by Timothy R. Lyman
U.S. grantmakers, both foundations and corporations, are showing increasing interest in "microfinance": the provision of capital and financial services to poor people whose businesses typically lack access to conventional market sources of support. The impressive successes of microfinance in alleviating poverty, creating and sustaining employment and encouraging economic development generally in countries as diverse as Bangladesh, Bolivia and Bosnia have helped to spur this interest. Although the legal issues of microfinance can be complex (see Author's Note below), there are ways both corporate and foundation funders can provide support for microfinance abroad that avoid much of the potential legal complexity. Different approaches to carrying out microfinance activities raise different legal issues for potential U.S. supporters. In addition, the legal issues faced by corporate supporters of microfinance differ from those that private foundations face.
Types of Microfinance Institutions That Funders May Support
U.S.-based sponsors of microfinance abroad.
An increasing number of U.S.-based humanitarian relief and development organizations carry out microfinance activities in an expanding number of countries throughout the world. These U.S.-based organizations are typically corporations recognized as public charities. Their microlending and related activities abroad may be carried out through branch offices or through locally formed implementing "partners" that receive funding from or through the U.S.-based sponsor. If the U.S.-based sponsor operates through a branch office, there is often a plan to spin off the microfinance program as a separate locally formed "microfinance institution," described below.
Foreign organizations. A wide variety of locally formed legal entities engage in microfinance activities in different countries. Microfinance practitioners tend to refer to all the various possible legal forms as "microfinance institutions" (MFIs), provided the services of the organization are directed toward a poorer clientele. Relatively few countries' laws specifically recognize MFIs as a separate form of legal entity, so that in most countries MFIs choose the most suitable form of legal entity available. They tend to divide into those organized as some form of nonprofit, nongovernmental organization (NGO MFIs) and those that can meet the qualifications to be recognized as some form of regulated financial institution.
Typically, NGO MFIs are "credit only" institutions by law, in that they are prohibited from offering financial services beyond their microlending and, in particular, are forbidden to raise capital in the form of deposits. NGO MFIs have no owners and are typically governed by a board elected by a general assembly of members or a self-perpetuating board. Often, NGO MFIs rely almost exclusively on donated capital, although many are legally permitted to borrow funds if they can find a willing lender.
There are several common types of non-NGO MFIs, though they go by a virtually infinite number of different names under different countries' laws. The simplest—basically a form of finance company—is also a non-depository, credit only MFI. Unlike NGO MFIs, however, a finance company has owners (its shareholders), who elect its governing board, and it has legal access to capital in the form of both equity from its shareholders and borrowed funds (presuming it can find willing investors and lenders).
A third common legal form taken by MFIs is a savings and credit association, cooperative or union. These membership-owned and -governed MFIs typically differ from both NGO MFIs and finance companies in many respects, including that they accept deposits (though often only from their membership). Some are permitted to issue nonvoting equity to nonmembers and most have the legal power also to borrow capital (subject, of course, to availability).
A fourth type of legal form growing more common among MFIs is sometimes referred to by microfinance practitioners as a "microfinance bank," in that it still targets its services to the poor, but it engages in a bank-like variety of lending and deposit taking within its targeted market. A microfinance bank is typically governed by a board elected by its voting shareholders, and has legal access to both equity and debt capital (again, presuming these are available).
In addition to these legal forms, microfinance practitioners are also working increasingly through conventional financial institutions such as local commercial banks, using various techniques to induce them to provide financial services to poor people, such as by guaranteeing loans to MFIs or by depositing funds that are then on-lent to MFIs or even directly to microentrepreneurs. Typically, this involves a separate program of microfinance services offered alongside the institution's other products and services.
Types of Support for Microfinance
Financial support for loan capital. Grants are perhaps the most common form of financial support for microfinance loan portfolios abroad. NGO MFIs can be particularly attractive as charitable grantees because they are often barred by law or their organizational documents from benefiting private interests. Funders have also provided grant capital to various privately owned forms of MFIs, however, subject to grant agreements that attempt to limit the power of the MFIs' owners to withdraw capital.
