The majority of charities will not pay tax on their investment income or experience problems with investments that they make.

However, the tax legislation does not provide a blanket tax exemption, and charities should be aware of the tax risks and pitfalls before making investment decisions. Where identified early, these risks are often easily managed. For those with large and diverse portfolios, it is worth regularly revisiting the scope of the exemptions and main risk areas to ensure that all relevant risks are identified and managed. The current rules and some of the current risk areas are considered below to give an idea of what to look out for and when to seek advice.

Investment income and capital gains

The main charitable exemptions cover investment income from:

• Land

• Interest and deeply discounted securities

• Dividends and distributions

• Unit trusts

• Royalties

• Annual payments

These exemptions are subject to the condition that the income is applied for charitable purposes and do not extend to income that is derived from a trading activity. There is also an exemption from capital gains tax on the sale of investments provided the gains are applicable and applied for charitable purposes only. Care needs to be exercised when considering significant investment in some overseas funds as these might be structured in such a way as to give rise to potentially taxable trading income in the charity, withholding taxes or an obligation to file returns in an overseas territory. For instance, US funds may take the form of tax transparent LLCs or LLPs where the income is taxed at the investor level rather than in the investment vehicle. When considering alternative investments such as marketable security funds, hedge funds and private-equity funds, it is important to speak with your investment advisors to understand the nature of the income you will receive, any overseas obligations that may be triggered and to identify whether professional advice is needed.

Land

Income and capital gains from land and buildings could be taxed as a trade. Broadly, this can be for one of two reasons:

• The level of services supplied is sufficient to change the nature of the income to trading – this could apply if a charity used excess accommodation for a hotel or conferencing centre business

• The “transactions in land” legislation causes a sale of land to be taxed as income – this applies where land is acquired or developed with the sole or main aim of realising a gain. It should be noted that this can cover arrangements where a charity agrees to sell land for a fixed price (exempt capital gain) plus a future payment based on the developer’s success (potentially taxable overage payment)

Approved charitable investments

Generally, a charity incurring ‘non-charitable expenditure’ pays tax on an equivalent amount of income. This means that a charity incurring non-charitable expenditure of £100,000 will pay tax on income of £100,000. This is important as any investment other than an approved charitable investment is considered to be non-charitable expenditure.

The main types of approved charitable investments are:

• Any investment in a charity common investment fund, common deposit fund or similar scheme

• Any interest in land (unless it is held as a security or a guarantee for a debt)

• Shares or securities of companies listed on a recognised stock exchange

• Units etc. in a Unit Trust Scheme

• Shares in an Open-Ended Investment Company

• Bank deposits - other than deposits made as part of an arrangement under which the bank makes a loan to somebody else (e.g. back to back loans)

• Certificates of deposit

• Any loan or other investment as to which HMRC is satisfied that it is made for the benefit of the charity and not for the avoidance of tax (whether by the charity or any other person)

Notably, there is no specific provision covering offshore funds – these are in principle approved charitable investments if the necessary claim is made and HMRC are satisfied that they are for the benefit of the charity and not the avoidance of tax. Unhelpfully, there are no provisions for pre-transaction clearance.

For investment purposes, the condition of being “for the benefit of the charity” can be met either:

• By being for the financial benefit of the charity, generating returns commensurate with the level of risk to enable it to carry out its objects, or,

• By being for the charitable benefit of the charity, directly furthering its objects.

In the past, HMRC has treated this is an either/or scenario but, more recently, has come to recognise that this is an area where it is acceptable for the trustees to exercise their judgement and strike a balance between the two. For instance, a lower financial return could be accepted on an investment used to directly enable a charitable project. This is still an area where care needs to be exercised and any loss of income needs to be offset against the charitable benefits flowing from the project. Such decisions need to be carefully considered with proper documentation and specialist advice sought where necessary to reduce the risk of challenge and loss of exemption.

It is important that advice is sought when taking on investments that do not clearly fall within one of the headings for approved charitable investments. HMRC do not always automatically accept that projections of good investment returns are enough to meet the condition of being an “other investment” for the benefit of the charity. Many historic areas of contention have been resolved over time but, for instance, HMRC have long rejected the idea that premiums paid into a life insurance policy by a charity are capable of being considered to be an investment. Although not common, charities are often targets for unusual bequests or opportunities, some of which create unexpected liabilities and, at the extreme, form part of elaborate and inappropriate tax evasion schemes for the benefit of others. It is wise to understand what you might be getting into even when accepting an investment as a gift and seek professional advice.

Other matters

It is unlikely but still possible that a charity can be taxed under anti-avoidance rules on a share of any chargeable gains accruing to a non-UK resident company in which it participates. Charities should consider the risk before acquiring interests in non-resident close companies or close unit trusts where their interests (together with connected parties’ interests) will exceed 25%.

What should we do?

Charities do not need to take detailed tax advice on every investment they make. However, it is important to plan ahead when making any investments that are more adventurous than a simple managed portfolio of listed securities.

Charities should be alert to the risks and be prepared to seek professional advice before the transaction so as not to be landed with an unexpected tax liability further down the line.