even if the money loaned was applied in non-qualifying expenditure (unless, perhaps, the loan and the repayment are closely linked transactions). However, the Revenue view is that repayment of a loan is not "expenditure for charitable purposes". See IR75 para 4.

5. Other expenditure

It is not surprising to conclude that the purchase of investments is not "expenditure" for the purpose of the qualifying expenditure rules. If that were not the case then a charity could easily avoid a shortfall of qualifying expenditure in any year simply by selling its investments and purchasing new ones. But if the purchase of investments is not "expenditure" (contrary to the usual meaning of the term) the possibility arises that the purchase of other capital assets might not be "expenditure" for this purpose. For instance, suppose a charity purchases a building for its own use. Such a charity would normally be said to have incurred "expenditure" in the purchase of the asset (it has paid a purchase price). But it could be argued that the charity has not incurred "expenditure" for the purpose of the qualifying expenditure rules, on analogy with the examples of investments and loans. After all, the value of the charity's estate is not diminished by the acquisition.

The authors take the view that an application of money in this way is "expenditure". This is for two reasons. First the natural meaning of the word "expenditure". The acquisition of capital assets for the use of a charity can readily be distinguished from the examples of investments and loans, where the special provision of s.506(4) must be given effect. Secondly, in construing the word "expenditure" we should consider the purpose of the rules. The restrictions are designed to encourage a charity to apply its funds in the form of qualifying expenditure at the cost of losing its tax relief if in default. But if the purchase of a capital asset were not "expenditure" it could not be qualifying expenditure and the result is an absurd one. A school charity might find that it could not purchase a school building for its use; or an educational charity could not purchase a library; a religious charity could not purchase an organ. Such an unlikely result strongly suggests that the purchase of capital assets (other than investments) must normally be "expenditure" within the meaning of s.506 ICTA 1988.

In short, it is considered that, as a general principle, any application of a charity's funds constitutes "expenditure", other than the purchase of qualifying investments or the making of qualifying loans.

It is therefore necessary to decide whether any particular application of funds constitutes "investment". For general observations on the meaning of Ainvestment@ in modern times, see Marson v Morton [1986] STC 463.

Each case would have to be considered on its own facts. For instance, take the case of the charity in Campbell v IRC 45 TC 427, an educational charity which purchased a company carrying on an educational business. This is thought to be an item of "expenditure" and not an "investment". In IRC v Plummer 54 TC 1 a charity purchased annuities for a lump sum. There the application of the lump sum might be described as an investment, in which case it would be a non-qualifying investment. One could perhaps argue that there was no "investment" at all in that case, so that the expenditure incurred might be qualifying expenditure.

If a charity sells assets for full consideration then it incurs no expenditure. That is so even if it leaves the purchase price outstanding; this is an effective way of making an interest-free "loan". See 2.28 (Meaning of AQualifying Loans@).

6. Gifts and release of loans

A gift of cash by a charity is considered to be Aexpenditure@.

Suppose a charity gives assets - say stock exchange securities - to another charity. Has that charity incurred "expenditure"? In the authors' view it has: the concept of expenditure is not limited to the expenditure of cash. Strange anomalies would arise if this were not the case. This is supported by Oram v Johnson 55 TC 319.

Likewise the release of a loan by a charity is Aexpenditure@. If the borrower is a company, watch the loan relationship rules. If the borrower is carrying on a trade, watch s.94 ICTA 1988.

7. Payment to a foreign body

A special rule governs payments made by a charity to a foreign body. Section 506(3) ICTA 1988 provides:

"A payment made (or to be made) to a body situated outside the United Kingdom shall not be qualifying expenditure ... unless the charity concerned has taken such steps as may be reasonable in the circumstances to ensure that the payment will be applied for charitable purposes."

"Body" is not defined; the term is not apt to describe an individual beneficiary of the charity. There is no guidance as to the situs of any particular body. Income tax or IHT principles must be applied.

