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Charities which have traditionally been given local authority grants are now increasingly being faced with having to act as if they have been procured under a contract to deliver a set service, complete with KPIs (key performance indicators) and outcomes. This can have significant VAT implications and give rise to accounting considerations which charities need to be aware of.
With greater scrutiny and accountability around the use of public bodies’ funding and budgets, contractual arrangements of this nature have become more and more commonplace in recent years. The knock-on effect is that agreements which charities have to enter into are becoming more complex.
From the start it is important to distinguish the difference between what is considered a grant and what is a contract.
Grants to support charities
A grant is a voluntary payment to support a charity to further its objectives, and can only be used for the purposes for which it has been given. If the grant is for the overall objectives of the charity, as opposed to use to support a particular project, the funding is usually deemed as unrestricted income.
In instances whereby the grant is supporting a set service, any surplus funding on completion of the project can be retained by the recipient organisation, unless a clause is included in the contract contrary to this.
Performance related grants will involve terms requiring performance of a specified service, and payment is conditional on specified outputs and if objectives have been delivered. Due to the payment being voluntary this is still recognised as a grant.
Contracts being binding agreements
A contract, on the other hand, is a binding agreement which distinguishes the supply of goods or services for a set fee and over a set period of time. Charitable organisations can enter into contracts if the terms further the charity’s objectives. Unless otherwise stated in the contract, any retained surplus on the performance is retained by the charity and the income is classed as unrestricted.
The benefits of avoiding errors at the outset of entering into a contract or accepting a grant cannot be underestimated.
If mistakes are made, it can be extremely costly in terms of time and also funds at a later date when HMRC carry out an inspection – especially if the charity no longer has the funds there to make up for a shortfall! Penalties and additional interest charges can also be added by HMRC.
So what do charities need to bear in mind when considering VAT and accounting issues?
In the cases of grants and contracts, charities sometimes have difficulties determining if the agreement is classed as a business transaction and if therefore VAT is due to be paid.
Although VAT is charged on most business transactions in the UK, a donation or a grant to a charity is not classed as business transaction and is not subject to VAT in a number of instances.
For instance, if a charity does not give the donor any benefit of value in direct exchange for a donation, or if the charity does not give a third party any benefit of value, and likewise if the donation has not been made subject to any other conditions.
In the main, VAT is a tax which falls on the end user of a product or service, and cannot be recovered by the final consumer.
Where it can get complicated is that while the organisation responsible for selling the service to the end user is liable for VAT for the costs of delivering the service, it is also able to recover this VAT.
There are some services however which are classed as exempt from VAT, such as education, care of children and the elderly, social welfare or medical services.
In cases like this, the organisation which sells the exempt service to the end user is still liable for VAT on its costs, but because the services sold are exempt from VAT it is not allowed to recover the VAT.
So for any charities providing exempt services they do not charge VAT, but also cannot recover the VAT they are liable for the attributable costs.
Choice of arrangement
It will be a balancing act for many charities about whether to explore using grant funding or if to enter into a procurement contract.
Traditionally it has been HMRC policy to treat payments described as grants as being outside the scope of VAT.
This was in contrast to money paid over as a payment (or consideration) for a supply under a contract. The nature of grant funding has changed and more and more conditions are now set by grant givers.
In many cases these have become nearly as onerous as the conditions found in contracts for service. Consequently although it is HMRC policy to allow "housekeeping provisions" for grants, the distinction between grants and contracts has become very blurred.
This is especially true if the only reason the work is undertaken is because a grant is received and the grant is obtained under a tender process. In such a case there is a very good argument that the grant is not in fact outside the scope of VAT.
There is less of an issue with non-restricted and core funding, and if you receive grant income it is worth considering if it should be subject to VAT.
Multitude of factors
The reality is that a multitude of factors will go into determining which route a charity should take, and tax-efficiency will in many circumstances not be at the top of this list.
Failing to take into account tax from the outset during decision making could however put charities in an extremely dangerous position. So they need to proceed with caution before entering into any agreements or contracts to protect their position.
The consequences for breach of contract can be severe so before signing on the dotted line, charities need to ascertain if entering into an agreement is in their best interests and if in any doubt should seek professional advice.
The use of contracts and grants is an extremely fast moving subject, and indeed new developments and guidance are imminent - so it’s very much a case of watch this space for the third sector.
"The benefits of avoiding errors at the outset of entering into a contract or accepting a grant cannot be underestimated."
Why is it that charities are becoming increasingly interested in social finance, enterprise and investment? The answer is that the prospect of alternative funding which can lead to meaningful outcomes in terms of the charity's purposes is an attractive one.
The charity sector is indisputably under pressure. Governmental budget cuts have begun to bite and experts seem to suggest that this will only get worse. Many charities have allowed public sector revenues to increase as a percentage of their income over the past decade or so and with this source in decline, the charitable sector is being squeezed.
Falls in interest rates to previously unfathomably low levels have reduced the income which foundations and endowments receive. While some have dipped into corpus in order to ease the short term pain of the sector, this is not a sustainable solution.
Similarly, charities had reserves, or undervalued assets such as buildings, and these have been used creatively to make up some of the shortfall, but this too is not unlimited. Finally, business plans based upon life "as things were" are simply not viable. As a result, the search is on for other means to finance work that can achieve charitable objects.
