Hungary's Legal Environment for Endowment Building Nilda Bullain
Although nothing prohibits the establishment of an endowment in Hungary, in practice endowments do not exist. As the new government is working on a comprehensive strategy towards the development of the NGO sector, the time might be right to address the barriers.
In this article, we will take a look at the reasons for the lack of endowment funds in the NGO sector in Hungary, analyse the most important legal aspects of establishing and managing endowments, and list the factors that could encourage the development of these funds. While focusing specifically on endowments, the article also looks at investment opportunities for NGOs in general. Hindering Factors
It has not been a political priority thus far to create a favourable environment for endowments. The economic circumstances were not considered developed enough either by the government or by private funders to provide for the private wealth needed for endowments. Foundations have not been prepared to administer such funds as the financial and management capacities of most have been limited by both lack of skills and funding. Due to the strong influence of state public foundations on the NGO sector, funding for NGOs has always been expected from government budgetary funds - therefore, there was no clear demand for endowments in the NGO community.
Finally, a number of legal barriers have also contributed to the fact that there are no endowed grant-giving foundations in Hungary today. These include unfavourable or unclear regulations regarding governance structures, the lack of adequate risk-management concepts, lack of clarity about liability for investment failures, and insufficient incentives with respect to the taxation of investment returns. Establishment of an Endowment
Interestingly, under Hungarian law the establishment of a foundation in itself involves the possibility of creating an endowment. In the current law, there are two ways to dedicate the property of a foundation, through a so-called "closed foundation", or through an "open foundation".
Article 74/A (1) of the Civil Code (Act IV of 1959) states that "the property required to realise the goals of a foundation must be assigned to the foundation" (closed foundation). This means that the assets are assigned for this purpose in perpetuity. Article 74/B (4) states that if the founder allows others to join the foundation (open foundation), anyone may join (i.e. contribute to) the foundation, under the conditions laid down in the founding statutes. In this case, only "the amount of property that is essential to start its operations" needs to be assigned to the foundation.
From the opinions issued by the Supreme Court (which are binding on the judiciary), it becomes clear that the initial capital of a closed foundation is considered an investment from which income is to be drawn; at the same time, the same opinions allow the expenditure of the initial capital for the purposes of the foundation , which is contrary to the notion of an endowment.
In practice, the number of closed foundations is minimal. Founders are not interested in assigning large amounts of property to a foundation's purpose in perpetuity. The law has created insufficient incentives and too many barriers to the establishment of an endowment; some of these legal obstacles are detailed below. Governance
One reason why there may be reluctance to endow foundations is that the governance principles of foundations in Hungary are not entirely clear. Although in principle the founder retains the right to appoint and dismiss board members throughout the life of a foundation (and is also the only person competent to modify the founding statutes), in practice Hungarian court rulings show a tendency to restrict the founder from active involvement in decision-making about the organisation. This is logical and understandable, given the fact that in most cases the founder has made only a minimal financial contribution to the organisation. There is also a legal argument that a foundation is a separate legal entity, so founders should be able to exercise only indirect control over foundations.
At the same time, grantmaking endowed foundations and grantseeking, operating foundations (essentially NGOs) are not distinguished in Hungary. It is also not possible to set up self-perpetuating boards of directors. The controversies surrounding the rights and responsibilities of the founder probably impede those who want to dedicate a greater amount of their wealth to a public purpose by creating an endowment. Principles of Investing
Article 4 (1)(b) of Act CLVI of 1997 on Public Benefit Organisations (PBOs), which lists the criteria for a public benefit organisation, provides overall guidance on prudence in financial matters when it states that a PBO "only undertakes entrepreneurial activity in order to further its public benefit purposes and without endangering them".
A concrete example of what a PBO is not allowed to do because it would endanger the realisation of its purposes is provided by Article 16 of the PBO Act: "A public benefit organisation shall not issue bills of exchange or other securities creating a debt obligation" and "a PBO, except a public benefit company, shall not draw credit with the aim of developing its business activity to an extent which jeopardises its public benefit activity".
