Charities and Investment: CC14, Hodgson and beyond

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1 Page 1 Charities and Investment: CC14, Hodgson and beyond James Maloney September 2012 After lengthy consultation, the Charity Commission published its revised guidance on Charities and Investment 1 in October Generally the new guidance is a consolidation of existing texts, although there are a number of headline changes and there is also plenty of Commission guidance that is still not in CC14, but can be found on the Charity Commission web-site here: Managing charity resources (under "Charity governance") es/default.aspx Common Investment Funds - A basic guide to their regulation (December 2009) see also Pooling Schemes and Pool Charities (OG 49) Endowed Charities: A Total Return Approach to Investment (OG 83) Trustee Act 2000 (OG 86) Some of the issues picked up in CC14 in particular relating to "mixed motive" investment have been the subject of further examination as part of Lord Hodgson's recent review of charity law. Headline changes in CC14 The headline changes are: 1. There is no longer an attempt to define what constitutes investment by a charity by reference to concepts of "investor" and "investee". 2. Investments are "property held for the purpose of generating money, whether income or capital growth". 3. An acknowledgement that derivatives and commodities can (possibly) be investments in their own right. 4. Borrowing to invest the accompanying legal underpinning document comments on the legitimacy of charities borrowing funds for investment purposes 2, and concludes that in order to do this charities should have an express power to that effect. 5. The duty to balance present and future interests of the beneficiaries of a charity has been clearly confined to permanent endowment trusts (previous Commission guidance was not so clear on this issue). 6. Efforts have been made to develop a consistent terminology for forms of investment activity for a charity. This was emphasised more in the consultation draft than the final version, but the following might obtain common currency: "Financial Investment" investment by a charity to obtain the best return that can reasonably be obtained, for spending on the charity's objects. "Mission-connected investment" financial investment that also happens to serve a social purpose, whether in furtherance of the charity's objects or not. "Ethical investment" financial investment where the return on investment might be less than normal due to ethical restrictions that the charity trustees have legitimately placed on the choice of investments. To be legitimate, the restriction must be because it serves the objects of the charity (eg cancer charities not buying By reference to In re Suenson-Taylor s Settlement Trusts [1974] 1 WLR 1280

2 Page 2 tobacco stocks), or would (on reasonable evidence) alienate supporters, or the trustees are satisfied it will not result in a significant reduction in the investment return 3 to the charity. "Programme-related investment" where a charity employs its capital to further its charitable objects, using an investment technique for that application (e.g. a loan at a less than market rate of interest). Funds lost, or return foregone, can be regarded as charitable expenditure. Programme-related investment is not suitable for permanent endowment (due to the possible capital expenditure element), and there must not be inappropriate private benefit (as it might result in charitable expenditure). "Mixed motive investment" where an investment activity cannot be justified entirely as a programme-related investment; or as a financial investment; but can be justified as a combination of the two. There are two minor points to note. First, the original text of the guidance suggested that charities with permanent endowment that invest on a total return basis with a total return order had to index-link their core capital. So, it stated trustees must: ".ensure that the value of their investments remains above the value of their initial capital (a positive total return). If the value of their investment falls beneath the value of their initial capital (a negative total return), adjusted for inflation, the trustees would not be able to distribute income until they achieve a positive total return" No total return order requires adjustment of core capital to take account of inflation, so "adjusted for inflation" has now been removed. Secondly, it is not entirely clear where the Commission stands on a duty (or otherwise) for trustees to take investment advice. Contrast: Executive Summary: Trustees must "...take advice from someone experienced in investment matters unless they have a good reason for not doing so". Section C2: Trustees must " take advice from someone experienced in investment matters where they consider they need it". Mixed motive investment This is the most significant innovation in the guidance. Mixed motive investment is described in the following terms: "However, sometimes trustees will want to invest in a way that they consider to be in the best interests of their charity but not entirely justified on just one of these grounds [i.e. financial investment or programme-related investment] alone. In this situation, they may be able to justify the investment as a mixed motive investment if they are satisfied that: (a) (b) the investment can be justified by the dual nature of the return - part financial and part justified by the investment's contribution to the charity's aims; and there is no other reason for making the investment, including: (i) creating unauthorised private benefit to some or all of the trustees or people connected with them; and (ii) creating unacceptable private benefit to other individuals." Previously the Commission had taken the view that investment of this kind was difficult, as it did not obviously come within a charity's power of investment, or its power of expenditure. 3 Here, as previously, the Commission does not attempt a definition of "significant".

