Trading subsidiaries, the pandemic and their financial support

One of the common dilemmas facing charity trustees as a result of the pandemic is how to manage their trading subsidiaries. As these subsidiaries are usually set up for tax-efficient profit generation, they may hold very little in reserves as all profits are gifted/covenanted to the charity each year within nine months of their year-end.

Profitable trading subsidiaries have usually managed their working capital and cash flow through this nine-month window after their year-end to allow them to create more profits and working capital before fully distributing their prior-year profits to their parent charity.  Overall, most subsidiaries have been able to operate in this way without the need for additional loans or investment from their parent charities.

However, during the pandemic and COVID-19 restrictions, many were unable to generate profits – not able to open shops, hold events, run conferences or otherwise trade. Therefore these profitable ventures were losing money – retail grants and furlough may have helped, but some unavoidable fixed costs meant that these entities were making losses. Some are continuing to be loss-making as they still cannot trade. So what do they do? There are no reserves to fall back on as they were all given away.

Trading subsidiaries that have overall net funds can be technically insolvent. Negative funds do not necessarily mean creditors cannot be paid when they fall due as the trading subsidiary may have longer-term debt or loans, which mean it can pay its creditors.

Investment in subsidiaries through loans, working capital and share capital

The Charity Commission updated its guidance on advice to charity Trustees in their coronavirus COVID-19 guidance for the charity sector in April 2021 and specifically picked on this issue regarding trading subsidiaries. https://www.gov.uk/guidance/coronavirus-covid-19-guidance-for-the-charity-sector#trading-subsidiaries–financial-support-from-parent-charities. This clarifies that the parent charity must consider any support and funding provided to its trading subsidiary the same as any other investment on an arm’s length basis. Hence the Trustees must consider the financial return on their investment, which means assessing the financial viability of the business – its profitability, forecasts and business plans – as part of that investment decision whether the funding is provided through a loan agreement from the parent charity, investment in share capital or temporary working capital provided by an inter-company balance which operates on normal payment terms. The share capital route requires stringent review as investing in a struggling trading subsidiary in this way risks the share capital. In contrast, a loan may be able to be secured on assets and can also earn interest. In the worst-case scenario, should the trading subsidiary need to formally close, a secured loan would have a better chance of a payout, whereas a capital injection would not be last to be repaid, if at all.

In normal times, and when first setting up a new trading business, such business plans and income generation projections/profitability are used by the charity to justify the ability to invest in that trading business and then reap the future rewards. At the start of the pandemic, and when lockdowns were lifted, the business plans were updated which expected a return to a viable, profitable business in a relatively short timescale and often within a year. Hence investment from charities to support these viable trading businesses meant charities did inject ‘capital’ into their trading subsidiaries on the basis that these funds would be returned in the near future and generate appropriate returns.

The landscape has now changed again; confidence in the economy fully opening up and allowing large scale conferences and events remains uncertain. The future of some business activities and their return to profitability is less predictable, and businesses which require international visitors and predicting their return is difficult. Even shops and hospitality that are currently open are not certain to continue as variants cause concern over the further easing of government-imposed restrictions. Will the vaccination programme prove successful against variants and allow businesses to return to a level of normality? Trustees looking at investment in trading subsidiaries face difficult decisions; furlough continuing until September may offer some assistance in their decision making by perhaps deferring discussions on the future viability of businesses until a later point. Continued investment and support of their trading subsidiaries may, on balance, still be justifiable by charity Boards for the moment. However, it may be appropriate for Boards to engage professional advice to help support their decision making at this critical time. The charity Trustees must put the interests of their charity first when looking to provide financial support and its justification as an investment. Charities cannot support and invest in failing businesses; hence it is essential that any support provided to their trading subsidiary has a clear business case and supporting documentation to evidence due diligence by the charity Board in making their decision to fund.  It is equally important that the charity Board monitors the situation to ensure that the basis of any decision remains sound and that if the situation changes, appropriate action is taken immediately.

Going concern

With charities currently going through their audit process, such as with March 2021 year ends, the going concern perspective on the charity and its trading subsidiary may require attention.

As already noted, the trading subsidiary may have overall deficit funds (net liabilities). It is technically insolvent, albeit that it may have cash to pay its creditors as they fall due through the use of the working capital/loan provided by the parent charity. The charity cannot guarantee the debts of a trading subsidiary that is not delivering primary purpose charitable activity as this would be using charitable funds for non-charitable purposes.

It is commonplace instead for the charity to provide a support letter. Typically, such support letters confirm that the charity will not require repayment of any of its balances owed by the trading subsidiary for at least 12 months from the date of signing the accounts unless funds allow. Whether such a support letter is sufficient to support a going concern perspective for the trading subsidiary will require forecasts, cashflows and budgets to show that the trading subsidiary will return to profitability or the resources it has, are sufficient to survive for at least that 12-month window. If there is doubt over its future viability, then this may cause a detailed discussion with the auditors and management to consider and understand the implications on the accounts and/or audit report.

Therefore, in considering the ability for the trading subsidiary accounts to be prepared on a going concern basis, there will need to be evidence on how it will be funded and will survive – be it through further cash injections from the parent charity, a return to profitability or being mothballed until better trading conditions are available, or a combination thereof. Negative funds (or formally equity) does not necessarily mean insolvency as the company may be able to still meet its debts as they fall due but does need careful management. Depending on their circumstances, advice from insolvency practitioners may be required where that situation changes.

Conclusions

Trading subsidiaries continue to cause concerns due to the pandemic in terms of their financial support, viability and going concern status.  Many now have negative funds at their latest balance sheet date, which brings a heightened responsibility on the directors over future potential insolvency and going concern issues, and future forecasts and projections may be difficult. Ensure you communicate your challenges with your professional advisers and keep them informed and take advice as the need arises. Trustees must ensure that any financial support provided to the trading subsidiary is based on sound business plans, which are closely monitored to ensure that the charity’s funds are not put at risk.

This blog was written by Helena Wilkinson, a Partner at Price Bailey. If you have any questions regarding this blog, you can contact Helena using the form below.