Capital available for deployment
What many charity CEOs have noticed is that there is a great buzz around social investment. What others have noted is that the pool of capital available for deployment, though small, seems to be growing at nearly 40% per annum. This is being underpinned by some widespread changes as well as some governmental programmes - all of which are being usefully crystallised by Big Society Capital, which is independent of government, but was created by it.
BSC will come to have over £600m of funds, mostly coming from unclaimed assets in financial institutions (few are shedding tears for the banks as they are losing these) to utilise in building a large and vibrant social investment market in the UK. As its funds are being matched at least equally by other funds, this represents a £1bn+ pot of funds that are available for social investment. In fact, it appears to be catalysing far more than this.
While insufficient to solve all the problems of the fiscal crisis for charities, this is an undeniably large pool of capital, growing fast, and has the potential to be deployed against projects which generate social impact and are consistent with, in certain instances, charitable objects.
Charities already own entrepreneurial endeavours - in fact many have already established trading subsidiaries, with the aim of generating income for use elsewhere in the charity. What is unique about social enterprises is that they can generate income, but at the same time, are achieving charitable objects.
Think of The Big Issue (one of the UK’s better known social enterprises), a self-sustaining organisation. The social enterprise creates a double benefit for the charity in that it generates income (all post-investment profits are passed to The Big Issue Foundation) and, by virtue of what the social enterprise does, it is also generating social impact.
In the case of the Big Issue there are several benefits: helping the homeless back into work; developing commercial skills for the individual vendor; helping the vendor generate an income in a fashion that is considered preferable to begging.
This is the beauty of social enterprise - it addresses many problems simultaneously, and should do so in a fashion that is cash-generative, like the trading subsidiary of the charity. Like the trading subsidiary, things may or may not work out financially, but unlike the trading subsidiary, even if they operate at a loss there is social benefit. With a trading subsidiary, it is generally only the profit that is sought, and if this does not result there are generally no social benefits.
Running a social enterprise contains similar challenges to running any business. A strong management team, financial controls, routes to market, a competent and well functioning board, and much more are necessary ingredients in any successful enterprise. Social entrepreneurs, like the executives of any organisation cannot and must not rely on their social mission to excuse sloppy practices or incompetence.
Evidencing positive social impact
What is unique is that social enterprises have certain obligations which normal businesses do not have - namely to generate, measure and evidence positive social impact. This is important to all stakeholders and might be mandatory to some of the socially-minded investors who are emerging to back such enterprises.
They do, on the other hand, possess important advantages, such as the ability to sell products at higher prices because of their ethical orientation (think of Fairtrade), the ability to secure volunteers and increasingly access to attractive sources of capital, sometimes at substantially superior rates to mainstream sources. It is for this reason that charity CEOs are increasingly interested in the sector.
However, social investment is not an alternative to grants. Social investment is only useful to charities when they themselves need to make an investment. This could be a capital investment, or an investment in technology, or even an investment in a new team of people - but such an investment must enable the charity, ultimately, to generate incremental income.
It is frequently the case that charities lack the capital resources to engage in long term projects that ultimately benefit their clients. Social investment is therefore a great tool which enables such investment and can unlock massive opportunities to generate income, even surpluses as well as to create more social impact - but it is most definitely not an alternative to donations or grants.
Investor perception of project risks
Social investors want their money back. In many cases, they also seek a return—and in some instances they look to make an attractive rate of return. This is one that at least compensates them in some way for the risk of non-repayment.
It is important for charities which are interested in securing social investment to understand how investors are likely to perceive the project risks. What might sound an extraordinarily high interest rate or expected return to investors just reflects this uncertainty. Frequently there are actions charities can take to mitigate such risks and which will reduce the cost of capital - but sometimes this is not possible.
There are investors who are willing to accept a rate of return that is below the rate that would be suggested by the inherent riskiness of the project. Their number is growing, but they are still somewhat rare. What is nearly non-existent is a group of investors who are not bothered about a return of capital.
Charities should understand that investors, unlike donors, expect at the very least to see their capital returned. If this is unlikely with respect to the projects at hand that charities would be better off not searching for social investment - but for those which are opportunity-rich and capital starved, social investment can be an extremely useful tool.
"It is important for charities which are interested in securing social investment to understand how investors are likely to perceive the project risks."
Although official statistics show that Britain's economic output is slowly recovering from the deepest recession in a generation, the economic climate is still tough, with many sectors, including the charitable sector, experiencing considerable financial pressure. Recent statistics show that the vast majority of charities have been adversely affected by the recession: 93% of charities have found raising funds tougher, with 63% considering or planning to draw on reserves to make up funding shortfalls. Even more stark a statistic is that 50% of charities have taken steps to reduce wages or salary costs, including by way of restructure or redundancies.
These statistics are hardly surprising: many charities rely on donations from individuals and businesses as their main income and, in a recession, such donors may consider charitable donations to be a luxury that they can ill-afford.
Fall in worth of legacies
As the recession has dragged down the value of property and shares, the financial worth of legacy donations has also fallen. Government spending cuts have also had a big impact. Not only have charities been directly affected by a fall in the level of grants and funding, but indirectly also, as a result of entities with which charities do business having to make cuts themselves.
In addition, Her Majesty's Revenue & Customs and the Charity Commission have begun challenging the charitable status of entities which do not appear to provide sufficient public benefit. These challenges have become particularly prevalent in the independent school sector, where test cases have recently been brought requiring independent schools to prove that they provide public benefit or face losing their charitable status, and consequently, the associated tax breaks.
