Annex A: Note on legal forms of TSOs and charitable status
Annex A | Annex B | Annex C
| Annex D | Annex E
What is meant by the term ‘third sector organisation’
(TSO)?
Organisations are traditionally divided on the basis of
‘private’ or ‘public’, and ‘for-profit’ or ‘not-for-profit’.
Organisations which are established on a not-for-profit basis, and
which are not directly controlled by the state (not part of the
public sector) are widely referred to as third sector
organisations (TSOs).
This definition includes not just the voluntary and community
sector, but also trade unions, not-for-profit trade associations,
political organisations, most co-operatives and social enterprises
(provided profits are retained for the benefit of the members or
community served), private clubs, most sports organisations, places
of worship, grant-making trusts, etc.
The Treasury’s 2004 report ‘Exploring the role of the third
sector in public service delivery and reform’ defines the sector as
made up of organisations that:
- are non-governmental
- are ‘value-driven’ – that is, that are primarily motivated
by the desire to further social, environmental and cultural
objectives rather than to make a profit per se; and
- principally reinvest surpluses to further their social,
environmental or cultural objectives.
TSOs include a range of organisations: small local community and
voluntary groups, registered charities both large and small,
foundations, trusts and the growing number of social enterprises
and co-operatives. These categories are not necessarily distinct:
some charities undertake income generating activities which leads
them to regard themselves as social enterprises, but for the
purposes of this DST, social enterprises will be defined as
organisations which trade with a social objective, but not having
charitable status.
Accordingly this annex focuses on two main types of TSOs which
might be considered for the delivery of public services:
- Voluntary and community organisations (VCOs) with charitable
status with a focus on service-delivery
- Non-charitable TSOs operating as social enterprises.
The structures and legal basis of these categories are
considered further below.
What is a charity?
A very wide range of organisations can be recognised as
charities. Charity law in the UK has long recognised an
organisation to be a charity if it (a) has exclusively charitable
objects and (b) exists for public benefit.
The objects will be stated in the governing document of the
organisation. The issue of public benefit is more complex, but to
be charitable an organisation must benefit a wide cross-section of
the public, not a small limited membership, and those controlling
the organisation (the trustees) must normally be voluntary, so that
all the resources are applied to support the beneficiaries.
These concepts ultimately date back to the Statute of
Charitable Uses of 1601 (Elizabeth I) as interpreted by case
law over the years – especially the famous 1891 case of
Commissioners of Inland Revenue v Pemsel in which it was
decided that a charity must have objects falling exclusively within
four heads:
- the relief of financial hardship
- the advancement of education
- the advancement of religion
- certain other purposes for the benefit of the community.
It is expected that a 2006 Charities Act will update these
definitions by extending the original four heads of charity to 13
heads and by adding greater clarity to the definition of public
benefit. However, the two tests of charitable objects and public
benefit remain the criteria.
It is important to note that an organisation whose objects are
charitable and which is established for public benefit is
a charity and would be recognised as such by the Courts and would
be entitled to charitable tax concessions: registration with the
Charity Commission is simply a means of confirming that an
organisation is a charity.
Nevertheless charity registration is not an optional status:
under s3 of the Charities Act 1993 all charities in England &
Wales must apply for charity registration, unless the
income is below £1000 (or £5000 once the Charities Act 2006 takes
effect) or unless it falls into one of the categories excepted or
exempted from the registration requirements such as places of
worship, armed forces charities, or charities constituted as
industrial & provident societies. (However, implementation of
the Charities Act 2006 will gradually phase out most categories of
excepted and exempted charities.)
What funds can charities receive?
The defining feature of all charities is that funds are held on
trust to advance the specific charitable objects defined
in a governing document. In many cases the objects refer to a
specific class of beneficiaries (e.g. elderly people living in a
particular locality) and the trustees would be committing a breach
of trust if they allowed charitable funds to be applied for
purposes outside the objects or for the benefit of individuals who
fall outside the specified class of beneficiaries.
It follows that charities can only accept funds for the delivery
of public services if the nature of the service and the
specified beneficiaries fall within the objects of the charity
concerned.