The Revenue view is in the Revenue Guidance Note Annex II.4:

AII.4.2 This means that the charity trustees must actively take steps to satisfy themselves and the Inland Revenue that any payment made to an overseas body has been applied for charitable purposes. They will need to be able to produce some evidence of their enquiries.

II.4.3 AApplied for charitable purposes@ means applied for purposes which are regarded as charitable under UK law. It is not sufficient for the charity to establish that the overseas entity is a charity under its domestic law.

II.4.4 When considering what is Areasonable in the circumstances@, the Inland Revenue will have regard to:

$ the charity=s knowledge of the overseas body

$ previous relations with and past history of that body.

Trustes are expected to make adequate enquiries to find out such information as is reasonably available about the overseas body. However, the trustees are not be expected to take account of circumstances which are unknown to them and which they have no possible reason for knowing.

II.4.5 Where a charity makes a series of payments to the same overseas recipient for the same charitable purpose, it is not necessary for fresh Asteps@ to be taken in respect of each new payment. If, however, the payments are for the different purpose, fresh Asteps@ will be expected.

II.4.6 There is no requirement for a charity to make application to the Inland Revenue for advance clearance in respect of overseas donations.@

This seems correct.

"Payment" is not defined; it is not thought that a transfer of assets other than cash could be a payment. The context shows that the section is not concerned with a payment for full consideration. The section must be construed in this way to avoid absurdity. For instance, suppose a religious charity pays income to a Dutch organ building company for a new organ. It can hardly be intended that payments of that sort are to be applied for charitable purposes by the Dutch company.

8. Non-qualifying investments and loans

We have seen that non-qualifying investments and loans are treated as "expenditure". Section 506(4) adds that they are treated "accordingly" as non-qualifying expenditure.

The penalty for making a non-qualifying loan is severe: the entire amount lent is non-qualifying expenditure. If a charity were to pay another person to make the non-qualifying loan then at most the payment made by the charity to that person would be non-qualifying expenditure.

If a charity makes a non-qualifying investment or (worse) a non-qualifying loan, the position cannot be set right by recalling the loan or realising the investment. The non-qualifying expenditure is not extinguished. Contrast the approach of s.419 ICTA 1988 (loans to participators) which is a fairer one. Section 506(5) does provide that if money so recalled is again expended on non-qualifying expenditure it is only counted once.

22. Meaning of "qualifying investments"

The reader will recall that qualifying investments are items of "non-expenditure", whereas other investments are deemed to constitute non-qualifying expenditure. The term "investment" is not defined. It will bear its usual meaning.

Part I Sch 20 ICTA 1988 sets out an exhaustive list of qualifying investments. All other investments are "non-qualifying". The following investments are "qualifying" (even if there is a tax avoidance motive):

A2 Any investment falling within Part I, Part II, apart from paragraph 13 (mortgages etc) or Part III of Schedule 1 to the Trustee Investments Act 1961.@

Most of the TIA 1961 has been repealed by the Trustee Act 2000 but schedule 1 has survived. The list of such investments is too long to be set out here.

A3 Any investment in a common investment fund established under section 22 of the Charities Act 1960, section 24 of the Charities Act 1993 or section 25 of the Charities Act (Northern Ireland) 1964 or in any similar fund established for the exclusive benefit of charities by or under any enactment relating to any particular charities or class of charities.

3A Any investment in a common deposit fund established under section 22A of the Charities Act 1960 or section 25 of the Charities Act 1993 or in any similar fund established for the exclusive benefit of charities by or under any enactment relating to any particular charities or class of charities.

4 Any interest in land, other than an interest held as security for a debt of any description.

5 Shares in, or securities of, a company which are listed on a recognised stock exchange, or which are dealt in on the Unlisted Securities Market.

6 Units, or other shares of the investments subject to the trusts, of a unit trust scheme within the meaning given by section 237(1) of the Financial Services and Markets Act 2000.

7-(1) Deposits with a bank in respect of which interest is payable at a commercial rate.