Many microfinance sponsors are now looking also at providing financial support to MFIs in the form of loans. One reason to provide capital as a loan is that local law may well provide more predictably effective enforcement mechanisms for loaned capital than for granted capital, leaving sponsors in a better position to ensure compliance with use restrictions on the capital they supply.
Finally, some sponsors are providing capital in the form of equity investments. Equity investment in an MFI itself (which is generally not possible with respect to NNGO MFIs) both increases directly the capital available for microfinance activities and potentially puts the MFI in a position to access borrowed capital from other sources. It can also provide meaningful control over the MFI's governance, through the shareholders' rights to elect the governing board. Equity investments in conventional commercial banks have even been used as a means of providing capital (and securing a commitment) for the bank in question to provide services to poor customers.
MFI operating support and technical assistance.
Besides financial support for microlending capital, many supporters of microfinance abroad provide operational support and fund technical assistance to MFIs. Typically, even the most successful MFI requires several years of deep operational subsidy before net earnings can sustain the high transaction costs of serving this customer base. For most MFIs, donor funding represents the only available source of this operating subsidy. Intensive technical assistance of many sorts is also required to build a self-sustaining MFI and to foster the businesses of its customers, and even very well established MFIs can benefit from ongoing subsidized training for their staff and clientele.
Legal Issues for Foundations
For foundations that wish to support microfinance abroad, the legal issues they will face will depend on the nature of the recipient and the nature of the support. If a foundation decides to work exclusively through grants to a U.S.-based sponsor that is recognized as a public charity, it will generally face no more challenging legal issues than with respect to other forms of domestic grantmaking. If the foundation decides to work directly with foreign MFIs, the legal complexity of its support will depend on whether it limits its funding to certain types of grantmaking to certain types of MFIs and whether, if it chooses not to, its support can qualify as a "program-related investment."
Grants to foreign MFIs. Foundations will want to be sure that their grants to any foreign entities do not constitute "taxable expenditures," and many will also need their grants to constitute "qualifying distributions," as discussed in the Legal Dimensions articles "Grantmaking by Private Foundations in the International Arena" by Thomas Chomicz and "The Out of Corpus Rule Reviewed" by Milton Cerny and Doug Varley. For grants to MFIs that qualify as equivalents of U.S. public charities, grants of capital to develop microfinance portfolios present the same issues as grants for capital equipment and capital endowment grants; the IRS may wish to know how the grantor will protect against the grantee diverting funds to noncharitable activities in the future. See John Edie and Jane Nober, Beyond Our Borders, Council on Foundations, revised ed. 1999 at 34.
Grants to MFIs that are not
the equivalent of a U.S. public charity present the additional challenges of "expenditure responsibility" and (if the grant needs to constitute a qualifying distribution) also the "out of corpus" rule. See Beyond Our Borders
at 35–36. Both issues can be particularly tricky in the case of grants to fund loan portfolios (although potentially simpler if the MFI grantee is the equivalent of a U.S. private foundation, as special rules applicable to endowment grants will help). See Beyond Our Borders
at 35. For all these reasons, regardless of the type of MFI grantee, a private foundation may prefer to provide grants for operational support or support for technical assistance, rather than grants for loan portfolio development.
Program related investments.
A U.S. foundation may be able to structure a loan to or equity investment in a foreign MFI as a program related investment (PRI). To meet the basic test for treatment as a PRI, the investment to provide microloan capital will have to be made for charitable purposes and not with any significant motivation to produce income or property appreciation on behalf of the private foundation investor. Meeting this test will avoid treatment as a "jeopardizing investment" or "excess business holding." Conveniently, satisfying this test will also qualify the expenditure as a "qualifying distribution." To avoid having its investment treated as "taxable expenditure," the foundation investor must generally exercise expenditure responsibility throughout the life of the investment (a process that has some slightly different requirements in the case of PRIs than in the case of grants). On PRIs generally, see Piton Foundation, Program Related Investment Primer , Council on Foundations, revised ed., 1993.
Legal Issues for Corporations
For corporate grantmakers that wish to support microfinance abroad, a primary consideration is likely to be the tax deductibility of their support. As for foundation grantmakers, the legal issues faced by corporate grantmakers will vary based upon the nature of the supported organization and the nature of the support.
