Setting up a trading subsidiary for academy trusts
We’ve asked Law firm Browne Jacobson, and Audit & Risk specialists Crowe UK, to explain some key considerations when academy trusts are looking to set up a trading subsidiary.
What is a trading subsidiary?
A trading subsidiary is typically a company with share capital owned and controlled by a parent charity (in our context an academy trust).
Why might trusts want to establish a trading subsidiary?
Increasingly, trusts are interested in exploring the establishment of a trading subsidiary. Reasons will vary between trusts but may include one or more of:
- the trust does not have power to undertake proposed activity (i.e. outside charitable objects);
- ring-fencing any risks associated with non-primary purpose trading;
- making the most of existing assets and resources to generate additional income.
Whilst on paper a trading subsidiary may look appealing often, when you get into the detail a rushed or very broad brush proposal, can be ruled out by the Board as too time consuming or too difficult to implement. It is therefore important to be fully prepared and this note seeks to help you start to plan your approach.
Trading subsidiaries is an area where the Education and Skills Funding Agency (ESFA), whilst acknowledging that they exist, have not provided a great deal of advice or guidance to trusts other than what is already included in the Academies Accounts Direction (Accounts Direction)(PDF, 724KB) and Academy Trust Handbook (Handbook)(PDF, 872KB). The Department of Education’s (DfE) model articles do include a specific power at Article 5 to establish a trading subsidiary. It is therefore worth noting that as they become more common ESFA may introduce more guidance (and rules).
Cost vs benefit of setting up a trading subsidiary
It is advisable to be really honest with yourself and ensure even where you have a good reason to establish a trading subsidiary on paper, that it is viable and that the costs and additional complexity of doing so are worth the anticipated benefits. A robust business plan based on a realistic and not best-case scenario is advisable.
There are inevitable costs in setting up a trading subsidiary (financial and resourcing costs). These may include;
- professional advice on constitution, relationship between the group entities, taxation and regularity;
- time incurred by trustees and management teams in establishing how the two entities will be managed and funded;
- additional governance costs;
- annual audit fees (the subsidiary will be subject to external audit in the same way as the academy trust).
The benefits tend to be a little more subjective and will depend on the business plan, but can include;
- an annual corporate tax saving each year assuming sufficient profits are generated in the subsidiary, but it may take many years for this saving to exceed the set up costs referenced above;
- ring-fence trading operations so that they don’t interfere with the trust’s primary objectives which is to provide education to its pupils;
- provide a less regulated environment for the activity to enable it to deliver on its potential;
- ring-fencing risk to protect the assets of the trust.
Making a profit
In the initial years of trading it is not uncommon for a subsidiary to be loss making. In order to make a gift aid payment, the subsidiary needs to have both the cash available and also sufficient distributable reserves. Gift aid payments need to be physically paid out within nine months of the year end, it is important to ensure that costs in the subsidiary are fully tax deductible to ensure taxable profits align closely with accounting profits.
Funding the subsidiary
Trustees will need to decide how to fund the subsidiary until it is able to fund itself. This may be through a mix of share and loan capital and both have associated advantages and disadvantages. You will need to consider the provisions in your Articles and the ESFA regulatory framework before committing to an approach. The source of any funds you intend to use to fund the subsidiary also needs careful consideration.
Where there is a loan there are a range of issues that will need to be considered from a charity law, regulatory and tax perspective.
VAT is often an afterthought when it comes to academy trust trading. It is important to remember that VAT is a tax on supplies so you need to look at your activities to determine how they should be treated for VAT.
Price lists for activities such as lettings or catering provision tend to be agreed well in advance of any VAT considerations. If subsequently you realise VAT is chargeable it can clearly erode margins (depending on whether you can pass to the end user) and/or impact on the deliverability of the business plan if increased prices impact on sales.
It may be necessary to explore whether to register for VAT, or become part of a VAT group with the academy trust.
When setting up a trading subsidiary, it is also advisable to put in place robust arrangements that go beyond setting up a shelf company to ensure robust governance for the group. In particular, trusts may want to consider:
- whether they have any consents required under the Funding Agreement/Handbook
- an appropriate company type for the planned activity (usually a company limited by shares)
- whether they have put in place appropriate corporate governance arrangements at both the academy trust and for the trading subsidiary (these will typically include appropriate Articles, an intra-group agreement and potentially a services agreement where support and other services are required)
- ensure they have appropriate mechanisms in place to ensure the trading subsidiary has sufficient working capital.
Other factors that will need to be considered:
There are of course a wide range of other factors that may be relevant. For example;
- the ownership and treatment of any intellectual property involved;
- the employment implications for the staff working on each of the service lines;
- suitable contractual terms and conditions for the proposed activities;
- insurance arrangements.
In terms of DfE/ESFA consents, you should consider your proposal in the round and reflect on whether what you are proposing would be caught by the ESFA’s rules. In particular, there are potentially two areas you may wish to consider; the ESFA’s rules on related party transactions and whether anything in the arrangement is likely to fall within the remit of “novel, contentious and/or repercussive transactions” as set out in the Handbook. The use of trust property by the trading subsidiary may also need consent.
Setting up a trading subsidiary is something that requires advance planning and an honest, early appraisal of the benefits vs costs.
In practice, many trusts establish a trading subsidiary through a desire to either mitigate risk or because the trading activity in question is significant enough to operationally ring-fence the activity from the trust’s core objectives. The associated corporation tax saving incentive is usually a secondary benefit; not the key driver.
The application of the regularity regime has been a key issue for CFOs in recent years. The ESFA’s latest accounts direction has brought welcome clarity as to whether the regularity regime will apply to a trust’s subsidiary. The accounts direction has now clarified that regularity only applies to a subsidiary to the extent that it is receiving and spending academy trust funds.
Self-generated funds of the subsidiary are not subject to the same regularity regime. This means some of the restrictions that once made subsidiaries less competitive compared to their charitable peers are no longer in place opening up new possibilities.
The information contained in this note is based on the position as at November 2022. It does, of course, only represent a summary of the subject matter covered and is not intended to be a substitute for detailed professional advice.
Further support from Crowe UK & Browne Jacobson LLP
Independent Schools and Charities | Crowe UK
Collaboration, Joint Ventures & Trading | Browne Jacobson LLP