9.1 Many charities raise funds through trading activities. The scale of these activities can vary considerably, from a fete stall to a large-scale business, and in some cases the activities are carried out by an entity separate from the charity. The income earned from these activities is tax-exempt; in other words, it is treated the same as any other income earned by a charity, on the basis that the profits from the activities will be ultimately used for charitable purposes.

9.2 A criticism often levelled at this exemption is that it provides the trading activity with a competitive advantage over its tax-paying competitors. One element of a firm's normal cost structure, income tax, is not present in the case of the charity-run trading operation. It is argued that this "lower" cost could be used by a large-scale entity to undercut its competitors, in order to improve its market share or to deter new entrants.

9.3 Any one type of cost, however, cannot be looked at in isolation. Because the tax-exempt entity can generally earn tax-free returns from all forms of investment,²⁵ the "after tax" return it expects from a trading activity is correspondingly higher than that of its taxed competitors. Therefore an income tax-exempt entity cannot rationally afford to lower its profit margins on a trading activity, as alternative forms of investment would then become relatively more attractive.

9.4 On this basis, the tax-exempt entity will charge the same price as its competitors. The tax exemption merely translates to higher profits and, hence, higher potential distributions to the relevant charitable purpose. Consequently, funding the charitable activity from trading activities is no more distortionary than sourcing it from "passive" investments, such as interest on bank deposits, or from direct fund raising.

9.5 In the short term, a large-scale tax-exempt entity could try to use its "deeper pockets" to eliminate competitors by temporarily lowering its prices, although there is no real evidence to suggest that this is occurring.

9.6 A charity could have a competitive advantage, however, if it were to accumulate its tax-free profits back into the capital structure of its trading activities, enabling it, through a faster accumulation of funds, to expand more rapidly than its competitors. We consider that this is the real competitive advantage that trading activities owned by charities have over their competitors. This competitive advantage potentially applies to other forms of income earned by charities, although there is more scope for that advantage to create distortions within the market in which a charity is trading than in other markets.

9.7 Further, it is possible that some benefit of the tax-free gains could be captured by individuals involved in the trading operation. This is contrary to the principles supporting the income tax exemption for charities. At present, however, a charity loses its tax exemption if a person who is in a position to influence remuneration or other financial benefits paid by a charity receives such remuneration or benefits.²⁶

Proposal

9.8 Trading operations owned by charities would be subject to tax in the same way as other businesses, but with an unlimited deduction for distributions made to the relevant charitable purposes. Donations made to other charities would be subject to the same deduction limits as other companies (see chapter 11). Because the competitive advantage arises only from the ability to grow a business faster by accumulating pre-tax funds, this proposal might not be necessary if accumulations were monitored. As noted earlier in the discussion on reporting requirements, although there need not be specific limits on accumulations, the accumulation of funds could lead to questions from the monitoring authority as to why this was happening.

Advantages

9.9 If a trading operation of a charity were being used as a means of raising funds for distribution to the relevant charitable purposes, the income would effectively be exempt, as the deduction for funds distributed appropriately would cover the relevant income. Although this rule could be circumvented by distributing and then immediately reinvesting funds, this would show up in the accounts of the charity. This could raise questions as to whether the charity was as a matter of fact pursuing its charitable objectives (see chapter 3).

Disadvantages

9.10 Removal of the exemption and its replacement with a deduction for distributions made to a parent charity would impose compliance and administrative costs, although charities should have information on their income and distributions readily available. This could be a problem particularly for charities with small-scale trading activities, in which case a turnover threshold could be introduced, below which the activity would not be taxed.

Specific issues for consultation Would the alternative of limits on accumulations of profits of businesses run by charities be preferable? Given that accumulation problems might also arise with passive investment activities, would you prefer to see the proposed rules apply to investment as well as trading activity? What level of threshold might be appropriate for small-scale trading activities?

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