Transformation or alternative income?

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Eddie Finch takes a closer look at the finance implications of charities engaging with, and transforming to social enterprise models

KEY POINTS

Social enterprise is a business model, not a legal structure
The financial climate is drawing charities towards it
There are complications when trading falls both inside and outside charitable objects
Beware ‘grey market mission creep’

Whatever one’s views about the definitions of charity and social enterprise (see page 12 of this issue), a key issue facing governing boards is the relationship between social enterprise as a business model and the legal status of charity – quite apart from any ‘message’ to donors. However, it is useful to distinguish between the use of social enterprise as one tool in the box and the transformation of the whole organisation from one paradigm to the other. Many see the trustee governance model and the necessity of heavy philanthropic, voluntary or state subsidy as defining and differentiating characteristics which require a wholly different culture from businesses trading in a market.

The social enterprise sector is at great pains to reinforce the differences between itself and the voluntary and community sector. The influential State of Social Enterprise Survey report of 2009¹ reveals that ‘around half’ of social enterprises have voluntary and community sector origins and underlines what distinguishes a social enterprise from other organisations – a majority of earned income, rather than voluntary contributions and subsidy, is the key hallmark.

The divergent views on the ability of charity and social enterprise to play nicely together are partly attributable to the variety of ways in which even passionate advocates and practitioners of social enterprise conceive it. They are though, just as much a result of the differing motivations that have led to charities’ interest in embracing social enterprise.

Attractions to charities

It is well documented how, in the past decade or so, the charity sector has become dependent on the state as its largest single source of income.²The ongoing drive to separate commissioning by the state and delivery by a variety of providers, payment by results, the personalisation agenda and of course the need to rethink the shape of service provision in an era of extreme austerity, spray onto our risk maps an array of opportunities and threats.

Many charities now have no choice but to redesign their service provision along social enterprise lines – competing for ever more fragmented sources of income and continually developing their offerings to remain attractive in a market where ‘consumers’ can not only choose from which provider to access care and other services, but also whether that type of service best meets their needs.

Reductions in the contribution to overheads as a result of lost grants and contracts along with the diminution of other income sources has led to a drought in unrestricted funds and development grants – needed to maintain corporate capacity and invest in new services. The attractions of banked income from trading and/or access to the promised riches of social investment are obvious.

The emergence (at least as a promise) of a social investment market has been linked to the rise of social enterprise – raising finance other than against bricks and mortar requires an investable business model and a commercial approach to risk that fits the change in culture toward enterprise.

Trading and social enterprise

There are other compelling reasons for charities to use enterprise to achieve their aims. The fair trade movement and many social firms grew up under the wing of charities. Creating opportunities for those excluded from, or poorly treated by, markets to participate on fair terms epitomises the transformation of social action from relief to empowerment.

Social enterprise can take many forms, in particular there are those which achieve impact through the way in which they conduct business (re-use and recycling or social firms for example), and those which generate profits from a mainstream business activity to reapply for social or environmental good (a charity trading subsidiary is one example.) The most compelling social enterprises are those that make a profit largely from socially beneficial activities and also reapply those profits for further social impact (as with fair trade.)

Many of the leading lights of the social enterprise sector are registered charities or owned by them.

Some of these organisations were established first and foremost as social enterprises but have adopted charity status because of the access to grants it can unlock and the very generous reliefs from tax it brings. Green Works, the company that has been ‘re-using, recycling and re-purposing’ furniture for over ten years was an award-winning social enterprise established without charity status but became a charity as it provided significant benefits without impeding the social enterprise ethos.

Others are themselves charities which have evolved from grant or donation dependent origins into dynamic businesses. HCT Group, long seen as a leading organisation in the social enterprise sector, began life as a small community transport charity working in Hackney. It has since adapted to life competing with uncompromising private sector operators for multi-million pound bus operating contracts – whilst ensuring its profits are ploughed back into the communities in which it works.

