Worthstone, a research and think tank for impact investment in the UK, prepared a report that investigates the feasibility of introducing tax incentives for social investment.
Commissioned by the City of London and Big Society Capital, with assistance provided by Wragge and Co LLP, the report looks at existing data to explore questions such as why the UK would want to introduce a tax relief, what are its implications, and how much capital might be raised from such a tax relief?
A common challenge in the impact investing sector today is a funding gap between social investors and social enterprises. There is a shortage of high-risk capital to meet the demand of social enterprises seeking “long-term patient capital”. Although grants and subsidies have certainly helped the development of the social investment sector, the continuous reliance on these tools is anything but a long-term strategy.
Recognizing this, UK’s social sector organizations, including charities, wish to reduce their reliance on grants by developing revenue-generating models. Given this trend, the demand for social investment will only continue to increase. According to the report, demand for social investment in 2015 is estimated at £750 million, in the form of equity-like products – where investors and investees share risk and improved revenue forms the basis of returns to investors – and unsecured debt products.
Developing a mature social investment market that has transitioned away from the reliance of grants and subsidies towards mainstream financial mechanisms is seen as a critical step.
The report, entitled The Role of Tax Incentives in Encouraging Social Investment, essentially evaluates tax reliefs for developing a mature social investment market.
On the tax relief
So why would the UK want a tax incentive in particular? In another report by Ipsos MORI, it was found that wealthy investors have an unmet appetite to use their wealth to reflect their social and ethical values and make money at the same time. A tax incentive would aim to target these high net worth individuals (HNWIs), the same way tax incentives encourage venture capital and charitable giving.
The Ipsos MORI report revealed that a tax incentive is influential in encouraging HNWIs – those with at least £100,000 of investable wealth – who are “actively interested” in social investment to engage in such activity, even though it is not the primary motivation.
In addition, HNWIs who had a “passive interest” in making social investments cited their primary motivation to do so was the creation of appropriate tax incentives. The research suggests that a tax relief could encourage social investment among a range of wealthy individuals.
At the moment, various grants and first-loss finance help cushion social investments, otherwise investors would not have committed to a deal at all. And since the goal is to transition away from grants, the argument is that tax reliefs can help in this transition.
Expected capital from tax relief
Based on the responses of 505 affluent and wealthy individuals that said they would be very or fairly likely to invest in equity-like social investment, the report forecasts that the amount of capital that could be raised among HNWIs, provided that there is a tax relief, is £165 million over a three-year period and £480 million over a five-year period.
However, what’s important here isn’t the sum that is generated, since the level of interest for a tax incentive is very delicate and can depend on a number of factors. But the report predicts the potential for such sums is reasonable, given that wealthy investors see the incentive to be influential and important.
Given the increase in incubator programs and laws to embed social value in the procurement of services in the UK, a tax relief would complement the many policy levers implemented by government.
At the same time, the report outlines some factors for which a tax relief may not release the intended capital. For example, although there are investment readiness programs, are social sector organizations ready and willing to take on social investment?
In addition, are there sufficient investment products? Interestingly, the EU Parliament voted in a new European Social Entrepreneurship Funds last week that aims to make it easy for social investment funds to raise capital across Europe and channel them into social enterprises. According to the EU Parliament, the European Commission shall review the regulation, no later than four years after the date of application of the regulation, to examine possible tax obstacles for the funds and assess possible tax incentives to encourage social entrepreneurship in the EU.
Other barriers to a tax relief could include regulatory barriers, investors’ motivation (another key consideration for investors is demonstrated social impact through social impact reporting), and whether it would cannibalize existing investment in small and medium enterprises and charitable giving. So far, research from Ipsos MORI shows little evidence of cannibalization, as investors view philanthropy and social investment with two different mindsets.
Tax or no tax relief?
In order to bridge the funding gap, move away from grants, meet the demand for social investment, and feed the appetite of investors, the report makes the early case for a tax relief for individual investors.
Given the recent changes in regulation in the EU, tax incentives will soon become the point of discussion.
If a tax relief is indeed considered, what is yet to be figured out is a framework that defines the types of investee organizations, at what rate and when in the investment lifecycle is the tax relief offered, and whether these rates would differ among the forms of capital provided.
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