3 Page 3 The Commission has now taken a more pragmatic line and is reconciled to a charity being able to do this. This may in time prove to be helpful for charities considering investments that do not sit easily within either financial investment or programme-related investment, but which contain elements of both. No examples of mixed motive investments are provided in CC14, although one was suggested by the Commission during the consultation process, as follows. A charity set up to promote the preservation, conservation and protection of the environment particularly through the prudent use of resources is interested in the support and development of new sustainable technologies in this area. It is offered an opportunity to invest in a commercial company that specialises in the development and installation of products that are designed to harvest rainwater for domestic use. This is intended to reduce water pollution. The company is unlikely to pay a dividend to investors in the short term, although medium term returns are projected to be healthy. In this case, the charity could justify the investment as a mixed motive investment if it considered that there would be a clear contribution to the furtherance of its aims and if there was some chance of a financial return in the medium term. While this example did not make it to the final guidance, it does give an indication of the sorts of investment activity the Commission had in mind. Two areas where it seems to us that the concept of mixed motive investment offers real opportunities are the financing of subsidiary trading companies and the structuring of joint ventures. On the former, the revised CC14 helpfully confirms that an investment by a charity in a subsidiary trading company can constitute a mixed motive investment. Many charities use subsidiaries to carry out riskier primary purpose trading activity. Where a subsidiary combines this with other, non-charitable trading activity, it seems to us that an investment by the parent charity (whether in the form of loan or equity finance) could be a mixed motive investment. The mixed motive methodology could also, it seems to us, be used by charities to structure joint ventures that might otherwise not be able to satisfy the requirements either for financial investment in that it would be unlikely to deliver the best financial return or for programme related investment because there may be non-charitable outcomes and/or too much private benefit. However, while new investment opportunities may be available, it is important to note that trustees considering any mixed motive investment will need to answer three questions: What discount am I accepting on a similar financial investment? Is the charitable objective we achieve an effective use of the return forgone? Is there too much private benefit, relative to the charitable objective achieved? It is not a straightforward exercise answering any of these questions. The first requires a relatively sophisticated understanding of the asset class and sector of the mixed motive investment. The second requires some impact assessment, which remains an imperfect and much-debated technique. The third accepts that all financial investment must anticipate a private benefit to somebody; how much is too much? What is as important is that HMRC has yet to make its own announcement about how it will approach mixed-motive investments for tax purposes, and in particular what it will need to be satisfied a mixed-motive investment is an "approved charitable investment" 4. HMRC is expected to produce guidance before the end of the year. In the meantime some disquiet at the concept has been expressed (hence its inclusion in Lord Hodgson's review). 4 As defined in ITA 2007 section 558 for trusts, and CTA 2010 section 511 for charitable companies and clubs.

4 Page 4 The Hodgson Review 5 Chapter 9 Lord Hodgson's wide-reaching review of the operation of and effectiveness of the Charities Act 2006 and, more generally, the legal and regulatory framework for charities, was laid before Parliament in July Chapter 9 of the report is dedicated to social investment. Lord Hodgson asserts that "social investment should become far better integrated into the overall legal and regulatory framework" and argues for "a more permissive legal environment, where trustees are confident of their ability to take the action they consider to be in the best interests of their charity." To this end, he makes a number of specific recommendations to encourage and facilitate social investment: 1. The rules governing investment by charities (in the Trustee Act 2000) should be amended as follows: 1.1 trustees should be entitled to consider the "totality of benefit" (i.e. both financial and social benefit) that an investment is expected to provide when making investment decisions; 2.1 "investment" should include any outlay of money where the charity expects some form of financial return whether or not that is the primary motive for making the outlay; 3.1 the other existing Trustee Act principles governing investment (e.g. the standard investment criteria, the requirement to review investments and the duty to take advice) should continue to apply. 2. The Government should draw attention to the distinct responsibilities imposed on charity trustees as opposed to trustees of private trusts (i.e. the need to further charitable purposes rather than simply preserve capital). 3. The Government should introduce a legal power for non-functional permanent endowment to be invested in mixed purpose investments, with a requirement that capital levels must be restored within a reasonable period. 4. The Government should work to develop a standard social investment vehicle to allow funding from different sources to be invested in the same product. 5. The permissible level of private benefit requirement in relation to investments in CC14 should be reworded from appropriate to "necessary and proportionate", with the Charity Commission producing clear guidance to ensure this does not undermine the wider public benefit principle. 6. Development of social impact measurement should not be added to the existing statutory list of charitable purposes at this time. 7. The existing Charities Statement of Recommended Practice (SORP) should be revised to facilitate the appropriate reporting of social investments. 8. The Government should consider amending the Financial Services Bill to provide a statutory and regulatory underpinning to social investment. (The Bill 6 was considered by the House of Lords at committee stage in July, and will return to committee stage in October when further amendments will be discussed.) You can view the full Bill page here:

5 Page 5 9. Charities should be able to apply to HMRC for prior clearance on tax treatment ahead of making an investment and, in time, HMRC should provide clear guidance on the tax treatment of different types of social investment. HMRC should also consider establishing a dedicated unit for social investment issues. 10. The Government should consider ways of revising financial promotion rules to allow social investment advice to be given. 11. The FSA should consider establishing a specialist unit to deal with the challenges of social investment for both the investor and the investee. 12. The name of the term "mixed motive investment" should be replaced with "mixed purpose investment" to provide the general public with a clearer understanding. Lord Hodgson's recommendations are ambitious and would make fundamental changes to the principles underlying social investment by charities. The proposals have generally been welcomed by the sector, although there is no specific timetable for their implementation. A number would require primary legislation and it is not clear whether charity law reform will be a priority for a Government whose legislative in-tray is already burgeoning. Some of the recommendations warrant further analysis; in particular, whether the third proposal above through which non-functional permanent endowment may be invested in the sector would create an unacceptable degree of risk. More immediately, it remains to be seen whether the Government takes up one of the more significant recommendations in the review, namely the proposal to amend the Financial Services Bill. With the Bill's progress due to resume in October, we should not have to wait long to find out. What Next? It is very much to be hoped that HMRC's guidance when it eventually appears provides clarity on the tax treatment of mixed motive investments. We also hope that Lord Hodgson's recommendations on social investment lead to further clarity for charity trustees, although we do not expect to see any progress towards his proposals in the immediate future. If you require further information on anything covered in this briefing please contact James Maloney (james.maloney@farrer.co.uk; +44 (0) ) or your usual contact at the firm on This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances. Farrer & Co LLP, September 2012