In light of this, some charities are having to modify their activities, sometimes at significant cost, to ensure that they are providing sufficient public benefit.
One of the impacts of these factors is that an increasing number of charities are facing financial difficulties. This article highlights certain key aspects that should be considered when a charity, which has borrowed money, is faced with financial difficulty. In such circumstances, the lender will have a key role to play in working with a charity as future plans are developed, particularly with regard to ongoing or additional funding.
When action should be taken
The key message is that, with proper management, many insolvencies can be avoided. Often action is "too little too late".
Although insolvency can happen overnight, for example following the loss of a valuable contract, or funding, insolvency is, in its early stages, generally a gradual process, occurring over a period of weeks or even months. In light of this, both lenders and charities should ensure that they have proper financial controls in place to identify when financial performance is suffering, identify the causes, and agree a strategy to deal with such challenges.
Although it is difficult to make generalisations, increasing creditor pressure, requiring (or utilising) credit from suppliers or experiencing difficulties making VAT or PAYE payments may indicate that a charity is in the early stages of a financial crisis.
Personal liability of trustees
Given that trustees can, in certain circumstances, find themselves personally liable for the debts of the charity, trustees should ensure that they have a complete picture of the financial position of the charity to enable them to comply with their duties.
The imposition of personal liability upon trustees will differ depending upon how the charity is structured. Trustees of incorporated charities, such as those set up as companies limited by guarantee, are treated as directors of that corporate entity. In these circumstances, the trustees are not generally liable for any debts incurred by the charity.
However, if it can be shown that the trustees did not act in accordance with their duties, they may become liable and, as with all directors, if the trustees continued to operate that charity and incur further credit (which includes trade credit and non-payment of employment liabilities) when it was clear that the charity could not avoid insolvency they may find themselves personally liable.
Where trustees face greater risk
Trustees of charities which operate as unincorporated associations or charitable trusts face a greater risk. Such charities do not have a separate legal personality. It is the trustees who contract with third parties and if the charity does not have sufficient assets to meet its liabilities, the trustees may be jointly and severally liable to make up any shortfall. Such liabilities can include not only trade creditors, but also any monies owing to employees, such as salaries or under-funded pension scheme liabilities.
Trustees should also ensure that they have a clear understanding of the purpose of the charity's separate funds and the permitted uses of such funds. In circumstances where a charity is experiencing financial difficulties, and there is no clear delineation of funds, money may possibly be utilised incorrectly or for purposes other than as specified by the donor, constituting a breach of trust.
Identifying and dealing with financial difficulties at an early stage is therefore vital to all parties. A lender may be able to offer solutions that prevent financial difficulties becoming more serious. A charity will also be more likely to formulate a viable plan to improve the situation or explore further sources of income, such as launching an emergency appeal or approaching the Charity Commission for permission to use restricted funds for general purposes.
In addition, the trustees will be able to satisfy themselves that they are doing everything they can to minimise any potential losses, particularly where there is a risk of personal liability or reputation-damaging criticism.
Compliance with the Charities Acts
The Charities Act 1993 (in respect of transactions entered into before 14 March 2012) and the Charities Act 2011 (in respect of transactions entered after this date) set down the requirements that should be complied with when a charity borrows money or grants security.
Establishing compliance with the relevant requirements of the Charities Acts in relation to the provision of a loan to, and grant of security by, a charity is of vital importance for the lender, the charity and the trustees. For a lender, it will provide an understanding of the validity of the loan and the security. For a charity, it could identify potential weaknesses that may be used for leverage in negotiations with lenders if appropriate.
Finally, trustees should seek to satisfy themselves that they have complied with all the relevant obligations placed upon them. This will enable them to, if necessary, take suitable action to reduce the likelihood of criticism and where possible personal liability.
Requirements of the Charities Acts
CAPACITY TO BORROW AND GRANT SECURITY. Many charities have restrictions in their constitution regarding borrowing and granting security. In light of this, the charity's constitutional documents (which may take the form of a deed of trust for an unincorporated trust, or memorandum and articles of association for an incorporated charity) should be carefully reviewed. Due to the nature of charities, it is arguable that unless the constitution of a charity specifically permits borrowing and granting security, that activity is prohibited under its constitution.
INDEPENDENT ADVICE ON GRANTING SECURITY. Under the Charities Acts, a charity is not permitted to grant a mortgage (which includes a legal charge and a debenture, the two of the most common types of security) without considering independent, written advice on:
• Whether the loan to be secured is necessary in order for the trustees to pursue the course of action they propose.
• Whether the terms of the loan are reasonable.
• Whether the charity is able to repay the loan.
Such advice is required at the time the security is granted initially, and if such security is stated to secure all monies lent, each time further monies are advanced.
Evidence of advice
Evidence of such advice (which may take the form of a confirmatory statement in the loan or security documentation) should be kept, as failure to follow such procedure may result in the security being invalid, or the trustees being criticised or, in the worst case, potentially being held personally liable.
EXECUTION OF DOCUMENTS BY A CHARITY. A charity may grant authority to a minimum of two trustees to execute documents. This comprises a general or limited authority to sign deeds and other documents, including loan and security documents, to which the charity is a party.
When checking that relevant authority was given, care should be taken to establish who the trustees were at the relevant time. This may be difficult if the number of trustees is large or if the trustees frequently change. Evidence to show that an authority was granted to any trustee signatory should be kept for both the benefit of the lender as to the validity of the loan and security, and to the trustees to show that they were duly authorised. A confirmatory statement could be included within the document itself.
