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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 ofCommissioners 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 isa 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 ontrust 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.

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: thecharitable 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.

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.

  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.
  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.

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