Changes to charity tax compliance: what does the draft legislation cover?

Background to the changes

Changes to charity tax compliance rules have been in the pipeline since the last Government launched a consultation in 2023. The response to the consultation, published with the Autumn Budget last year, made clear the current Government’s intention to strengthen the existing rules. Draft legislation has now been produced which changes the rules for: 

• tainted donations to charity;
• approved charitable investments; and
• attributable income.

The draft legislation is open for comment, via charitypolicy.taxteam@hmrc.gov.uk, until 15 September.

In addition, the Autumn Budget announced that sanctions will be brought in for failure to meet tax obligations. Guidance dealing with this change will be published in draft in due course.

All these changes will take effect from April 2026, and will cover not just charities but also community amateur sports clubs. For simplicity, we refer just to charities in this note. 

Tainted donations changes

The existing tainted charity donations rules are based on a purpose test applied where a donor, or someone connected to a donor, enters into arrangements to make a donation, and the purpose of those arrangements is to secure a financial advantage. 

Three conditions must be met for the rules to apply. Where all three conditions are satisfied, the donor loses any tax relief that they would have been entitled to claim, had the donation not been tainted.

The key change proposed here is to the current condition that the main purpose of entering into such arrangements is for the donor, or someone connected to the donor, to receive a financial advantage directly or indirectly from the charity. Under the new rules, it is the outcome, not the purpose, of the arrangements that will be critical, allowing HMRC to look at a series of transactions in the round. 

The bar for establishing whether a donation is tainted is also lowered by replacing the test of “financial advantage” with that of “financial assistance”. “Financial assistance” is defined to include “a loan, a guarantee, an indemnity or any form of investment (in each case, whether or not on arm’s length terms).” Including transactions on arm’s length terms is controversial – if a transaction is on an arm’s length basis, it is not clear why it should result in a donor being penalised and a charity’s ability to enter into potentially beneficial transactions restricted. The inclusion of arm’s length transactions clearly  indicates the intended wide scope of the financial assistance test, coupled with the outcomes test. 

The Government’s response to the consultation on the changes contained a commitment to produce comprehensive guidance to support charities that “will clearly explain the new rules and set out how HMRC will apply the new financial benefit or assistance outcome tests and will contain examples where helpful.” Draft  guidance is expected to be produced after the period for comment on the draft legislation closes.

Changes to approved charitable investments

Charity tax reliefs on income and gains require that the funds are applied for the charity’s purposes, that is its charitable activity and administration. Any non-charitable expenditure will trigger loss of tax exemption on an equivalent amount of income or gains. For these purposes, non-charitable expenditure includes investments or loans if they are not deemed to be approved charitable investments. 

Tax legislation lists types of investment which are regarded as approved charitable investments. This covers most common forms of investment and includes a final category of any loan or other investment made for the benefit of the charity and not for the avoidance of tax (whether by the charity or any other person). 

The proposed changes will require all approved charitable investments to be for “an allowable purpose”. An investment is for an allowable purpose if it is reasonable to draw the conclusion, from all the circumstances of the case, that it is made for the sole purpose of benefiting the charity. This is a wider test, potentially bringing in consideration of incidental private benefit flowing from an investment, not just tax avoidance. 

In the majority of cases, investing charities will have professional investment managers and satisfying the new test should not be problematic. Outside that context,  for example, when a charity is considering investment in a social enterprise or other non-charitable body, and seeks a financial return whilst also achieving the charity’s purpose, care will be required to ensure that there is clear evidence of how the new test is met. 

HMRC will not be providing an advance clearance process but, in response to the consultation, the Government has confirmed it will supply comprehensive guidance and will set out examples of records and documents it considers will provide evidence that a charity is compliant.

Extending attributable income rules

Where a charity has incurred non-charitable expenditure, the loss of tax relief this triggers bites on an equivalent amount of its ‘attributable income and gains’. Attributable income and gains means the amount of income and gains that are eligible for tax relief or exemption. It includes gift aid donations, rental income, interest received, profits from a charity’s primary purpose trading activity, and capital gains. Currently, legacies and other income donations made outside the gift aid regime are not included.

The proposed change is to include legacies within the scope of attributable income. The rationale for this is that, although legacies are not tax relieved in the charity, they are exempt from inheritance tax in the deceased donor’s estate. As the Government response to the consultation stated, the intended changes “will make it clear that if income could be relieved in either the donor’s or the charity’s hands it should be subject to the non-charitable expenditure rules”. 

The consultation originally proposed that the six-year period for carry-back of excess non-charitable expenditure should be extended. The Government has decided not to proceed with this at this time, although it will keep this under review.

Summing up 

The proposed changes are the latest in a long line of measures over the years to tackle the issue of tax-relieved charitable donations being turned to private benefit. Whilst it is acknowledged that abuse stemming from charitable conduct and governance are primarily for the charity regulators across the UK to monitor, the consultation response made clear that the Government does and will continue to play an active role where tax reliefs have been given. It is estimated that the additional tax revenue generated from the year 2027/28 onwards will be £35m.

The draft legislation, explanatory note and policy paper can be found here: Changes to charity compliance measures - GOV.UK