Equally, many leading charities that do not identify themselves as social enterprises currently operate in a way which is recognisable as social enterprise. Care homes, research programmes, pre-school education and child care, sport and leisure facilities are just the first examples of sectors in which charities compete with public and commercial sector organisations for income, usually relying predominantly on earned income. Some of the largest operational charities have made high profile forays into social enterprise and social investment. Alongside success stories like the innovative venture philanthropy funding of Scope’s Grangewood project,³ are cautionary tales such as Age Concern’s ill fated Heyday venture.

All of this highlights the central fact that social enterprise is a business model and not a legal status or organisational form (see also page 25 of this issue). The constraining factor is charity status and whether a particular social enterprise business can be carried out within a given set of charitable objects. The examples cited also make clear the reality that successful business can have great impact but always carries a risk of failure.

Mixed trade peril

There are a few pitfalls that need to be avoided if a social enterprise which is directly or, as a subsidiary, part of a charity engaged in trade which mixes profitable and subsidised elements, especially where these are both within and without its ‘primary purpose’ boundaries.

In general terms, charities should only apply their funds to either further their charitable objects (and for this purpose organisational governance is included) or to generate additional, which in turn will be applied to furthering the objects. This applies to the investment of funds in the same way as to expending them. The detail is slightly different but the broad principle is the same both for determining what is “non charitable expenditure” for tax purposes and what is ultra vires. This is all usefully summarised at www.hmrc.gov.uk/charities/guidance-notes/intro.htm.⁴

Figure 1 shows the range of combinations that can arise between impact and financial return or cost. The horizontal axis represents impact – right of the line being positive. The vertical shows whether an activity generates or absorbs funds. Three of the four combinations are permissible, one is not. Traditionally, investment or income-generating activity will be resource positive but blind to the impact (though of course many charities apply ethical investment policies) Charitable spending absorbs funds but should always be intended to further the charities aims. More recent forms of investing – impact investing, programme related investment and so on – are more complex as both financial and mission-related aims are incorporated.

From a governance perspective, the extent to which compromises between return on investment and achievement of mission are justifiable is open to argument; indeed this is at the heart of the current soul searching about social investment at the heart of the revision of the Charity Commission’s guidance on charity investment (CC14). What is in principle unacceptable is to condone a net reduction in the charity’s funds to undertake activity falling outside its specific charitable objects – however worthy it might be.

This leads to a question around what we could call grey market mission creep. For example, I am treasurer of a local Age Concern charity that operates three minibuses which are almost wholly used in the morning and afternoon on three week days. Our charity was approached to consider bidding to be part of a consortium providing dial-a-ride services in our local area. This would have delivered a great deal of additional social benefit from our vehicles at times when they are otherwise idle.

Whilst it was very likely that a majority of service users would fall within our beneficiary group, there would also be many who would not (young disabled people for example). It would have been difficult to demonstrate that our charitable resources were being applied wholly within our objects. As it happens the contract on offer was poor, but assuming it had been lucrative, we as trustees may have concluded that the service should be carried out in a trading subsidiary. As long as the contract returned a profit, we would be able to justify it as delivering a ‘blended return’ on our inputs.

If it had subsequently turned out to be loss making after all, could we have squared that off as being a valid use of charity funds as our support had subsidised mission relevant services for our beneficiaries? Possibly, but you can imagine the other side of that argument. It would be difficult to demonstrate that some beneficiaries absorbed our subsidy while others did not.

Tax issues

There are three main types of social enterprise activity in which charities already engage:

primary purpose trading – business activities which themselves further the charity’s aims;
trading as a means to a primary purpose end – whether to open or balance markets or to bring excluded people into them; and
fundraising trading – to generate income to fund the charity’s work in pursuit of its aims.

This is all familiar ground – the categorisation above is used to determine whether a trading activity is exempt from tax when carried out by a charity.5 However, the categorisation above does not fully deal with the ideal social enterprise – a business which both delivers profits and impact.

Whereas the subsidy of activities by the charity that it could equally well have carried out itself is unproblematic, the cross subsidy of different activities within a single subsidiary can create a tax as well as a charity compliance problem. This is particularly the case where more than one distinct activity is undertaken in a company. The problem arises because different trades are assessed for tax separately and non-business expenditure may not be deductible in arriving at taxable profit.

