It is important for charities to be able to distinguish between the nature of grant and contractual arrangements because the accounting treatment is different and there are also direct and indirect tax implications for charities.
Whilst this article is primarily about accounting and tax issues, charities should exercise caution when entering into contracts. Contracts are governed by contract law and there can be onerous consequences for breach of contract. Charities need to understand the implications of entering such contracts and ensure that they are in their best interests – including their financial impact if they are both successful and if they are not.
Charities also need to understand the direct tax and indirect tax treatment of such contracts and ensure as far as possible that the charity’s risk is minimised and its position protected as much as possible. That is not to say that all contractual arrangements are bad and it seems that we will continue to see more of them, so they are to be well managed rather than avoided.
A grant is a voluntary payment to further a charity’s objects, whereas a contract is a legally binding agreement for the supply of goods or the performance of a service at a specified price. Trust law governs the former; contract law the latter.
A contract may be entered into by a charity either because the contract activity furthers its objects, or, if it does not further its charitable objects, as a means of income generation, usually through a trading subsidiary. A grant must be used for the purposes for which it was given, whereas unless the contract says otherwise, a surplus on a contract, after performance of the terms, may be retained by the seller of the goods or provider of the service. Unfortunately for the recipient charity, a growing trend is to include a contractual term requiring any surplus to be returned to the ‘funder’.
The distinction between grants and contracts is an important one. The first consideration to distinguish between the two is to decide whether trust or contract law applies.
A grant is essentially a voluntary payment, motivated by a desire to further the recipient’s activities rather than to secure goods or services. It is held on trust by the recipient to be used only for the purposes for which it was given. This may be the same as the charity’s objects, or may be more specific. If it is not used in an accounting period it should be carried forward in the balance sheet as a reserve, restricted if necessary. It may be repayable if never used for the purposes for which it was given. With this simple type of grant it is not unusual for the funder merely to ask for a report on how the grant was spent – perhaps on its impact.
A development of the simple grant described above is the performance related grant. The terms of such a grant require performance – the carrying out of a specified activity or provision of specified items – before the recipient is entitled to recognise the grant as income. This gives the donor more control over how and when the grant is used, more so than simply relying on a retrospective report. This is still a grant rather than a contract, however, because it remains a voluntary payment, but it can sometimes be hard to distinguish it from a contractual arrangement.
An approach to distinguishing between the two is to ask what happens if it all goes wrong? What is the funder entitled to? Just repayment of the grant or are they entitled to seek redress for breach of contract? It may well help to take legal advice when considering this issue. Remedies for breach of contract extend beyond a simple refund into claims for damages. Such terms are indicative of contractual rather than voluntary arrangements.
When considering accounting issues it is necessary to not only consider the requirements of the Charities Statement of Recommended Practice, but also accounting standards, principally SSAP 4 and FRS 5.
Contractual income is recognised in the Statement of Financial Activities on performance – that is when the contractual terms have been met. Until such time as performance has taken place, the associated consideration, if paid in advance, is treated as that – a payment in advance, held within creditors. The same is true of performance related grants – entitlement only arises when the performance conditions have been met.
Contractual income derived from the provision of goods and services to beneficiaries should be analysed as incoming resources from charitable activities. Income from performance related grants is usually analysed in the same way. If contracts are entered into primarily to raise funds the income is categorised as activities for generating funds, with the resultant expenditure forming part of costs of generating funds.
Unless grant income is for a future period, it is recognised in the Statement of Financial Activities (SOFA) on entitlement, once the criteria of certainty and measurability have been met. This is regardless of whether the related expenditure has been incurred by the end of the accounting period. Grants received for the general purposes of the charity or not having particular service requirements are analysed as voluntary income in the SOFA.
Some grants come with conditions. If meeting the conditions is within the charity’s control and there is sufficient evidence that the criteria will be met, the grant should be recognised in the SOFA. Where there is uncertainty as to whether the conditions will be met, (such as a requirement to raise matching funding) then the grant should not be recognised within the SOFA but carried forward as a liability within the balance sheet until it is certain that the conditions can be met. However, in such a circumstance it may then be necessary to disclose a contingent asset, if it is probable but not certain that the conditions will be met in the future.
Where a grant is to acquire a fixed asset, the grant is recognised on entitlement and, if restricted, held in a separate fund. The fund is then diminished over the asset’s useful life by periodic depreciation charges, or released immediately on acquisition if the terms of the funding are thereby met.
A key aspect of charity accounting is the proper adoption of fund accounting. Contractual income is corporate income to the charity hence will always represent unrestricted funds. Grant income may be either restricted or unrestricted funds, depending on the terms of the funding.
Trading is the provision of goods or services with a view to profit. Primary purpose trading by a charity is covered by the exemptions from taxation available to charities in UK tax law and is therefore not taxable. An example would be the sale of tickets by a theatre charity to see a performance carried out as part of its charitable objects.
Ancillary trading is part of the primary purpose trade and takes the form of incidental trading not carried out in its own right, such as a charity theatre’s bar and restaurant in the previous example. Accordingly, ancillary trading also enjoys tax exemption. There are no monetary thresholds and it is a matter of judgement as to whether such activities are ancillary.
There is also currently a small trades exemption for low level taxable trading activities and an extra statutory concession in respect of fund raising events that might, otherwise, be regarded as trading activities. The small trades exemption is related to the size of the charity’s total income but has an upper limit of £50,000 of taxable turnover, and reference should be made to the current rates. The Extra Statutory Concession (ESC C4) sets out a number of detailed requirements for the concession to apply and again reference should be made to the current document.
Grants and performance related grants are treated as donations and are not regarded as income for tax purposes at all and are, therefore, not taxable. Contractual income is trading income, but if derived from primary purpose activities, is not taxable. It may be taxable if it is carried out to raise funds to further the charity’s objects, in which case unless it is covered by the small trades exemption or the extra statutory concession for fund raising events, is usually undertaken by a trading subsidiary that can then pay up its profits by way of Gift Aid.
Trading subsidiaries are however a topic in themselves outside the scope of this article.
Charities have more of an issue, however, with contractual income because the prescriptive terms of the contract may render the income a supply of services for consideration and therefore liable to VAT if the registration threshold is exceeded (the limit increased to £68,000 per annum with effect 1 May 2009). If this issue isn’t addressed at the time the contract is entered into, charities run the risk of HMRC raising an assessment on income that they deem should have been subject to VAT. On the other hand charities may prefer for the grant to be subject to VAT as the grantor may be able to recover the VAT charged by the charity therefore allowing the charity to recover VAT on its costs.
VAT is a complex area and charities should consider taking professional advice before entering into such contracts.