Financial Reporting Exposure Draft (FRED) 68, ‘Draft amendments to FRS 102 – Payments by subsidiaries to their charitable parents that qualify for gift aid’, was published by the Financial Reporting Council (FRC) in September 2017. We expect it to become mandatory from accounting periods beginning on or after 1 January 2019.
The FRED is the first sector-specific amendment to FRS 102 to be put forward by the FRC. But why the need for it – and what’s it trying to achieve?
To understand the reason for the FRED, we first need to understand why charitable groups commonly exist. In recent years, as charities have found themselves fighting hard for a slice of a limited pool of donor funds, they have increasingly turned to non-charitable trading activities which would ordinarily be subject to corporation tax.
However, a legitimate way of avoiding corporation tax is to operate the trade through a separate subsidiary and then have the subsidiary make a charitable donation of all its profits to its parent charity.
This potentially reduces the subsidiary’s taxable profits to nil. It’s a kind of ‘fiscal alchemy’ because the profits aren’t taxed in the charity either – because it’s a charity!
From a tax point of view, because the donation from the subsidiary is made under the gift aid scheme, then, provided it is made within nine months of the subsidiary’s year end, the fiscal alchemy works! This is a longstanding principle, totally unaffected by FRED 68.
Donation or distribution?
The origins of the FRED date back to 2014, when ICAEW published a Technical Release called Tech 16/14BL. This concluded that, contrary to the view previously held by many, a donation made from a subsidiary to its parent charity is legally a ‘distribution.’
The consequence of this was to put subsidiaries on guard that such a distribution could only legally be made when they had sufficient available accounting profits for the purpose. So if a subsidiary with no brought forward P&L reserve made an accounting profit of £20K but a taxable profit of £25K, as a result of adding back disallowable expenses, it could only distribute £20K to its parent charity. Any over-distribution (e.g. of the extra £5K of taxable profit) would be owed back to the subsidiary by the parent charity.
Many have had issue with this. Why should a charitable donation be construed as a distribution? And in view of the fact that it is most tax efficient for a subsidiary to remit every last penny of its taxable profits to its parent charity, it could quite feasibly find itself ‘over-distributing’ with money then being owed back to it. Tech 16/14BL has stuck though!
ICAEW’s ruling on the legality of the payment then got some in the profession thinking about the accounting treatment. Two issues have arisen:
· When should the payment be accounted for – in the year in which the profits are made or in the year in which the payment is made?
· In which of the subsidiary’s primary statements should the payment be presented – in the profit and loss account or in the statement of changes in equity?
In the absence of absolute clarity on either of these points in the current version of FRS 102, FRED 68 has sought to settle the argument and achieve a consistent accounting approach.
Dealing with the tax
The FRED makes clear that the tax effects of a gift aid payment that it is probable will be made in the nine months following the reporting date should be taken into account at the reporting date and recognised in proﬁt or loss.
This means that if all the subsidiary’s profits are remitted to its parent during the year OR within nine months of the year end, the P&L tax charge of the subsidiary in that first year is reduced to zero.
Dealing with the distribution
To understand the basis for the accounting treatment of the distribution it is worth considering how GAAP has had us deal with dividends in financial statements for some years now.
Interim dividends paid during a year are accounted for during that year. However, a company does not normally, at its year end, have an obligation to pay a final dividend which, though paid out of current year profits, is typically finalised after the accounts have been signed. This usually gets accounted for in the following period.
Under FRED 68, the same logic will apply to distributions made by a charity’s subsidiary. Any payment made post year end will only be accrued for at the year-end where the subsidiary is obligated at the balance sheet date to make the payment.
The FRED points out that, if the distribution is made under a deed of covenant, such an obligation will exist at the balance sheet date. If it is not made under a deed of covenant, such an obligation won’t exist at the balance sheet date and the payment won’t be accounted for until the subsequent period, when it is made.
P&L or SOCIE?
It is a long-established principle of GAAP that distributions are debited to reserves not to P&L. For this reason the FRED advocates that the payment appears – in whichever year it is accounted for – as a movement in the subsidiary’s Statement of Changes in Equity (SOCIE) not in its P&L account.
No big deal?
FRED 68 certainly settles the argument, but for two important reasons it is – for many – flawed:
· If 100% of the distribution is made post-year end and there is no deed of covenant in place, the distribution will be accounted for in year two, but its tax consequences will be accounted for in year one. This seems to contradict the matching principle.
· The FRED assumes that the recipient of the payment will always be a parent and the payer will always be a subsidiary. This might not always be the case – it could be the other way around.
Presentation in subsidiary accounts
Where implementation of the FRED gives rise to a material change in accounting approach (this depends on how the accounting was done previously) a prior year adjustment will be required and comparatives will need restating.
In view of the fact that the distribution might be accounted for in a different accounting period to its tax effects, careful thought will need to be given to disclosure in the subsidiary’s financial statements, to ensure that the reader understands what has happened.
Whether this will happen is debatable. Many relevant subsidiaries will be small entities preparing financial statements under FRS 102 Section 1A which adopts a very ‘light touch to mandatory’ disclosure.
Here are some practical considerations:
1. Give thought as to whether charitable subsidiaries you act for/are involved with are ever in breach of company law when they distribute all their profits to their parent charity. Take steps to introduce a distribution policy which prevents this happening.
2. Make key stakeholders aware of the different approach which the FRED will require. Dividends payable (and receivable by the parent charity) will only be booked when they have been paid/received or possibly earlier where a deed of covenant exists. Although this is only a cut-off issue, the accounts will potentially look strange and may need careful explanation to key stakeholders.
3. Be aware that, on implementation of FRED 68, a prior period adjustment will be required. Early adoption is feasible as the FRED does not breach current GAAP – which is presently silent on this issue.
4. Give careful thought as to how the transaction will be explained, especially in the financial statements of the subsidiary. Any disclosure is likely to be at the discretion of you/your client where the subsidiary is small, as new accounting rules in FRS 102 Section 1A require very limited disclosure.
5. Remember that the ICAEW Technical Release and FRED 68 do not, in any way, change the tax treatment of the payment and the corporation tax reliefs available.