However, a charity can accept grants or donations given for a
specific project or activity provided it falls within the objects:
in law this constitutes a ‘special trust’ and must be accounted for
as a restricted fund of the charity.
Also, there is no general prohibition on trading by charities,
and hence a charity is also free to enter into contracts for
delivery of services [Footnote 1],
including contracts with government, provided the trustees are
satisfied that it is in the interests of the charity and its
beneficiaries to do so. This is called primary purpose
trading and does not create any liability to corporation tax
provided any profits are applied to the support of the services
provided (which will virtually always be the case, since a charity
cannot distribute profits).
More complex is the situation where a charity undertakes a
trading activity that falls outside its objects. This is generally
permissible where the aim is to raise funds to support the
charity’s objects, although some charities have limits on this in
their governing documents and in any case there are strict tax
limits on such trading for non-charitable purposes and in
some cases corporation tax would be payable. (This tax liability
can be averted by arranging for the trade to be undertaken by a
non-charitable trading subsidiary company controlled by the charity
– but in that case the service is not delivered by the charity
itself: for more on this see below under social enterprises.) So,
trading for non-charitable purposes by the charity itself is
normally limited to small scale fundraising activities: it is not
appropriate for a charity to seek to deliver significant public
services on this basis.
It follows that public service delivery by charities can be
funded either by grants, or by contracts, but in both cases the
activity must fall within the charity’s objects.
What are the most common legal structures for charities?
There is no single legal structure for a charity: many different
types of organisations can be charitable if they meet the tests of
charitable objects and public benefit. However, most modern
charities use one of three legal forms.
(a) A charitable trust is governed by a trust deed, and
can be established simply by an initial donor (‘the settlor’)
declaring a trust over some property (usually a sum of money) and
appointing initial trustees. The trustees can subsequently raise
further funds, provided all funds are applied for the specific
charitable objects.
This structure is mainly used by grant-making trusts, but a
number of small charities running specific projects use the
structure of a trust. There is no wider membership, and usually the
trustees appoint their own successors, although sometimes external
organisations have the right to appoint trustees.
Charitable trusts do not have a legal personality [Footnote 2] – so, in law, any
agreements must be made with the trustees collectively, and there
is no issue of limited liability.
(b) A charitable association is a group of members who
agree to be governed by a set of rules known as the constitution.
This structure is used by a very wide range of voluntary
organisations. In most associations, the members elect a committee
who are empowered to make decisions on the use of funds, and hence
the committee members are the charity trustees.
This is a very flexible structure, suitable for a wide range of
small and medium voluntary organisations, including many involved
in delivering public services. However, it is again not a corporate
form – so agreements must be made with the trustees for the time
being – and there is no limited liability.
(c) A charitable company is formed by establishing a
company under the provisions of the Companies Act 1985, with clear
charitable objects in its Memorandum, and limitations to prevent
payments to trustees etc. The structure will almost always be a
company limited by guarantee (rather than by shares – a company
with shares would normally be distributing profits to
shareholders). Provided the company meets the tests of charitable
status, it can be registered with the Charity Commission: if so,
the directors of the company are also the trustees of the
charity.
Some charitable companies have a wide membership, where the
members elect the directors/trustees: in other cases the only
members of the company are the trustees themselves.
This structure is widely used by larger service-providing
charities, but it has the major disadvantage of requiring dual
regulation by Companies House and by the Charity Commission.
However, such charities have the benefit of a corporate legal form,
able to enter directly into contracts, and the trustees have the
protection of limited liability provided they comply with all the
relevant requirements of company law.
(d) A smaller number of organisations use the structure of a
charitable industrial and provident society (IPS) – since 2003 such
organisations are described as community benefit
societies. An IPS is an incorporated body with limited
liability – and the name normally ends with the word ‘limited’ –
but governed by the Industrial and Provident Societies Acts, rather
than the Companies Acts. If an IPS has rules with charitable
objects it can be recognised as a charity by the Inland Revenue and
then falls within the charity tax regime. At present, charitable
IPSs are exempt charities – they are not required to register with
the Charity Commission – but the forthcoming Charities Act 2006
will remove this exemption.