Monitoring financial performance
Overall, it is critical in these uncertain financial times that charities, their lenders and trustees monitor financial performance closely to identify financial difficulties at an early stage and negotiate with all relevant parties to reach the most advantageous solution possible.
"A lender may be able to offer solutions that prevent financial difficulties becoming more serious."
"Many charities have restrictions in their constitution regarding borrowing and granting security."
The wait is over. In March 2013, FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland was published. After years of debate, consultations and exposure drafts, this single coherent standard will replace all existing FRSs, SSAPs and UITF abstracts.
The new standard is significantly shorter than the patchwork UK Generally Accepted Accounting Principles (GAAP) it replaces, being derived from the IFRS for SMEs but with significant modifications to address company law requirements and retain many of the options available under current UK GAAP. There is integrated guidance for public benefit entities and the Charities SORP (Statement of Recommended Practices) will be updated in line with FRS 102, with consultation expected during the summer of 2013.
Effect for charities
Charities which prepare their accounts under the Financial Reporting Standard for Smaller Entities (FRSSE) can continue to do so, although the FRSSE will also be revised in the future. Smaller charities may now choose to follow the FRSSE rather than FRS 102 as the revised SORP is expected to be more tailored for FRSSE entities.
Under the current SORP, entities following the FRSSE had to comply with the vast majority of SORP disclosure in any case, such that the benefit of applying the FRSSE was limited. For larger charities there will be only one accounting framework: FRS 102. UK law currently prohibits charities from reporting under IFRS and they will also be unable to take advantage of the reduced disclosure framework in FRS 101.
Impact of change
It is not just the debits and credits that may change. There are wide-reaching implications for charities as FRS 102 will affect not only the financial statements, but also areas such as tax (for subsidiaries), banking arrangements, systems and performance management. Each charity will need to assess the impact of the new accounting standards and the disclosure regime.
FRS 102 highlights
CASH FLOW STATEMENTS IN FRS 102. There is no exemption for small charities from preparing a cash flow statement, as is permitted under current UK GAAP. Therefore, unless small charities follow the FRSSE, they will have to prepare a cash flow statement.
Subsidiaries of charities and parent entities within a consolidated group will be able to take advantage of the exemption from preparing a cash flow statement under FRS 102.
REVALUATION GAINS AND LOSSES ON EQUITY INVESTMENTS AND INVESTMENT PROPERTY IN FRS 102. For entities currently applying UK GAAP, the concept of valuing publically traded equity investments at their market value (fair value) is not new, but revaluation gains or losses will now be recorded in income rather than in the other recognised gains and losses section of the Statement of Financial Activities.
Movements in the fair value of investment property, where this can be measured reliably, will also be recorded directly in income rather than as other recognised gains and losses. All other investment property (i.e. where the fair value cannot be measure reliably without undue cost of effort) will be accounted for using the cost model.
DONATED GOODS AND SERVICES IN FRS 102. The standard states that donated services and facilities which would otherwise have been purchased shall be measured at the value to the entity and that all other incoming resources from non-exchange transactions shall be measured at the fair value of the resources received or receivable.
On a practical basis this means that donated items to be used in the course of the charity’s work (e.g. tents and blankets received for a disaster appeal) will now need to be valued and recognised to the extent they are material.
In terms of donated goods for resale, concerns had been raised by charity shops that they would have to value gifted items on receipt. However, the final standard contains a practical exemption that states where the value of the resource cannot be estimated with sufficient reliability, the income can be recognised on sale.
It is expected that contributions made by volunteers cannot be reasonably quantified and therefore those services shall not be recognised, but shall be disclosed.
GRANTS IN FRS 102. For government grants FRS 102 introduces an accounting policy choice to either use the performance model or the accrual model. The revised SORP is expected not to permit the use of the accrual model even for government grants. The performance model requires the grant to be recognised as soon as the grant is received or receivable where there are no performance related conditions.
Where conditions are imposed the grant may only be recognised when they are met. Where a grant may be clawed back if all the grant money is not spent then it may potentially be appropriate to recognise both the entitlement to the whole of the grant and a provision for clawback when the grant is receivable.
The existence of a restriction over use does not prohibit a grant from being recognised when it is receivable.
COMMITMENTS IN FRS 102. FRS 102 clarifies the requirements relating to commitments, including the specific guidance in appendix A to Section 34. It emphasises the treatment of commitments and, in particular, the distinction between an obligation and a commitment.
Recognise a liability
Where there is an obligation, either legal or constructive, the charity must recognise a liability, and that liability will be the present value of the resources committed (i.e. based on discounted cash flows). If that obligation is, however, subject to the satisfactory completion of performance related conditions then it will not be recognised as a liability but a commitment.
The standard makes clear that where a charity has made a commitment it shall disclose the commitment made; the time frame of the commitment; any performance-related conditions attached to that commitment; and details of how the commitment will be funded. Separate disclosure of recognised and unrecognised commitments will be required.
MULTI-EMPLOYER DEFINED BENEFIT PENSION SCHEMES. Where the entity has entered into an agreement with the scheme that determines how the entity will fund the deficit, the liability for those agreed contributions may need to be recognised as a provision depending on the extent to which it is clear the agreed contributions only cover past service deficits.