(2) A deposit mentioned in sub-paragraph (1) above is not a qualifying investment if it is made as part of an arrangement under which a loan is made by the authorised institution to some other person.

(3) In this paragraph "bank" has the meaning given by section 840A.

8 Certificates of deposit as defined in section 56(5).@

Loans to banks are qualifying investments even if they are made with a tax avoidance motive, so long as there is no back-to-back arrangement.

1. Back-to-back loans

Suppose a deposit with a bank is part of a back-to-back arrangement. Paragraph 7(2)) states that this is not a qualifying investment. May the back-to-back loan be a qualifying investments by virtue of paragraph 9? It is submitted that the answer is yes. Even though paragraph 7(2) appears to state without reservation that the back-to-back loan "is not a qualifying investment" the true meaning is that such a loan is not a qualifying investment by virtue of paragraph 7(1). So the loan might be a qualifying investment by virtue of paragraph 9. Any other construction leads to absurd results.

A charity should not make a back-to-back loan to a bank unless it is satisfied that a claim under paragraph 9 will succeed. There are various alternative possibilities. The charity may acquire a certificate of deposit in connection with a back-to-back arrangement. The certificate of deposit is a qualifying investment: see above. It may be possible to make a back-to-back loan through a building society, the charity's loan to the building society being a qualifying investment under Sch 20 para 2. Arrangements may be made where the charity lends money to one bank, and then another company in the same group lends the money to a third party. Lastly, it may be possible to make arrangements which do not involve a "loan".

23. Other investments

Any other investments are qualifying investments if:

"the loan or other investment is made for the benefit of the charity and not for the avoidance of tax (whether by the charity or by any other person)".

See Schedule 20 para 9 ICTA 1988.

There are two separate conditions both of which must be satisfied:

(1) the investment is made for the benefit of the charity; and

(2) the investment is not for the avoidance of tax.

1. AMade for the benefit of the charity@

It is well established that Abenefit@ is a word of wide import.

The words do not mean Ain a manner which proves ultimately to be for the benefit of the charity@. The context clearly excludes this interpretation. The ultimate result can only be discovered with the benefit of hindsight, perhaps years after the investment is made. It is clear that one needs to know almost immediately an investment is made whether or not it falls within paragraph 9. So whatever the test is, it should be applied at the time that the expenditure is incurred, and without the benefit of hindsight. The passage from the Guidance Notes set out below confirms that the Revenue accept this.

The more difficult question arises whether one should apply:

(1) an objective test: i.e., whether an objective observer would regard the investment as Afor the benefit of the charity@, having regard to the circumstances at the time it was made; or

(2) a subjective test: i.e., whether the charity subjectively considered the investment to be for its benefit at the time it was made (applying the appropriate company law principles to attribute the views of the trustees or senior management of the charity to the charity itself); or

(3) a mixture of objective or subjective.

There is very little guidance in the statute. The question only arises in the unusual situation where trustees act in good faith but negligently or otherwise in breach of charity law.

The better view is that the test is wholly subjective. This is supported by a purposive construction. The purpose of the qualifying expenditure rules is to prevent tax avoidance and to deny charity tax relief in cases where it is not appropriate. It is certainly the intention to deny relief where those making investments do not do so in order to benefit the charity. It is difficult to see the purpose of provisions to withdraw tax relief in the case where they bona fide intend to benefit the charity, even if they fail to meet some objective standard.

Purposive construction (as so often) can be argued both ways. The Revenue may argue for an objective test along the following lines:

(1) Charity tax reliefs are effectively a subsidy by other taxpayers. Where a charity makes objectively bad investments, even in good faith, these subsidies are inappropriate.

(2) The charity itself may not lose out by any loss of tax relief. The trustees are in breach of trust and must reimburse it.

But the effect of this construction is to put an unreasonably harsh burden on trustees. Moreover, charities would in practice lose out because trustees will often be unable to meet claims against them by the charity.

