News Analysis: Should dividends mix with charity?

Share-issuing industrial and provident societies are being challenged by the regulator, writes Paul Jump.

The disagreement between the Financial Services Authority and the Charity Commission over whether share-issuing industrial and provident societies should be charities raises the troublesome issue of how to encourage investment in charitable and community projects.

IPSs often strike people as relics from the Victorian age, admits Tim Waldron, a charity lawyer at Coffin Mew. But as charities seek to find new ways to boost their income, ISPs are coming back into vogue because of their unique ability to issue shares.

The structure is used by about 15 per cent of community development finance institutions and is increasingly favoured by local renewable energy projects and land trusts, says Waldron.

"The big advantage of IPSs is that they can raise share capital on a relatively unregulated basis," he says. Community interest companies can also issue shares, but if they do so publicly, the FSA's charges are many times higher than for IPSs.

The FSA says shares generally carry voting rights, but do not permit holders to participate in the distribution of any surplus if the organisation is wound up.

But the position of IPSs in the sector is under threat. They used to be exempt charities; they were assumed to be charitable provided they met the FSA's community benefit criteria, and they did not fall under the Charity Commission's gaze.

But the Charities Act 2006 requires them to register with the commission, which is not convinced that shares and charity should mix (Third Sector, 19 March). Philip Kirkpatrick, a partner at charity lawyers Bates Wells & Braithwaite, agrees with the commission. "The basic principle of charity law is that the pursuit of private profit is not a charitable purpose," he says. "A corporation that can pay dividends to private investors exists, at least in part, to pursue private profit; that is what dividends are. A charity must have exclusively charitable purposes."

But not everyone agrees with this interpretation. Waldron describes it as a "narrow and outdated view of the charity sector". He says IPSs pay dividends, often called 'interest' in the context of IPSs, only if they can afford to do so and only in support of their charitable aims. "Taken to its logical conclusion, the argument against dividends becomes ridiculous," he says. "No one says charities can't pay market rents to institutional landlords. No one argues that by paying interest on a bank loan a charity is not pursuing charitable purposes."

Dividends given to social investors are more likely to be reinvested in the sector than the interest paid on bank loans, he points out.

Faisal Rahman, managing director of another CDFI, Fair Finance, complains that the commission registered Charity Bank even though it issues shares. Malcolm Hayday, the bank's chief executive, says it is permitted to pay dividends only to charitable investors, but admits that it has "always seemed weird" that charities can pay interest, but not dividends, to banks.

Losing charitable status would be a blow to IPSs: Rahman says many foundations put money only into registered charities. They would also lose some VAT relief and the big discounts offered to charities by software companies - not to mention the kudos of being a charity. But Rahman is reluctant to set up a separate charitable arm for Fair Finance because of the administrative burdens it would impose.

The Charity Commission objects to any charity raising money by issuing withdrawable share capital. Hayday suggests they could avoid this problem by paying traditional interest rather than dividends to non-charitable investors, but Waldron says interest might be unaffordable for some IPSs because, unlike dividends, it is an inflexible obligation.

Independent schools recently suggested that they should be removed from the charity register and be given separate not-for-profit status, with tax breaks similar to those of charities (Third Sector, 26 March). Such a system might also be worth exploring for IPSs, says Hayday.

The debate brings to the fore the issue of how organisations with charitable purposes can become more entrepreneurial without using risk-and-reward mechanisms, says Hayday. He admits that Charity Bank's inability to offer dividends to its corporate investors could be unsustainable in the long term.

The commission says it is in "the early stages of discussions with the FSA and other interested parties". Prolonged uncertainty is likely to be painful for cash-strapped CDFIs, but don't be surprised if this issue becomes the first point of law the new Charity Tribunal has to grapple with. As Hayday says: "One way or another, this has to be resolved."

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