Grants to U.S. corporations.
Generally, non-earmarked corporate grants to public charities organized as corporations in the United States to support their microfinance activities abroad will be tax deductible as charitable contributions. A grant for the same purposes to any organization formed under a foreign country's laws cannot be deducted as a charitable contribution. A corporate donor with an affiliated private foundation has the option of making deductible non-earmarked contributions to its foundation.
Direct support for foreign MFIs.
Many would-be corporate supporters of microfinance abroad may have funding options that are unique to their specific circumstances. A common example would be a U.S. corporation with a non-U.S. subsidiary in the country in which it wishes to support a local MFI. In this instance, the subsidiary may be in a position to make the grant and take advantage of whatever deductions local tax law provides, without bringing U.S. tax law into play. Corporations may also be in a position to justify treating support for a foreign MFI as a deductible business expense. The availability, nature and amount of a business expense deduction may depend upon such factors as the presence or absence of foreign income, and, in the case of a U.S. corporation without foreign source income, whether the support in question could qualify as a charitable contribution (since business expense deductions are generally disallowed if the expenditure in question qualifies as "charitable").
Simple Approaches to Start Supporting Microfinance Abroad
Both corporate donors and foundations contemplating major support for microfinance abroad may wish to set up a special program to address the issues outlined above. However, some potentially simple approaches permit both types of grantmakers to get started quickly without committing the resources to designing a specialized program.
Collaborate with a U.S. public charity organized in the corporate form. By far the simplest way to get started is to team up with one of the many public charities incorporated in the U.S. that are carrying out microfinance activities abroad. The "ins and outs" of such collaborations are outlined in the Legal Dimensions article "Simpler Approaches to Cross-Border Giving through Domestic Collaborations" by Timothy R. Lyman.
For foundations: provide operating support and technical assistance grants to NGO MFIs.
Many foreign MFIs organized as some form of NGO can meet the requirements for an equivalency determination. See the Legal Dimensions article "What's Behind the Foreign Public Charity Equivalency Affidavit?" by Betsy Adler and Ingrid Mittermaier. Grants may be made to these MFIs for operating support and technical assistance without triggering long-term monitoring concerns. Moreover, many of these MFIs will have enhanced access to funding for loan portfolio development from non-foundation sources if they can show that their operational subsidy and technical assistance needs are already funded by foundation grants.
For corporations: "non-charitable" investments that can be treated as business expenses.
Corporate investments in foreign MFIs can be structured relatively easily so that they do not qualify as deductible charitable contributions. Generally, these investments will produce business expenses that can be deducted in some fashion—from foreign income, if applicable; or, if not, directly in computing U.S. taxable income.
Author's note: the scope of this article is limited largely to legal issues for U.S. grantmakers under U.S. law. Under the law of many foreign countries, direct support for microfinance may raise other legal issues not addressed here.
About the Author
Timothy R. Lyman is a partner in the Hartford, Connecticut, office of Day, Berry & Howard LLP, where he heads the firm's Nonprofit Institutions Practice Group. In this capacity and as president of the Day, Berry & Howard Foundation ("promoting positive developments in the law, legal scholarship and legal education"), he is a frequent advisor on the legal and regulatory environment for microfinance and legal structuring of microfinance institutions abroad. He heads the Day, Berry & Howard Foundation's Microfinance Law Collaborative.
This article was edited by Kenneth Anderson, who is on the faculty of Washington College of Law at American University and Jane Nober, who is Special Counsel at the Council on Foundations. Mr. Anderson is former General Counsel of Open Society Institute, a significant supporter of microfinance abroad, and serves on the board of directors of the Media Development Loan Fund, a successful microfinance institution operating in Eastern Europe.
The Legal Dimensions series is coordinated by Joyce Chandran of the Council on Foundations, with assistance from the Day, Berry & Howard Foundation (“promoting positive developments in the law, legal scholarship and legal education”). Inquiries may be addressed to Timothy R. Lyman, president of the Day, Berry & Howard Foundation, at email@example.com or 860/275-0329.