The Revenue Guidance Notes provide at Annex III:

AIII.4 For the benefit of the charity

III.4.1 An investment or loan will normally be Afor the benefit of the charity@ where it is made on sound commercial terms. Whether or not an investment or loan is commercially sound should be considered by reference to the circumstances prevailing at the time it was made.

III.4.2 There is no one test of commercial soundness, and each case must be viewed on its own facts. Where a loan or investment:

$ carries a commercial rate of interest; and

$ is adequately secured; and

$ is made under a formal written agreement which includes reasonable repayment terms

we will normally accept that the investment or loan is for the benefit of the charity.

III.4.3 Where one or more of the factors in paragraph III.4.2 is not present, we may ask the charity for full details of the investment or loan and for the reasons it was considered to be for the benefit of the charity.

III.5 Investments and loans to trading subsidiaries

III.5.1 Many charities have subsidiary companies that pass their taxable profits to the parent charity. Where an investment is made in, or loan to, such a subsidiary company, the charity is unlikely to be able to obtain normal security for the investment or loan. In such cases we may ask to see the business plans, cash-flow forecasts and other business projections which informed the charity=s decision to make the investment or loan.

III.6 Probity of investments and loans.

III.6.1 When deciding whether to make an investment charities should bear in mind the requirements of charity law relating to:

$ objectivity in the selection of investments

$ the need to avoid undue risk or speculation; and

$ the need for a proper spread of investments.@

Also at Annex IV.35.4:

AIV.35.4 Charities should also of course bear in mind the scope of the requirements of the Trustee Investment Act 1961 as well as their own investment powers as set out in the charity's governing document. All investment decisions should be properly minuted, including the factors on which the decisions were based. Depending on the size of a proposed investment, the decision may be based on the following:

$ business plans

$ cashflow forecasts

$ projections of future profits.

Investments should be reviewed regularly.@

This guidance conflates four conceptually distinct requirements:

(1) the tax rule that income must be applied for charitable purposes only (see 2.13 (Application for charitable purposes only));

(2) the tax rule that the loan or investment must be for the benefit of the charity;

(3) the charity law rule that trustees must act prudently in making investments;

(4) the Charity Commissions views on trustee loans/investments. See 6.24 (Funding the trading company). These in many cases may be regarded as the Commission=s advice or guidance on best practice, and not as mandatory rules of charity law.

These different rules certainly contain a large element of overlap.

2. Practical advice before making investment

A standard Revenue enquiry in the case of a charity Aaudit@ is to require copies of the relevant correspondence in respect of the loan/investment including copies of trustees= meetings which details the arrangements in respect of that loan/investment. Proper records of trustees' meetings and investment decisions will be essential.

In short, trustees must be in a position to show that its trading subsidiary was reasonably efficiently run and had a reasonable expectation of making a profit: and that the trustees took proper care in carrying out their duties of investment.

3. AFor the avoidance of tax (by the charity or any other person.)@

The avoidance of tax by a person other than the charity is a comparatively straightforward notion.

The idea of avoidance of tax by the charity itself is more difficult. Charities benefit from so many exemptions from tax that they can be expected to and generally do arrange their affairs so as to ensure that income and gains which accrue to them are of a type which is tax exempt. Thus some tax planning strategies adopted by charities are so widespread and so well established that Parliament could reasonably be said to acquiesce in their acceptability. It is most unlikely that the Revenue intended, in introducing the qualifying expenditure provisions, to counteract them and it is considered that it has not done so. The Courts have given Atax avoidance@ a narrow meaning: contrary to the evident intention of Parliament: Willoughby v IRC [1997] STC 995. An arrangement which for decades has been carried on with the approval of the Revenue can hardly be regarded as avoidance by this test.

Further, in principle, the charity will usually be able to say that the use of trading companies is needed for bona fide commercial purposes.