Article 17 of the PBO Act requires that "a public benefit organisation pursuing investment activity shall prepare investment rules which are approved by its highest body". Apart from the above-mentioned, however, the law provides no further guidance as to what these policies should involve. Thus, there is no clear guidance as to how a foundation endowment may be invested and the extent to which prudent investment policies govern such investments. Taxation
In Hungary there is a differentiation between "economic activity" and "entrepreneurial activity" (or, in another translation, "business activity"). Act LXXXI of 1996 on Corporate Tax and Dividend Tax (CTDT Law) defines in its first paragraph (Article 1.1.) "entrepreneurial activity" as "economic activity aimed at or resulting in obtaining income and property". Here "income" means taxable income, i.e. profit for distribution. This type of economic activity - and only this type - is what a legal person is required to pay tax on, whether it is a for-profit or a not-for-profit entity. Tax-exempt (i.e. non-entrepreneurial) economic activity (e.g. charging fees for services) is that which does not aim at profit for distribution but income for enhancing a public interest purpose.
From the CTDT Law it appears that "part of the interest received from a credit institution or the issuer of securities, or a part of the yield of state bonds", along with grant support, gifts and own income serving statutory purposes, are not considered entrepreneurial activity. Therefore, such income from investments is at least partially tax-free, proportionate to the percentage of revenue from public benefit or statutory activity as related to the entire revenue (revenues counted without the interest and the yield) of the organisation.
All in all, if a PBO does not have commercial activity at all, its income from investments in credit-type securities (bonds, whether government or corporate-issued) will not be counted as entrepreneurial income. On the other hand, income from investments in shares, limited partnerships, and perpetual investment funds will be tax-exempt only as long as it is under 10% of its total revenue or less than 10,000,000 Hungarian forints or about 42,550 euros (in other words, it will be treated as income from entrepreneurial activity). Liability
As pointed out by ICNL in its memorandum on the same issue for Poland , civil law countries do not have the concept of trust and fiduciary duty in the sense used in common law countries, such as England or the United States. In common law countries, issues of liability with respect to endowment funds have largely been derived from trust and fiduciary law. The issue of liability for bad investment decisions is not clear at the present time in Hungary, as the issue of liability of board members and management is not clear in general.
The most concrete reference to such liability is in Article 74/C (6) of the Civil Code that determines the liability of a foundation for damages to a third party caused by a board member or official of the foundation; and states that the board member or official is liable to the foundation according to the general tort rules of the Civil Code. Changing Winds
The recently elected new government is open to work with NGOs on the reform of the legal framework affecting them. In its newly devised strategy towards the non-profit sector , the government declares the importance of ensuring long-term sustainability and independent and depoliticised financing of the sector. Although the concept of endowments is not spelled out in this strategy, it is likely that key players in the NGO sector are now ready to demand inclusion of it.
The environment is now becoming more favourable at the macroeconomic level as well as in terms of the growth of the non-profit sector. In 2000, the Hungarian non-profit sector yielded 40 million euros from investments only; 10-12% of the income of certain types of NGOs came from investment and financial transactions; the value of fixed assets in foundations was 215 million euros. Although these figures include the data of "quasi-governmental" public foundations, they show an encouraging opportunity for investments by NGOs.
In order to take advantage of the window of opportunity in the political and economic environment, NGOs will need to be able to: effectively advocate with the government and legislature; increase their capacity and skills in financial management; and, perhaps most importantly, establish good communication with the banking community and awaken its interest in achieving this ambitious goal.
Nilda Bullain is a Senior Legal Advisor at the International Center for Not-for-Profit Law (ICNL) office in Budapest.
This article is an adapted version of the paper "The Legal Environment for Endowments in Hungary" by Nilda Bullain that appeared in Issue 4 Volume 4 of IJNL (see www.icnl.org/journal
F irst published in SEAL (Social Economy and Law Journal), Winter 2002-2003. See http://www.efc.be/publications/sealabstract.html .