Other areas to watch
One of the biggest areas for change, in addition to the treatment of listed investments discussed above, will be accounting for financial instruments, at least for those who haven’t applied FRS 26. Complex financial instruments, such as derivatives which may historically have been off balance sheet, will now come on balance sheet and be measured at fair value through profit and loss. Limited hedge accounting will be permitted.
Income recognition criteria under FRS 102 focuses on when income receivable is “probable” rather than “virtually certain”. In many cases there will be no difference as these hurdles are to all intents and purposes reached at the same time. However, in cases where recognition is delayed until receipt (for example some charities recognise legacy income in this way) the income may need to be recognised earlier.
Another area for change is employee benefits. Short term benefits, such as holiday pay which can be carried over from one financial year to the next would need to be recognised as a liability.
Infrastructure assets shall be recognised under the financial lease liability model as assets of the grantor together with a liability for its obligations under the service concession arrangement.
Where the useful economic life for goodwill and intangibles cannot be reliably estimated, amortisation must be calculated over no more than five years rather than a 20 year maximum life.
The revised SORP
The revised SORP will be modular with core modules covering all charities and additional modules only relevant where a charity has transactions covered by those modules. This should reduce the burden on smaller charities.
However, increased disclosure is expected to be required for key risks and going concern.
Timing and resources
FRS 102 applies for periods beginning on or after 1 January 2015 with early application permitted. It is not expected that charities will be able to adopt early, even once the revised SORP is issued.
The implementation period may seem a long way away, but the opening balance sheet for 31 March 2016 financial statements will be 1 April 2014, which means that during 2013 charities will at least need to start planning their approach, regardless of whether they would implement early.
"Smaller charities may now choose to follow the FRSSE rather than FRS 102 as the revised SORP is expected to be more tailored for FRSSE entities."
"For larger charities there will be only one accounting framework: FRS 102."
"…FRS 102 will affect not only the financial statements, but also areas such as tax (for subsidiaries), banking arrangements, systems and performance management."
"…increased disclosure is expected to be required for key risks and going concern."
It's tempting for charities to feel safely detached from the currency markets. But volatile exchange rates aren't just a problem for City traders or international businesses. Any charity which operates overseas will be affected too – and could pay a high price for getting it wrong.
Money may make the world go around, but it does so in many different, fluctuating currencies. Charities which send or receive money from abroad will need to exchange currency to do so. Even on a good day, the currency markets can be choppy, but the persistent doubts about the future of the eurozone and the weak global economy have made the currency markets more volatile than ever.
Yo-yoing exchange rates
So how to avoid falling foul of yo-yoing exchange rates? Unless you specify otherwise, when you buy or sell foreign currency (i.e. send funds overseas or receive them from abroad), the conversion will be made at the rate of the time and day. This exchange rate can go up or down, meaning that each time you make the same transaction, it could cost you more or less.
For example, let's say your charity runs a project in Kenya and each month needs to send a set amount of Kenyan shillings to your local bank account in Nairobi. It's an easy thing to do. But if you send the money at the "rate of the time and day" every month, the amount of sterling needed to do so could rise or fall dramatically, making it harder to keep on top of the budget back home.
However, you can insulate yourself from this risk by taking out what's called a forward contract. This allows you to reserve future foreign currency now with a small deposit – no more than 10% – while locking into a specific exchange rate.
You only pay for the remainder when you actually need to complete the transaction. The fixed rate protects you against a sharp move "against you" between now and the time when you send the rest of the money. Forward contracts allow you to fix an exchange rate for up to two years.
Speculation or protection?
Businesses which trade overseas often use forward contracts as a way of "hedging" against currency fluctuations. Contracts like this offer companies the reassurance of knowing that when they agree a deal with an overseas client or supplier, they will know exactly what sums will be involved – and that their profit won't be swallowed up if the exchange rate changes.
However, the practice is less common among charities. This is not down to any lack of financial sophistication among charities – many charities eschew such contracts as a form of speculation.
While a lot of charities are barred by their own rules from "speculation", forward contracts are really about the elimination rather than the encouragement of risk. By locking into an exchange rate, a charity could miss out if the currency movements go in its favour, but that risk is surely more than outweighed by the benefit of being protected if the exchange rate movement goes against it.
By definition, a large portion of the charity money we send overseas is heading to parts of the world where the need is immediate and acute. Often this means places which have suffered a natural disaster or conflict – in other words, places where infrastructure is likely to have been damaged.
Take the case of charities which were active in Sri Lanka during the country's long-running civil war. Government troops refused to allow access to the northern part of the island where the fighting was most fierce. Large numbers of civilians were trapped there, and getting the funds to relief teams in the affected area required a lot of patience and ingenuity.
When sending funds to a conflict zone, the number of official checks the money has to go through increases dramatically. The extra red tape is designed to ensure that the money does not end up in the wrong hands, but it can cause serious delays.
Natural disasters can pose even greater challenges. Rather than an excess of bureaucracy, the problem here tends to be the lack of any infrastructure. Communications, as well as physical buildings like banks, can be destroyed. If the communications cables that carry digital money transfers are damaged, alternative means must be found of getting the currency through.
This was certainly the case with relief operations in Haiti, following the catastrophic earthquake there in January 2010. Much of the capital was destroyed and there was widespread looting, leaving the traditional banking network unable to function.
Relief efforts in Burma a couple of years earlier faced the twin obstacles of official bureaucracy and smashed infrastructure. After the country was ravaged by Cyclone Nargis in May 2008, its military rulers initially refused most international aid. Under sustained pressure from the international community, they relented and allowed in foreign aid workers.