Note that it is only the investment which must not be made for the avoidance of tax. It does not matter if the investment forms part of a scheme or arrangement whose purpose is the avoidance of tax - provided that the investment itself is not for the avoidance of tax (contrast s.137 TCGA 1992). Thus the scheme in IRC v Campbell 45 TC 427 might be described as a tax avoidance scheme; but the purchase of the business by the charity, if it is to be described as an investment at all, is in the authors' view a qualifying investment.

4. Claims and appeals

A claim is in strict law essential. The usual six year limit applies. In the absence of a claim the investment is non-qualifying expenditure even though a timeous claim would be acceptable. It would appear that in practice the Revenue do not receive claims in plain cases.

The onus lies on the charity to satisfy the Board that any investment is made with proper motives. The ICTA 1988 does not provide an express method of appeal if the charity fails to satisfy the Board in this respect. An appeal against a resulting assessment would not be appropriate. It is thought, however, that an appeal can be made under s.42 TMA 1970 ("procedure for making claims").

That section allows an appeal against a refused claim, if, on making the claim, anything is to be "done". This can apply to a dispute under para 9 Sch 20, for that paragraph provides for the making of a claim, on which the Board are expected to "do" something, namely to indicate their satisfaction or dissatisfaction. It is thought that the Commissioners would have jurisdiction to substitute their own views for those of the Board, though it is arguable that their jurisdiction is purely supervisory.

24. Meaning of "qualifying loans"

Loans by way of investment have been considered above: we are now concerned with loans which are not "by way of investment", e.g., an interest-free loan or a loan on uncommercial terms. If a charity makes a non-qualifying loan then it incurs non-qualifying expenditure; if a charity makes a qualifying loan, it does not incur any expenditure at all: see 2.25.1 (Loans).

"Loan" is not defined. This is surprising: contrast other anti-avoidance provisions such as s.419 ICTA 1988 (close companies) or s.677 (loans to settlors). If a charity sells an asset to a person but leaves that amount outstanding there is not necessarily a loan; likewise if a charity allows a donor to delay making payments due under a covenant: see Ramsden v IRC 37 TC 619.

A qualifying loan is defined in Part II Sch 20 ICTA 1988. There are four types of qualifying loan:

(a) A loan made to another charity for charitable purposes only.

It is considered that any loan made in good faith to another charity for the purposes of that charity is made for charitable purposes only. It does not matter if the borrower charity intends to incur non-qualifying expenditure, or intends to accumulate the sum loaned, so long as it is not intended to make a breach of trust. Compare the Helen Slater case, which held that any bona fide inter-charity payment is a payment for charitable purposes only.

(b) A loan to a beneficiary of the charity which is made in the course of carrying out the purposes of the charity.

(c) Money placed on current account with a bank otherwise than as part of an arrangement under which a loan is made by the bank to some other person.

(d) "Any other loan as to which the Board [of Inland Revenue] are satisfied ... that the loan is made for the benefit of the charity and not for the avoidance of tax (whether by the charity or by some other person)". This corresponds to the provision of para 9(1) Sch 20, see 2.27 (Other investments).

25. Trading losses

The Revenue Guidance Note Annex IV.28 provides:

AIV.28.1 Charities may make trading losses. If the trading activities are within the charitable objects of a charity, losses will be regarded as charitable expenditure. But if trading activities are not within the charitable objects, losses may be regarded as non-charitable expenditure. The exemptions from tax for the profits of charities all depend on the profits being applied for charitable purposes. The exemptions may be restricted where there is non-charitable expenditure, depending on the circumstances of the case.@

This is arguable. The note continues:

AWhere a trading loss arises as a result of the deduction of a notional market price in respect of goods or services provided free or less than market price the loss will not be regarded as non-charitable expenditure.

IV.28.2 Similarly a trading loss might arise as a result of the allocation of a proportion of the charity=s fixed costs. Again the loss will not be regarded as non-charitable expenditure, provided that:

$ there is a surplus after deduction of direct costs, and

$ the fixed costs would have been incurred by the charity in any event.@

This is fair enough.

