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U.S Treasury Announce Major Rule Changes To Support Global Entrepreneurs And Impact Investment

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President Obama, along with 182 heads of state, will sign the Sustainable Development Goals (SDG) today at the United Nations General Assembly.   But earlier this week, the Obama Administration’s Treasury Department announced two major regulatory changes that could unlock significant amounts of capital, innovation and entrepreneurial energy for development worldwide.

The seventeen SDG’s create a common set of development goals for the world – in the areas of education, health, the environment, poverty alleviation and citizenship.  While many, including myself, have been critical of the SDG’s, and their predecessor, the Millennium Development Goals (MDG); there is little disagreement that global leaders must stay engaged on the challenges of global poverty and sustainability.

Starting with the Marshall Plan and continuing today, the United States has long supported development, democracy and enterprise.  But the leadership of our private sector – individuals, charitable organizations, foundations and investors, towards development has been far ahead of the rest of the world.  Today, while several governments spend a larger percentage of their GDP on official foreign assistance than the United States, there is no country that provides as much private assistance, as a percentage or in aggregate, as the United States.

The two rule changes put forward by the U.S. Treasury Department earlier this week remove important barriers that have historically kept even more American capital from being deployed around the world.   Until this week, American philanthropy was generally reserved for non-profit organizations that were registered in the United States as public charities.    This kept funding from reaching social entrepreneurs, high-performing foreign NGO’s, social enterprise and triple-bottom line companies outside the United States unless the funder was willing to spend 5-10% of the grant on due-diligence and certification.  This is referred to as “global equivalency”.  During my time as Executive Director of the Deshpande Foundation, we regularly spent close to 10% of each grant on consultants and staff time to approve foreign grants.  We did not pass those costs onto our grantees, although many foundations do.

This Thursday, Treasury has announced that it will make it easier to provide grants to foreign organizations.   Specifically, it allows a “good faith determination that a foreign organization is a charitable organization that is not a private foundation, so that grants made to that foreign organization may be qualifying distributions and not taxable expenditure”.  Essentially, foundations will now be able to rely on their own experience, in-house staff and outside experts, to determine if a foreign organization is the equivalent of an American non-profit.  In addition, the U.S. Treasury Department may be more flexible on three related issues: the time frame for which these assessments are valid, the definition of a public charity outside the United States, and the amount of grant funding for which an affidavit is required to certify the foreign charity.

In a world full of social innovation like Akshara, social entrepreneurs like Agastya, and social enterprise like Mann Deshi, it is frustrating, expensive and regressive to only allow funding to organizations that have charitable American roots, or to require expensive investigations for each foreign grant.  Now, more foundations and philanthropy will bet on those social entrepreneurs and local NGO’s because the fear of penalty has been removed and the cost of compliance has been drastically reduced.

The second regulation change has the potential to unlock greater investment capital worldwide for entrepreneurs and companies seeking profitability and impact.  In this case, the rule change announced by the U.S. Treasury will not just be limited to foreign organizations, but will unlock capital for American entrepreneurs as well by making philanthropic capital available for impact investors.

For several decades now, foundations have only spent 5% of their endowment for grant-making.  The other 95% has been in the hands of professional investment managers.  Historically, investment managers and boards have discouraged impact investment on the grounds that foundations would be penalized by the IRS for not taking “ordinary business care and prudence” to maximize returns, or forced to pay an excise tax for grants to organizations that were not charitable.  But on Tuesday, the IRS announced that mission-related investments (MRI), and program related investments (PRI) DO NOT jeopardize the financial future of a foundation, and therefore, should not be automatically taxed.  As long as foundations are making a “good-faith effort” and showing appropriate prudence in their investment process, the IRS would not judge the investment to be taxable.

All of a sudden, the “other 95%” is now available for impact investors, entrepreneurs and DBL/TBL companies.  Indeed, the Kresge Foundation has already announced that it will now put 10% of its endowment – or $350 million, into impact investment.   And according to the Center for Effective Philanthropy, 46% of major foundation CEO’s will make mission-related investments in 2015.   But the median percentage of impact investments has been low until now – only about 2% of endowments for MRI’s, and less than 0.5% for PRI’s.

The explosive growth of microfinance worldwide validated that impact investing can reduce poverty while reaping strong returns.  But the challenges of the microfinance industry, particularly in India, also laid bare the reputational concerns that come with investment in for-profit entities serving the poor, and the vagaries of tax-policy outside the United States.

Proven impact investors like the Calvert Foundation will see a great boost from this ruling, as more foundations invest for impact alongside their grant-making.  And entrepreneurs worldwide will have access to the patient capital they need – whether they are creating products for the base of the pyramid internationally; or building a network of charter schools in urban areas of the United States.

With these rule changes, the Obama Administration may have unlocked more private capital for sustainable development than it would have officially allocated for the Sustainable Development Goals.  And it won’t matter where that money comes from if we remain focused on solving the problems of global poverty and sustainability.