For British charities trying to send funds to teams inside Burma, the red tape and lack of infrastructure slowed the process dramatically. When money was sent to Burma on behalf of several charities, in every case the authorities queried what the payments were for and where they were going.
This meant that the foreign exchange specialists sending the money had to be rigorous in providing the necessary supporting information, to ensure that hold-ups were kept to a minimum.
Whenever a natural disaster strikes, the quicker money can be got to the affected area the better. Bureaucracy and damaged infrastructure can slow things down – and this is why it's important that the process is managed by an experienced and professional team.
Means to an end
Whatever the charity, wherever the money is being sent, the general principle of money transfers stays the same. A UK-based charity sends an amount, in sterling, from its British bank account – which is then delivered in local currency to an overseas bank account.
Large charities often request that all currency transfers should be denominated in a major currency – usually dollars or euros – and then converted into local currency in the destination country. Smaller charities tend to make the conversion straight away – paying for their sterling to be converted directly into the currency of the country they are sending the money too.
The reason larger charities send their money via a third currency is primarily about ease of planning. Even though this method involves two currency conversions rather than one, it can often be more cost efficient. The "spread" on major currencies tends to be lower than on minor ones, meaning that using this route results in the charity's pounds going further in the destination currency.
One thing common to all charities is that they often rely on their banks for making overseas transfers, even though the exchange rates offered and the fees charged by the banks are rarely the most competitive. Foreign exchange specialists often offer more attractive exchange rates and charge lower fees, as well providing a more personalised service.
Charities' reliance on the banks and their reluctance to consider sending money via an intermediary currency could mean that many of them, especially the smallest charities, are paying more than they need to transfer money.
Focusing on making savings
No one who sets up a charity does so thinking that above all, it must have first rate foreign exchange procedures. For an organisation which is focused on making the world a better place, the finer points of foreign exchange can seem a very secondary priority.
But when donations are down, all charities must focus on reducing waste; and stopping unnecessary spending on regular activities like overseas transfers is a great place to start. A little bit of research and the willingness to try other ways of sending money abroad can yield big savings.
Of course, both charity supporters and staff want as much of its funds as possible to be spent on its chosen cause. For any charity which is active abroad, foreign exchange transfers are central to the means of getting the funds direct to the cause. A small investment of time and effort here is a uniquely efficient way to ensure that a charity's precious donations go as far as possible.
"Unless you specify otherwise, when you buy or sell foreign currency…the conversion rate will be made at the rate of the time and day."
"Forward contracts are really about the elimination rather than the encouragement of risk."
"The reason larger charities send their money via a third currency is primarily about ease of planning."
Gift Aid can only be claimed on gifts of money. It cannot be claimed upon the value of goods given to a charity even when they are to be sold in a charity shop. Since 2006 it has been recognised that charities could overcome the problem by selling the goods as agent of the donor (having collected up a completed Gift Aid form) and then writing to the donor to ask if they wished to donate the proceeds. If the donor agreed or did not reply within 21 days, Gift Aid could be claimed on the proceeds of sale after the deduction of any commission charged by the seller.
This scheme requires a letter to the donor in relation to every sale. It can still be used and is known as “the Standard Method”. The template letters produced by HMRC to be sent to donors have however changed and the new letters must be used if Gift Aid claims are to be valid.
In order to avoid the need to write to donors in relation to every sale, two new procedures have been introduced, Method A and Method B. Method A can be used in shops run directly by charities or through trading subsidiaries. Method B can only be used by a trading subsidiary.
Key features of both methods
• The charity/trading subsidiary sells the goods as agent of the donor and a Gift Aid declaration must be completed by the donor.
• The scheme must be explained to the donor.
• The agreement of the donor to the scheme (the agency agreement) must be in writing. HMRC refers to a leaflet or information sheet. I would advise that a copy of it is signed at the same time as the Gift Aid declaration and kept with it.
• The donor must be asked if he or she want a summary of the sale proceeds at the end of the tax year. The tax payer should check that they have paid sufficient tax to meet the Gift Aid claim and higher rate tax payers will require the letter to reclaim tax paid at the higher rate.
Key features of Method A – charities and trading subsidiaries
• If the net proceeds of sale of the donated goods are less than £100 in any tax year, the proceeds of sale are automatically donated to the charity.
• If the net proceeds of sale exceed £100, the charity must write to the donor to ask if he or she wishes to donate the excess.
• It must therefore be possible to link the goods to the individual donor.
Key features of Method B – trading subsidiaries only
• Method B applies to all goods sold on behalf of a donor during a tax year. Trading subsidiaries must be able to track this not only within an individual shop but across all their shops.
• If the net proceeds of sale in any tax year are £1,000 or less, the whole of the proceeds may be regarded as donated to the charity without the need for further letters. The donor can stipulate a lower amount.
• If the net proceeds of sale exceed £1,000 (or any agreed lesser figure), the charity must write to the donor to ask if he or she wishes to donate the excess. The charity can either write individual letters for each sale once the £1,000 limit has been reached or a single letter at the end of the year.
HMRC has produced template letters for use with all the methods. The words in italics in the templates must be used.
The agency agreement with the donor must cover points set out in the Guidance.
Record keeping is a key element in ensuring that a Gift Aid claim is allowed.
Shop staff must be trained in the procedure and a record kept of the training.