26. Clearance procedure

There is no formal clearance procedure. It appears to be the practice of the Revenue to give informal intimation of whether a proposed transaction will be regarded as a qualifying investment or loan. If the correspondence is suitably worded this would bind the Revenue.

27. Operation of the qualifying expenditure rules

In order to understand how the rules operate it must be borne in mind that in any year:

(a) a charity may incur expenditure (qualifying and/or non-qualifying) equal to its relevant income and gains; or

(b) its expenditure may exceed its relevant income and gains, e.g., if the charity borrows or consumes capital; or

(c) its relevant income and gains may exceed its expenditure - e.g., if some of its income is retained and not expended.

In particular, a charity may find that its qualifying expenditure is less than its relevant income and gains. The legislation refers to the "excess of the relevant income and gains over the qualifying expenditure"; and our discussion is easier to follow if we use some particular expression to define the amount of that excess. We shall therefore coin a phrase and describe the amount of a charity's relevant income and gains less its qualifying expenditure in any year as the "shortfall of qualifying expenditure" of that year.

The restriction on charity relief is set out in s.505(3):

"If in any chargeable period of a charity...

(b) its relevant income and gains exceed the amount of its qualifying expenditure; and

(c) the charity incurs ... non-qualifying expenditure;

relief shall not be available under either [s.505(1) TA 1988] or [s.256 TCGA 1992] for so much of the excess as does not exceed the non-qualifying expenditure incurred in that period."

The rules operate to withhold:

(a) income tax relief under s.505(1); and

(b) CGT relief under s.256 TCGA 1992.

CGT relief is available only under s.256 TCGA 1992, so all a charity's chargeable gains may become taxable if the qualifying expenditure rules take full effect. The most common and important forms of income fall within the scope of s.505 and the qualifying expenditure rules. However, a charity's income may enjoy tax relief under various sections apart from s.505(1). See 2.12 (Miscellaneous minor exemptions). Thus charitable relief for income tax charges on certificates of deposit, etc., is not affected by the qualifying expenditure rules.

The qualifying expenditure rules impose a twofold test: a charity's tax relief in any year is reduced by the smaller of:

(a) the shortfall of qualifying expenditure of that year (relevant income less qualifying expenditure); and

(b) the non-qualifying expenditure of that year.

 

1. Power of selection

The effect of the rules may be that a charity is completely disqualified from tax relief in any year. That would only be the case if:

(a) a charity incurs no qualifying expenditure, and

(b) it incurs non-qualifying expenditure equal to its relevant income and gains.

More often a charity will only lose part of its tax relief. For instance, assume a charity in the following position:

Income: ,100,000

Chargeable gains: ,60,000

Non-qualifying expenditure: ,40,000

Qualifying expenditure: ,70,000

,40,000 tax relief is lost and the charity's income or gains in excess of ,40,000 still qualify for tax relief. One must then consider which items of income or chargeable gains are to lose the tax relief. The charity has power to select which items of its income and/or gains are to be taxed: see s.505(6) ICTA 1988.

It may make no difference to a defaulting charity whether it elects to be taxed on its income exempting its gains, or vice versa. The rate of tax is the same in either case. However, there may be situations where it is highly material whether items of income or gains lose tax relief. A charity might have losses to set against its chargeable gains, or some relief to set against its taxable income.

2. Unapplied non-qualifying expenditure: the carry-back rule

It is clear from the twofold approach of s.505(3) that the qualifying expenditure rules can be avoided in two ways. First, a charity could ensure that it does not incur any non-qualifying expenditure. In that case it does not matter whether its relevant income exceeds its qualifying expenditure, that is, in our terminology, if it incurs a shortfall of qualifying expenditure in any tax year.

Secondly, the charity may arrange that its qualifying income equals or exceeds its relevant income and gains. In that case the charity does not incur any shortfall. The non-qualifying expenditure of that year cannot then be applied in that year to reduce the tax relief. If a charity takes this precaution, is it safe to incur non-qualifying expenditure ? The "unapplied non-qualifying expenditure" may be carried back to earlier periods: see s.506(6) and Sch 20 Part III ICTA 1988. The result is that tax relief may then be forfeit in the earlier periods.