(e) The Charities Act 2006 will introduce a new legal form: the
charitable incorporated organisation (CIO). CIOs will be
governed entirely by charity law: all CIOs will be registered
charities and regulated entirely by the Charity Commission. CIOs
will have corporate status and will have the benefits of limited
liability. It is likely that once the CIO form becomes available,
many existing charities will convert to this form.
What legal forms are used by social enterprises?
A huge range of organisations can potentially be classed as
social enterprises and there is no single regulator analogous to
the Charity Commission. Some of the main categories of
non-charitable social enterprises are as follows.
Because these organisations are not charities, they are free to
pay fees or salaries to their directors or committee members.
(a)Community Interest Companies (CICs). CICs are
companies incorporated under the Companies Acts, as amended by the
Companies (Audit, Investigations and Community Enterprise) Act
2004. CICs are subject to the general framework of company law, and
are registered with Companies House, but are also subject to the
Regulator of Community Interest Companies. CICs must trade for
purposes which are for the benefit of the community, and are
subject to restrictions on the distribution of their assets,
although a small return to external investors is possible. A CIC
cannot be a charity. It has only been possible to register CICs
since July 2005, but it is anticipated that many social enterprises
will choose to adopt this form in due course.
(b) Companies limited by guarantee (CLG). Companies
formed on a not-for-profit basis are usually constituted as
companies limited by guarantee: although these are normal companies
subject to company law, they do not have shareholders, but instead
the members agree to guarantee a nominal sum towards winding-up
costs.
(c) Companies limited by shares but owned by a body with
charitable or benevolent objects. As noted above, it is common
for charities to establish subsidiary companies to undertake
trading activities which fall outside the charity’s objects, but
where the aim is to make a profit to support the charity. These
technically fall outside the ‘not-for-profit’ definition, as these
entities seek to make a profit for their shareholders, but where
the sole shareholder is a charity or another not-for-profit entity
(so no profits are distributed to individuals) they are generally
seen as belonging to the social enterprise category.
(d) Non-charitable voluntary associations. Some groups
clearly fall within the broad categories of voluntary or community
organisations, but have objects which are not exclusively
charitable, or perhaps fall outside the definition of public
benefit because of having paid committee members, or because their
activities are only open to a closed membership. Such organisations
would be governed by a constitution (similar to a charitable
association, but without charitable status) and do not therefore
have a corporate form or limited liability. Some organisations of
this kind may still be appropriate for delivery of public services,
particularly at local level: tenants and residents associations
often fall within this definition. However, such organisations are
not subject to any statutory regulator.
(e) Co-operatives and other non-charitable industrial and
provident societies. The IPS structure (see above) is also
used by a wide range of organisations trading on a co-operative
basis, or otherwise offering goods and services on a not-for-profit
basis. This includes a number of trading organisations providing
therapeutic work, where charitable status has been eschewed in
favour of a structure allowing paid workers to serve as board
members. The IPS legislation also extends to friendly societies,
which are normally financial institutions, although credit
unions also fall within this category and are generally
regarded as TSOs. All these entities are regulated by the FSA.
What funds can social enterprises receive?
Where social enterprises are used to deliver public services,
the funding arrangement will normally be a contract for provision
of specific services, where both parties accepts the obligations of
contract law.
It is, however, possible to make grants to social enterprises,
typically for start-up costs or purchase of specific fixed assets.
In principle, a social enterprise could be grant-funded to deliver
particular services, but this would imply a high level of trust in
the directors or committee of the entity concerned, because there
would be no regulation in terms of charity law to ensure the funds
were properly applied: only in the event of a clear breach of trust
could action by taken by the courts.
However, unlike charities, social enterprises can frequently
accept equity investments, and there could be situations where a
public sector body agreed to fund a social enterprise directly
through an equity stake – although any such investment would have
to fall within government accounting requirements.
Notes
- [back to footnote 1] Unless there was a
specific prohibition in the governing document for trading of any
kind – but a prohibition on primary purpose trading would be very
rare.
- [back to footnote 2] It is possible in
principle for the Charity Commission to make an order incorporating
a body of trustees, thus allowing the charity to hold property in
its own name, for example. But this is rarely used, and even when
done, it does not confer limited liability.