The government should look again at reducing VAT on investment management fees for charities, says Diane Wilde.

'Third sector', a term sometimes used to describe the UK charitable sector, might encourage the misconception that it exists separately from other companies and organisations in a bubble.

This is certainly not the case and is only highlighted by the current economic malaise and contraction of government expenditure, conditions which exert further pressure on charities. The recent government Giving White Paper highlights initiatives to encourage the charitable sector to help provide social services more effectively to communities. We should not forget that organisations with charitable status, like any company, have to manage their money effectively in the current economic climate. They experience the same risk environment, returns, and for many, the reduction in central spending and decreased income from donors has created an unlevel playing field.

In addition, there is the added pressure that charging of VAT on investment management fees can put on a charity’s ability to carry out its charitable purpose effectively.

Currently charities have to pay VAT at the rate of 20 per cent on asset management fees. But does it make sense that members of the voluntary sector have to pay this extra tax? It is a fiduciary duty of trustees to appoint professional external advisers to provide investment advice and support to help them achieve their charitable purpose. If VAT on management fees is essentially taxing the charitable funds raised from the tax-paying public, then HMRC is indirectly recirculating assets contributed by taxpayers back into the public sector.

If the charity has passed the public benefit test, the monies that are currently paid as taxes could instead be used for the charitable purpose of those trusts. Our clients experience a direct economic cost of paying tax on management fees, and further impact is felt when there are not sufficient grants available to further assist them in this difficult environment.

Alternative management fee structures such as trading commission do not attract the VAT charge. Trading commission is charged on every deal transacted by the manager and can create a conflict of interest if it is used as part of a discretionary management service as the asset manager is remunerated by the number of trades, rather than by the quality (performance) of those trades. Only an agreed fixed percentage fee can remove this conflict and align the interests of the asset manager and of the trustees and their charitable purpose. Essential to this is a clear audit trail of reporting and performance on all charity assets. The manager has to be accountable to the trustees and the trustees require the audit trail to fulfill their fiduciary duty of linking the assets to the charitable purpose and passing the public benefit test.

In an era of increasing regulation and protection of trustee interests it is very important that trustees can choose an asset manager who can define the costs of management. However, the charity sector would hugely benefit from the disposal of tax on management services to allow trustees to protect their fiduciary interests and to choose asset management services with clear and transparent reporting and cost structures.

Early Interventions: An Economic Approach to Charitable Giving, produced by Barclays Wealth and New Philanthropy Capital, attempts to encourage more philanthropic support into the voluntary sector as public sector and local authority spending is slashed in this period of extreme austerity. People giving to charity would then wish to know that the transfer of assets would result in efficient and effective giving to the charitable purpose.

In 2007, HMRC discussed allowing charities to reclaim a proportion of VAT costs on their investment managers' fees, a move that could have resulted in potential savings and retrospective claims worth tens of millions of pounds for the sector. Unfortunately such a move was never progressed despite the significant campaign of public sector pension funds. We would welcome the reopening of these discussions in what would be a positive and practical step to support our stretched voluntary sector.

Diane Wilde is director of charities at Barclays Wealth, Scotland