The amount that can be carried back is the "unapplied non-qualifying expenditure", which is a self-explanatory term. (There is an exception for "non-taxable sums", discussed below.) If a charity has ,100,000 non-qualifying expenditure, and forfeits ,20,000 tax relief in that year, ,80,000 remains "unapplied". Statute does set out the definition of the term in full: see s.506(6) and para 11(b) Sch 20. It might be conveniently described as the amount of the non-qualifying expenditure less the shortfall of relevant expenditure in the tax year.

The effect of the "carry-back rule" is that unapplied non-qualifying expenditure is treated as non-qualifying expenditure of earlier years, up to a maximum of six years. An example will illustrate the rule. Consider the following charity:

1986/87 Relevant income ,100,000

Qualifying expenditure ,100,000

Non-qualifying expenditure ,0

The rules do not apply. The charity has no shortfall of relevant expenditure - its qualifying expenditure equals its income; and in any case there is no non-qualifying expenditure.

1987/88 Relevant income ,100,000

Qualifying expenditure ,50,000

Non-qualifying expenditure ,0

The rules do not apply. Even though the charity has a shortfall of ,50,000, it has not incurred any non-qualifying expenditure.

1988/89 Relevant income ,100,000

Qualifying expenditure ,50,000

Non-qualifying expenditure ,120,000

The shortfall of qualifying expenditure (i.e., relevant income less qualifying expenditure) is ,50,000 and the charity loses tax relief on ,50,000 in 1988/89. The unapplied non-qualifying expenditure - ,70,000 - is carried back to 1987/88. Thus in 1987/88 the charity is retrospectively deemed to have incurred non-qualifying expenditure of ,70,000. The amount of tax relief lost is the lesser of the shortfall of that year and the (deemed) non-qualifying expenditure of that year, i.e., ,50,000. This leaves ,20,000 unapplied non-qualifying expenditure to be carried back to 1986/87. However, no tax relief is lost for that year as there is no shortfall in that year. The ,20,000 cannot be carried back before 1986/87 as that is when the new provisions were introduced.

1989/90 Relevant income ,100,000

Qualifying expenditure ,50,000

Non-qualifying expenditure ,0

The rules do not apply. There is no non-qualifying expenditure in that year. The unapplied non-qualifying expenditure from the previous year cannot be carried forward. This is a generous feature of the rules, which gives some scope for tax planning. However, the charity is at risk of losing its tax relief if there is any non-qualifying expenditure in the subsequent six years which can be carried back to 1989/90.

There is one limitation on the carry-back principle. Expenditure is not carried back if the charity can show that it represents expenditure of non-taxable sums. The expression "non-taxable sums" is defined to mean:

"donations, legacies and other sums of a similar nature which, apart from [s.505(1) TA 1988] and [s.256 TCGA 1992], are not within the charge to tax".

See para 12 Sch 20 ICTA 1988

Donations under the payroll deduction scheme are non-taxable sums. It is not entirely clear whether sums borrowed by a charity could be non-taxable sums. Money borrowed is certainly not within the charge to tax, but is it "of a similar nature" to donations and legacies? There is much to be said in favour of that view. However, the authors consider that a charity should proceed on the cautious view that money borrowed is not a non-taxable sum; and if such sums are used to incur non-qualifying expenditure, that expenditure may be carried back to previous years.