As an illustration, we might consider a trading subsidiary established by an art gallery. The subsidiary operates the lucrative gallery gift shop and also the fee charging but loss-making activity of guided tours for schools.

Based on the data in Figure 2, the directors determine to pay a donation under Gift Aid of £135,000 (all the profit from the trading subsidiary) to the parent charity. Provided this is paid within nine months of the company’s year end, its taxable profit will be zero and no tax will be payable. However, it is possible that the tour activity could be deemed a non business (and therefore non-trading) activity by HMRC and its losses not available for offset against other income and profits. In this instance, a Gift Aid payment of £200,000 is required to extinguish the tax liability and a grant of £65,000 from the gallery charity may be acceptable to cover off the deficit.

This illustrates the difficulties arising from carrying out trading activity which is partly within and partly outside the charity’s objects. The problem can arise because of the class of beneficiaries, because of fee charging or because some services were for explicitly private or not public benefit, for example. If the activity as a whole is carried out in a subsidiary and remains profitable, cross subsidy between customers may not be a problem. But if the trade is loss making, there is a greater risk that the business intentions behind services provided at subsidised rates might be questioned.

Of course, the taxation issues set out here are largely familiar as those which arise when charities trade regardless of whether it is perceived as social enterprise. The same can be said of other tax implications, for example the different VAT status of some services when provided by ‘eligible’ and other bodies (a distinction that usually includes reference to profit.)

Accountability

A similar analysis of the activities of charities is contained in the charity SORP accounting framework – including those activities undertaken by subsidiaries and brought into group accounts. Where a social enterprise carries out its business in largely but not exclusively mission-connected work it can be difficult to properly categorise its activities in the charity’s accounts and report.

On the one hand, it is invalid to describe spending that falls outside the charity’s objects as ‘charitable expenditure’ whilst on the other it will often not reflect the trustees’ true intentions to describe activities established to further the charity’s mission as activities to generate funds.

This can be dealt with by using additional headings in the statement of financial activities but such an approach may require a departure from the SORP. This is an area which the developers of the proposed Financial Reporting Standard for Public Benefit Entities may be encouraged to address.⁶

Subsidy

Although larger social enterprises are becoming more sustainable (according to the State of Social Enterprise Survey only eight per cent of social enterprises with income over £1m have over 50 per cent non-trading income) very few social enterprises exist without any subsidy. This is understandable as many enterprises exist to bring those on the excluded margins closer to the mainstream of the economy. It is equally understandable that those enterprises established by charities are likely to be among the most in need of subsidy – particularly given the requirements of the public benefit test.

This does not preclude charities from transforming their cultures to one of social enterprise but it may act as a limiting factor. Many of the social enterprise initiatives springing up under the wing of established charities have been established for their empowering and enabling potential. Establishing a separate social enterprise arm is not done as part of an income generation strategy but so that those working in the enterprise gain the experience of a true business operation rather than just working on a charitable project.

A good example is the Geared 4 Life enterprise recently established by Depaul UK . It has been established with funding from Accenture and Northern Rock Foundation principally to increase the employment prospects of young people (whose idea the enterprise is). Depaul’s trustees are clear that the enterprise is first and foremost about delivery of mission and that while good business will be at its heart, any financial return to Depaul’s other work is an incidental consideration. That other work, with homeless and vulnerable young people, could never be carried out without a combination of voluntary and state support.

For many charities, establishing a genuine social enterprise is a progressive approach to supporting their beneficiary group but will always be a part and not the whole of the organisation’s work.

1. www.socialenterprise.org.uk/data/files/stateofsocialenterprise2009.pdf. The 2011 report is due shortly.

2. The Office for National Statistics recorded income into the sector from the government at £12.8bn for 2007/08

3. www.charitiesdirect.com/caritas-magazine/leveraged-fundraising-792.html

4. See www.charitiesdirect.com/caritas-magazine/sources-of-finance-a-culture-of-change-938.html

5. See www.charitiesdirect.com/caritas-magazine/a-charitable-trade-711.html

6. See www.charitiesdirect.com/caritas-magazine/a-threetiered-structure-1017.html

7. www.depauluk.org/projects/geared-4-life