How to set up a trading subsidiary

Charities are allowed to trade under certain circumstances, but if you've decided to develop a trading activity which is not allowed, you'll need to establish a trading subsidiary. This subsidiary will normally have an incorporated legal form, and will require start-up finance, working capital and resources.

It's recommended that you seek professional advice to help you with setting up a trading subsidiary.

Any charity planning to set up a trading subsidiary must first check it has the powers to do this written into its constitution. If it doesn’t have these powers, it will need to amend its constitution, which will require the consent of the Charity Commission.

Trading subsidiaries can take any legal form appropriate for businesses. This could be a company, including a Community Interest Company, or an Industrial and Provident Society.

All new businesses, including trading subsidiaries of charities, need start-up finance. Charities may invest funds in a trading subsidiary by making a loan, purchasing shares (equity investment), issuing a guarantee or making a donation. However, if your organisation is a registered charity, any investment of charitable funds in the trading subsidiary will have to be consistent with the rules governing investment by charities. These rules require you to take a prudent approach to investment and not to take undue risks with charitable funds. Further guidance on the basic principles governing the investment of charitable funds is available from the Charity Commission. 

Essentially, trustees have to consider three questions before they invest charitable money in a trading subsidiary.

• Do the charity's investment powers actually permit investment in a trading company that it owns?
• Is this investment too speculative?
• Is the investment in line with the charity's own current investment policy?

If it's considered prudent for the charity to finance the trading subsidiary then it should carefully consider what form this finance should take. Options include:

• Equity investment: Share capital is fully at risk, and although this is the best form of finance for a business, it's more at risk than loan finance and therefore less preferable from the point of view of the parent charity.
• Loans: Loans are usually preferred by the parent charity because a loan can be secured against the assets of the subsidiary. Another attraction of loans for the parent charity is that it can look forward to a time when the loans will be repaid, and the subsidiary will no longer be financially dependent on it.
• Guarantees: Rather than lending money to a trading subsidiary, a parent charity might consider acting as a guarantor to a commercial loan taken out by the trading subsidiary. However, the same prudent approach to investment is required when providing guarantees.
• Donations: A charity cannot make a donation to a trading subsidiary unless such a donation would meet the primary purpose of the charity.

If the trading subsidiary is considered to be high risk, it should raise its start-up finance from non-charitable sources. 

It's important to establish and maintain a clear boundary between the parent charity and its trading subsidiary to avoid any possibility that charitable resources are used for non-charitable purposes. Particular attention should be paid to the following areas:

• Financial management: Separate accounts should be established for the parent charity and its subsidiary, and any transfer of funds between the two should be recorded as transactions. The rules governing investment by charities in subsidiaries applies not only to start-up finance but also to ongoing finance and support.  
• Sharing resources: If the trading subsidiary uses the charity’s premises it must pay an open market rent. Employees that work both for the charity and for the subsidiary must have their employment costs correctly apportioned. The same applies to equipment, services, consumables or resources that are used by both the charity and the subsidiary.
• Trading profits and Gift Aid: One of the main reasons for setting up a trading subsidiary is to generate funds for the charity. A trading subsidiary can donate its profits to its parent charity and claim Gift Aid tax relief on the donation, if it's liable for corporation tax. Caution should be taken when deciding how much of the profit should be donated, because the subsidiary will need to retain and reinvest some profit to ensure its sustainability.

Charities should reduce potential conflicts of interest by ensuring that the directors of the trading subsidiary are not all trustees of the charity. The Charity Commission provides further guidance on the governance of trading subsidiaries.