Charities and the rise of social enterprises

As a previous article has highlighted (“Charities and the changing legal landscape”, Journal, October 2013, 18), the charities sector in Scotland is being subjected to many changes, not least as a result of funding pressures.

One response for a number of charities to an increasingly difficult financial climate is to explore means of raising additional income themselves rather than relying on grant or contractual funding from third parties.

Generally, this is being achieved by charities developing social enterprise businesses, and this article explores some of the legal issues arising from this.

We are increasingly being asked by our charity clients to advise on issues relating to establishing and operating social enterprises.

Charity law

The issue of trading can be a difficult one for charities. Charity law does not permit charities to exercise a trade on a substantial or regular basis simply for the purpose of raising funds. Only “primary purpose” trading (i.e. trading which directly fulfils the charity’s purposes) is exempt from corporation tax. However, the charity law and tax implications of trading can generally be avoided if a trading subsidiary is used.

In simple terms, the charity sets up and funds a trading company in which it owns all the shares. The trading company then carries out the trading activity outside the restrictions of charity and tax law, as it is not itself a charitable entity. Although the trading company benefits from no direct tax reliefs, its profits can then be paid to the parent charity under the Gift Aid scheme, so the trading company will, in fact, pay no tax. The trading activity has effectively been carried out tax free. However, running a trading company brings its own complications for any charity.

While it is often tempting for boards of charities to seek to increase their revenue by means of undertaking income-generating activities, the governance consequences in particular of such activities are often overlooked or not appreciated by charity trustees. The governance issues that can arise include:

• skills of existing board members in relation to a trading venture – charity trustees need to
• recognise that they may not always have the skills necessary to operate successfully
• a company with an entirely commercial profit focus;
• a requirement for a separate board – often with at least one individual sitting on
• both boards;
• awareness of the risk of operating a trading venture – commercial opportunities generally bring a degree of risk;
• the need for the parent charity to exercise control over the trading venture – see below;
• the need for the trading venture to operate with a degree of independence – see above.
• The relationship between charities and their trading companies must be at arms’ length.

A trading company is a separate legal entity from the charity and this must be recognised at
all times.

Before taking forward a trading venture, the foregoing issues should all be fully addressed by the charity’s board.

A key factor for success of a trading company or social enterprise is a thorough understanding of the relationship and dynamic between the parent charity and the trading entity, and between the two boards.

Social enterprises

Social enterprises are generally established as limited companies, and often have a requirement for premises and employees, which can result in a need for advice over a broad spectrum of legal areas.

A study was recently commissioned by the Big Lottery Fund in Scotland to map social enterprises and their activity in Scotland (Social Enterprise Mapping Study Report for the Big Lottery Fund (February 2014)). While there is not a legal definition of “social enterprise”, the Big Lottery study adopted a definition requiring social enterprises to aspire to trading, have social and/or environmental objectives, and be driven by values both in their mission and business practices.

Social enterprises deliver all over Scotland, with a slightly larger emphasis on rural areas, but there is no significantly higher concentration of them in disadvantaged areas. The sector where most future growth is expected is the environment and recycling sectors.

Social enterprises are embedded in our communities and on high streets – from the Co-op to Divine chocolate through to The Big Issue magazine. They are businesses that trade to tackle social problems and issues and to improve communities. They make their money from selling goods and services, and reinvest profits back into the business or the local community to meet their aims. They include trading charities, development trusts, community interest companies (CICs), social enterprise networks, housing associations, credit unions and co-operatives.

The research found that the sector employs almost 121,000 people and expects to increase trading income by 40% over the next three years, with around 60% of organisations generating more than half of their income through their trading activities.

The growth in social enterprises is rapid. A sector survey in 2013 found a startup rate in social enterprises three times that of the traditional SME sector, with around 70,000 social enterprises operating throughout the UK. In Scotland, we can continue to expect these figures to rise, as charities are increasingly moving away from their traditional models of fundraising and becoming more businesslike to ensure their sustainability.

The majority of social enterprises currently operating in Scotland are trading subsidiaries of charities or trading charities. Interestingly, however, the next largest area of social enterprises are those operated by CICs, and such entities cannot be charities.

Overall, social enterprises are organisations of significant and increasing importance
in Scotland principally operated by charities, operating widely, employing many staff, offering thousands of volunteering opportunities, and generating significant income.

Social enterprises are an under-reported success story that many solicitors in Scotland have been involved with to date. Legal firms should see social enterprises as potential future sources of business, and seek to understand the particular legal and governance issues and challenges that arise with the operation of social enterprises.

Illustration: Age Scotland

Age Scotland Enterprises is the commercial services arm of Age Scotland and sells a range of insurance products and other services which are designed to address market failure.

All of the insurance products have no upper age limits, and unlike most providers have no hidden charges.

The business was set up over 20 years ago and has offices in Edinburgh and Glasgow, where it still offers a face-to-face service as well as over the phone or online.

To the year ending 31 March 2014 it gift aided £733,000 to the two owners, Age Scotland and Age UK Enterprises. This unrestricted income enables the charity to fund its valuable work with older people in Scotland.

The business has been a Social Mark Holder since 2010.