How will future changes to endowments affect UK charity legacies?

Article Experience

As the 2021 Charities Bill makes its passage through the House of Lords, this article examines the proposed changes regarding permanent endowment, how these might affect charity legacies, and how donors and charities can both benefit.

Permanent endowment

‘Permanent endowment’ is a term which, in essence, describes capital property held by a charity which cannot be spent as if it were income. Such property can include land, buildings, cash or investments. Charities are only able to apply the income relating to property held on permanent endowment to further their charitable purposes.

There are two types of permanent endowment – functional and investment.

  • Functional permanent endowment is property, such as a building or sports field, which must only be used by a charity to advance a specific charitable purpose. An example, in relation to a charity operating a school, would be a laboratory restricted for teaching science.
  • Investment permanent endowment, on the other hand, is not restricted for a particular functional use by a charity. It usually comes in the form of a capital pot of cash, shares and/or securities which, although it cannot be spent, is invested annually to produce an income stream for the charity.

It is important to differentiate between permanent endowment and ‘expendable endowment’ (where all or some capital can be accessed in certain circumstances) and ‘restricted income funds’ (where capital is freely accessible, but the fund can only be applied towards more narrow charitable purposes than the general purposes of the charity itself).

Legacy gifts of capital assets which impose permanent endowment restrictions are received by charities from time to time, usually from donors wishing to guarantee the long-term preservation of their gift. Being able to offer support via a legacy gift structured as permanent endowment can be a useful means for a charity to reassure and encourage some donors, who may not otherwise have wished to give.

The current landscape

Under current charity law, the trustees of charities holding investment permanent endowment have powers to lift the capital spending restrictions in certain circumstances.

  • Section 281 Charities Act 2011 provides charity trustees with the potential to lift restrictions on ‘smaller’ permanent endowment funds without Charity Commission approval. However, this power (amongst other limitations):

o only applies to funds with a gross annual income of £1,000 or less or a market value of £10,000 or less; and
o can only be exercised if the trustees are satisfied that the purposes of the endowment fund could be carried out more effectively if the capital could be spent.

  • Section 282 Charities Act 2011, which applies to ‘larger’ permanent endowment funds, effectively allows charity trustees to apply to the Charity Commission for authority to lift restrictions on spending capital. It similarly requires the trustees to be satisfied that the purposes of the endowment fund could be carried out more effectively if the capital could be spent. In addition, a ‘statement of reasons’ outlining the justification for lifting the restrictions, and explaining how what is proposed remains within the spirit of the original gift, must be filed with the Commission alongside the application. Without Commission approval (actual or deemed, in instances where the Commission does not object within a set deadline), the capital restrictions must remain.

Restrictions relating to functional permanent endowment are much harder for charity trustees to lift. This is because of the added requirement for replacement functional property to be purchased. Moreover, there is the obstacle to spending functional permanent endowment if its retention is necessary to achieve the charitable purpose for which it is held.

The current landscape can present challenges, particularly in the case of legacies. (With legacy gifts there is no ability for charities to approach the donor to propose new or adjusted uses, as a means of reacting to changing circumstances or maximising the impact of a gift).

In terms of such challenges, firstly there is the potential for donors unintentionally to undermine the usefulness of their gift, by attaching capital restrictions without realising the practical impact these may have on delivery of their charitable aims. For example, by establishing a capital fund which, for whatever reason (perhaps insufficient relative size), is incapable of producing an adequate income stream. Equally, by rendering their gift inaccessible in response to a crisis or pressing need directly relevant to their charitable aim/s.

Secondly, there is the potential for charity trustees, in a situation where a legator’s charitable aims could be more efficiently achieved if a small portion of capital could be spent and later replenished, to find themselves unable to lift restrictions because one of the statutory criteria cannot be met.

The future landscape

The 2021 Charities Bill, which is still in its early stages of development, proposes to alter the law as it relates to permanent endowment in a number of ways, including the following:

  • A new power would be introduced allowing charity trustees to borrow monies from an investment permanent endowment fund. Such a power would not require Charity Commission approval. However, there would be several criteria applying to it, including:

o a borrowing limit of 25% of the value of the fund;
o requirement for a repayment plan for any amount borrowed;
o requirement for repayment to be made within 20 years; and
o requirement to seek Charity Commission direction if repayment is not possible within the prescribed timescale.