HMRC requires charities to accept that if it finds that a taxpayer has paid insufficient tax to cover the Gift Aid claim, the charity would voluntarily repay the Gift Aid. The individual tax payer would not be identified because of confidentiality rules and future Gift Aid claims by the charity would be restricted by the same percentage until a further HMRC audit is undertaken.
Only a summary
This is only a summary of the Guidance, which contains some very detailed provisions. It is not comprehensive or a substitute for a detailed reading of the Guidance and should not be relied upon in any individual cases.
Like commercial businesses, charities have been affected by the impact of the recession and a reduction in government spending. Whilst the number of organisations which have failed is historically low when compared to the last recession, the fact is that some have and if the economic position worsens during the next few years it is likely that we’ll see further failures and possibly even a spike as austerity measures deepen – not least of all amongst charities and not for profit organisations.
During the current recession, a number of factors have helped to keep the failure level down. Amongst those relevant to charities in particular is the fact that the financial management of many charities has improved and adapted during the downturn, to be more focused on efficiency and caution.
Although there is no data on the level of failures in the charitable sector relative to the corporate sector, the impression is that because there have been relatively few high profile charity failures, the sector’s more prudential management has insulated it from the worst effects of the recession.
The worst may be yet to come
However, after more than three years of economic downturn and with no end in sight, it would be surprising if the pressure on charities did not increase, not least because the government’s much debated austerity budget is yet to fully bite.
So far only 15% of the Coalition’s cuts in spending have been made. This means that in the remaining three years of this government another £70bn of cuts will have to be implemented, and it has already been mooted that funding for the charitable sector will be central to this. The impact that this will have on charities is clear, and they need to be thinking now, if they’re not already, of how they’ll weather the storm through an appraisal of their current and projected financial position and future budgets.
Aside from government cuts, there are also systemic issues in the current economic environment that pose a threat to charities and not for profit organisations. One of the biggest of these is the growing unaffordability of pensions and pension deficits.
Compared to the corporate sector, the charitable sector has traditionally offered attractive pension rewards. However, many of these schemes are now unaffordable and large pension deficits have accrued. It is not uncommon for relatively small charities to have potentially unmanageable pension deficits of many of millions of pounds that result in technical balance sheet insolvency.
Planning for tough times ahead
One of the most common factors in a business failure, whatever the sector, is a lack of understanding by management of the financial position, and a consequential miscalculation of the risks to the organisation continuing.
One of the fundamental steps for charities to avoid failure, therefore, is to fully understand the financial position and put in place a strategy to address these risks.
This process needn’t be a complicated one. Like most solutions to problems there are some simple steps that can be taken by charities and these include:
• Establishing the current financial position and the future funding requirement.
• If there is a funding requirement, calculating the level of unrestricted cash reserves, how long these will last, and what steps can be taken to reduce the cash burn.
• If there is a pension deficit, considering whether it is of a magnitude which could endanger viability.
• Developing a clear and focused turnaround plan if there are financial concerns (including bridging the gap left by falling donations and the funding of pension responsibilities) that could endanger viability.
• Regularly reviewing the financial position and formally minuting conclusions and actions/steps that are undertaken.
• If necessary, entering into early dialogue with stakeholders including lenders, donors, grant-makers and creditors.
• Finally, if issues cannot be resolved, seeking appropriate professional advice.
If time has almost run out
However, often because the true level of cash burn is underestimated, the time available to develop and implement a turnaround strategy is constrained and organisations find themselves with insufficient cash reserves and little time to implement such a plan.
If a charitable organisation is incurring deficits and is insolvent, any delay in a recovery plan becomes a critical factor. Cash reserves should not be depleted unless there is reasonable certainty that a turnaround plan can be implemented and will succeed, such that over time the cash reserves consumed will be replaced.
If through funding deficits an insolvent charitable organisation depletes its cash reserves with little or no likelihood of improved financial performance or avoiding failure, the trustees can be criticised by creditors and, although rare, can become personally liable for the losses caused to creditors.
Organisations which do not develop appropriate strategies often find that they are on a slippery slope – a situation that amongst restructuring professionals is referred to as the decline curve, whereby as the financial situation becomes worse the risk of failure becomes higher and the options open to management quickly reduce.
This is no less the case for the charitable sector and if these organisations do find themselves on the slippery slope with financial problems, the steps that should then be considered are outlined below.
The steps in blue are internal to an organisation and many charities will no doubt have implemented these and other measures already.
The steps coloured grey are those that relate to actions outside the organisation in connection with competitors and other third parties. These are by their nature more difficult to achieve and take considerable time and management effort, but done properly can have a significant impact on the chances of recovery and ongoing operations.
Considering more drastic solutions
Finally, and if none of the others address the problems, a charitable organisation may have to consider more drastic solutions. Coloured red in the diagram these could include restructuring through an insolvency process.
The type of insolvency process will differ according to the circumstances, however the aim is to preserve the charitable purpose by transferring a charity’s assets, employees and activities to a purchaser. This could be achieved through a pre-packaged administration process – a restructuring tool common in the corporate world.
Whilst circumstances giving rise to these situations are not common, they are an important restructuring mechanism for charities which can no longer continue trading. There have not been many instances of formal charitable restructuring, due mainly to the fact that most situations are dealt with without the need for an insolvency process. However, where substantial pension deficits have been incurred and withdrawal of government grant funding experienced, this has, on occasion, regrettably happened.