A charity which wishes to avoid the carry-back rule must show that its non-qualifying expenditure was the expenditure of non-taxable sums. The onus of proof lies on the charity, but how is it to be satisfied? It is possible that an accounting exercise only is required. If a charity incurs non-qualifying expenditure of ,1,000,000 it need then only show that it has received non-taxable sums of ,1,000,000 by the time that the expenditure was incurred. But another possible view is that a tracing exercise is required. That is, the charity must show that any non-qualifying expenditure is the expenditure of funds which can be identified as non-taxable sums. The safest course is to identify the non-taxable sums as they are received and to hold them in a separate bank from the charity's other funds. Failing that, there should at least be a separate identifiable bank account. If those sums are invested, the investments must be separately identifiable from the charity's other investments. If a charity realises its investments, the proceeds (assuming there is no chargeable gain) can still be identified as non-taxable sums: see Pattuck v Lloyd 26 TC 284.

If a charity mixes non-taxable sums and other sums (e.g., relevant income) into a single bank account, it may in the authors' opinion be possible to withdraw the non-taxable sums from the account; and thus to separate non-taxable sums from the income. This view is supported by cases such as Kneen v Martin 19 TC 33; IRC v McNaught's Executors 42 TC 71. The position is not free from doubt and the Revenue may not take a lenient view.

It must be noted that non-taxable sums do not enjoy a complete immunity from the qualifying expenditure rules by any means. As far as the carry-back rule is concerned, a charity may safely apply its non-taxable sums on non-qualifying expenditure. But if a charity does so it may forfeit its tax relief in the year that the expenditure is incurred, if the charity incurs a shortfall of qualifying expenditure in that year. The result cannot be described as entirely logical.

3. De minimis rule

The qualifying expenditure rules do not withhold tax relief in any year if the charity's relevant income and gains are less than ,10,000; s.505(3)(a) ICTA 1988. (If a charity has a chargeable period of less than 12 months the ,10,000 is apportioned: s.505(4).) However, this de minimis exemption only exempts a charity from taxation in the year in question. Suppose in year 1 a charity has a large income, but incurs no expenditure. In year 2 the charity's income is less than ,10,000, but it incurs substantial non-qualifying expenditure. Even though the de minimis rule allows a charity to claim tax relief in year 2, the unapplied non-qualifying expenditure may be carried back to year 1 so that the tax relief from year 1 is lost.

The limit of the de minimis exemption - ,10,000 - was set fairly high. However -as the authors predicted in the first edition of this book - the limit has not been increased since 1986; nor is any increase to be expected. Inflation will inexorably continue to draw more charities into the scope of the qualifying expenditure rules. The Revenue also have power to remove the de minimis exemption when two or more charities acting in concert are engaged in transactions of which the main purpose or one of the main purposes is the avoidance of tax (whether by the charities or by any other person): s.505(7). The de minimis rules cannot be exploited by the use of a fragmentation scheme.

28. Avoiding the restrictions

In order to avoid the restrictions on tax relief, a number of options are open to a charity.

(a) Ensure that the charity does not incur any non-qualifying expenditure. This is the simplest course and avoids any problems under the rules.

(b) A charity may incur expenditure which is or might be non-qualifying. One must then consider the tax position in the year in question and in the previous six years.

(i) In the year that the non-qualifying expenditure is incurred, the charity must not incur a shortfall of qualifying expenditure; that is, its qualifying expenditure must equal its relevant income. Possible ways to achieve this are discussed below.

Alternatively, the charity might arrange for its relevant income to fall beneath the de minimis level in that year.

(ii) The non-qualifying expenditure incurred in that year will then be "unapplied" and the charity must consider how to avoid the carry-back rule. The charity has two or three options:

(I) First the charity may have anticipated the problem by avoiding a shortfall in earlier years. It may be the case that in each of the previous six years (or since 1986/87):

(1) the charity incurs qualifying expenditure equal to its relevant income;

or

(2) the de minimis exemption applies.

In either case, the "unapplied non-qualifying expenditure" will be carried back but will remain "unapplied".

(II) If the charity has not anticipated the problem, the only solution is for the charity to arrange that the non-qualifying expenditure is made out of non-taxable sums. The carry-back rule will not then apply.

1. Avoiding a shortfall

For these reasons a charity will often wish to avoid a shortfall, i.e., it will wish to incur qualifying expenditure equal