  • A new Social Investment power for charities which have resolved to take a ‘total return’ approach to investment (ie where any increase in the capital value of investments can be expended as well as the income generated). This would allow the trustees of such charities to undertake social investment in circumstances where achievement of a financial return is uncertain or unlikely.
  • A new definition of ‘permanent endowment’, which would assist in clarifying the scope of this often misunderstood term (albeit there is currently no indication that the term will be reclassified or amended to any degree).
  • The section 281 power for lifting restrictions for ‘smaller’ permanent endowment funds would be exercisable on funds up to a maximum market value of £25,000. (The income generated would no longer be relevant).
  • The deadline for objection or requests from the Charity Commission in relation to applications from the trustees of ‘larger’ endowment funds (ie section 282) would be reduced from three months to 60 days.

Impact of the changes on charity legacies

The proposed reforms of the Charities Bill 2021 do not represent a fundamental shift to the permanent endowment regime. However, they do underscore the importance of dialogue between legacy teams and donors, so that donor and charity can be sure that the proposed structure is an effective means of delivering the charitable impact desired by the donor.

  • The new statutory definition will provide much needed clarity to the sector as to what permanent endowment is, and – just as importantly – the extent of the restrictions that come with it.
  • The proposed amendment to section 281 (‘smaller’ endowment funds), despite simplifying the procedure, will actually limit the number of endowment funds eligible for amendment via this process. This is because some funds of relatively large value (eg £50,000 to £100,000) can produce relatively low annual income return (ie less than £1,000), particularly in challenging economic times. Such funds currently fall within the section 281 criteria (via the income threshold test), but following the changes proposed by the 2021 Charities Bill, all funds with a value higher than £25,000 will no longer be eligible for amendment without Commission authority. This means it is all the more important for legacy teams to be clear with prospective donors keen on preserving capital as to the downsides and risks of doing so. A gift structured as permanent endowment, rather than as expendable endowment or as a restricted income fund, which ended up producing insufficient income for advancement of its own charitable purpose would be a detriment for the donor and charity alike.
  • The introduction of the social investment power for a total return approach will provide flexibility for trustees – at their discretion – to make investments which advance the purposes of the endowment fund, despite a highly improbable financial return. Some donors will see this as a benefit to be celebrated, as it will provide an opportunity for increased advancement of their charitable aim, particularly in circumstances where investment return is low. Other donors may view it as an undesirable leak of capital from their gift. This means discussion between legacy teams and donors about whether a total return approach should be included, or prohibited, in the governing document of the endowment fund is all the more important.
  • The power to borrow against permanent endowment will give trustees a novel opportunity to access permanent endowment capital in times of need or in response to a particular circumstance or event. A real benefit of this route will be avoiding the need for a charity to borrow much needed money at a commercial rate of interest. The safeguards on how much can be borrowed, formulation of a repayment plan and timescale for repayment in full of the borrowed capital, will give donors comfort as to the preservation of their gift.
  • The reduction in the deadline for objection from the Charity Commission in response to applications from the trustees of ‘larger’ endowment funds (ie section 282) will be a welcome change for charity trustees from an administrative perspective.

These proposed changes, particularly the removal of the income threshold test for section 281, make it all the more important for charities to have clarity on the basis on which they hold funds. Charities should be reviewing the endowment funds they hold on a regular basis to make sure it they are fit for purpose, and that the original aims of the donors are being fulfilled. Keeping records of endowment funds and restricted income funds will assist charities and legacy teams in staying on top of these funds, and being able to consider making amendments where possible and appropriate.

Looking more widely, the proposed changes offer an opportunity for charities and donors (particularly legacy donors) to engage with each other. Early dialogue and reciprocal clarity as to what permanent endowment is, what it would mean in terms of restrictiveness, and examination as to whether it would present the best giving structure in the circumstances (and if so whether a total return approach should be adopted), would benefit donor and charity, and support the more effective advancement of their shared charitable aim/s.

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