Whilst often these charities had already begun to restructure and alter their operations, including reducing employee levels and targeting new sources of income, these measures were ultimately insufficient to improve financial performance at the rate necessary to avoid insolvency. When this has happened, the organisations have been saved by transferring their activities to a "purchaser", i.e. another charity, which has allowed its work to continue under the merger.
Committing to financial watchfulness
The future is seldom certain and economic downturn simply adds to this uncertainty. What is certain however is that the charitable sector faces a continuing tough ride – one that can be made less uncomfortable by increased careful planning and a commitment by the management to keep an eye on the current and future financial position, and paying due consideration to the actions needed to be taken should things become more distressed.
The belief of so many restructuring practitioners is such that sufficient time and planning, and of course an acceptance of the reality of a difficult situation, can literally be the difference between eventual survival and insolvency for a charity. Let’s work together to make sure it’s the former and not the latter.
"One of the most common factors in a business failure, whatever the sector, is a lack of understanding by management of the financial position."
"If a charitable organisation is incurring deficits and is insolvent, any delay in a recovery plan becomes a critical factor."
A review by an independent third party will also provide assurance that the trustees are maintaining proper financial records and the accounts reflect those records. For charities with gross income over £25,000 in the accounting year, there is a legal requirement for external scrutiny. This will be in the form of an independent examination or an audit. However, the charity's governing document may require an audit to be performed regardless of income levels.
Charities with gross income over £25,000 in the accounting year must file their trustees' annual report and accounts with the Charity Commission. The Commission will scan the report and accounts onto their website where they will be available to everyone who wants to know more about the charity. Even where the accounts and trustees' annual report are not required to be submitted to the Charity Commission, they will still need to be prepared.
Between 1996 and 2009 the thresholds and types of external scrutiny required changed considerably. The Charity Commission guidance, "The Reporting and Accounting Framework for Charities", sets out the thresholds for scrutiny in any particular financial year from 1996 to date. In addition, "Charity reporting and Accounting – the essentials (CC15b)", gives further guidance on the accounting requirements, the need for an audit or other external scrutiny and information that has to be sent to the Charity Commission.
The Charity Commission has placed renewed emphasis on ensuring its online Register of Charities provides people with the correct information about charities. This includes getting tougher on charities which fail to file their annual documents and accounts within the 10-month deadline. By filing annual documents and accounts late, and thereby incurring a "red mark" against their name on the register, charities risk reduced public trust not only in their own organisation, but also in the wider charitable sector.
Trustees should also remember charitable companies need to report separately to both the Charity Commission and to Companies House. When preparing accounts for a charity company, the trustees must also comply with company law. Amongst other requirements, this will include the need to prepare a directors' report, although in practice the requirements are often incorporated into the trustees' annual report. In addition, trustees should note the shorter nine-month Companies House filing deadline.
Animal charities in particular, which care or rehouse lost and abandoned pets, may be missing out on significant tax savings. Many such charities are very small, run by volunteers, and do not have access to the business advice larger good causes can often call on for help.
As a result, there are many charities unaware that they may be entitled to register for VAT and to reclaim VAT on many of the essential costs they incur in the day-to-day running of their charity. Some animal charities are able to claim the VAT on the operating costs they have paid out simply to keep the charity going, such as rent or fuel payments. Others are careful to adhere to restrictions which keep certain activities zero rated.
With the standard rate of VAT at 20% clearly this may be a significant saving for charities, many of which rely on donations simply to continue operating day-to-day.
Good causes which incur the tax on costs – including premises rental, buying or leasing vans, vehicle fuel or repairs, along with repairs and upkeep to premises such as electricity and heating bills – may be eligible for VAT registration and hence reclaiming VAT.
The opportunity is available thanks to two important tribunal rulings. The first, from 2008, involved Gables Farm Dogs & Cats Home, a Plymouth based charity established to rescue and shelter lost, unwanted and homeless dogs and cats. The charity sold the animals to new owners, and treated such sales as zero rated for VAT.
However, HMRC charged the charity tax on the basis that the animals which had been abandoned were not "donated for sale", a key part of the regulations concerning VAT. The charity then appealed, and the tribunal allowed the appeal holding that “a gift of a stray cat or dog to the appellant by a person other than the original owner was capable of transferring ownership rights in the animal to the appellant". The animals therefore come within the definition of “donated goods” and qualify for zero rating.
As a result, HMRC now accepts that charities selling animals in these circumstances can zero rate their sales.
The second ruling dates from 2011 and concerns Three Counties Dog Rescue, Lincolnshire. Three Counties also received abandoned and rescued dogs, rehousing them in return for a payment which it classified as a "donation".
Following the Gables decision, Three Counties also applied to HMRC to register for VAT and therefore submitted reclaims of VAT. However, HMRC rejected the claims on the basis that the charity was "merely rehoming dogs in return for a voluntary donation" which was not a taxable supply, so Three Counties could not therefore be registered for VAT.
The charity appealed, arguing that the donations it received meant it was entitled to be registered. The tribunal accepted this argument and allowed the appeal.
There are a number of factors which determine whether charities making similar supplies are eligible to be VAT registered, such as the way people make donations, and there are also strict parameters set by the relevant legal rulings.
Those charities which believe they may fit into this category should take advice from their accountant or a specialist VAT adviser, who can look at how the charity is run and whether VAT can be reclaimed, or whether it is possible to amend the way in which the charity operates to enable it to take advantage of the Ttribunal rulings.