Tax-exempt Charities that wish to retain their tax-exempt status must register with the new Charities Commission – but this does not necessarily mean that they will continue to be tax exempt.
Perceptions of the Charities Act 2005 (the Charities Act
) may be far from the reality. The newly formed Charities Commission is not the streamlined “one-stop shop” that the Government originally promised. This Counsel outlines the ways that the Charities Act potentially confuses the process for Charities to confirm their tax exempt status and may increase their administrative burdens. In addition, this Counsel also discusses common tax pitfalls faced by Charities, which may receive more attention with the establishment of the Charities Commission.
The Charities Act was passed by Parliament in April of this year. The Charities Act establishes a Charities Commission to register and monitor new and existing charitable entities. While registration is not technically compulsory, the failure by an entity to do so means that its income will not be exempt from tax. Registration with the Charities Commission is expected to commence in March 2006 and regulations are to be passed to set out the registration process. Amendments to the Revenue Acts, which will deprive Charities that do not register their tax exempt status, are not expected to apply until 2007, although a specific date is yet to be set.
At the end of this article we provide a checklist of things that all new and existing Charities should consider before the registration regime commences. In the meantime you should familiarise yourself with the reporting obligations imposed under the Charities Act.
We will update our website as further information in relation to the registration requirements becomes available.
The Charities Act and what it really means for Charities
Rather than minimising or simplifying the bureaucracy applying to Charities, the Charities Act adds to the administrative burden for Charities. In particular, there is now potentially a three-stage process in order for a new Charity to be afforded the relevant tax exemptions.
Under this process, new Charities will be required to:
- register as a qualifying charitable entity with the Charities Commission
- seek confirmation of tax exempt status from the Commissioner of the Inland Revenue (the Commissioner) either:
- informally (if the Commissioner continues to provide informal approvals), or
- formally through the binding rulings process;
- make a separate application to the Commissioner for approval as a donee for income tax purposes (if this is required).
Existing Charities which already have confirmation from the Commissioner of their tax exempt and donee status will not be required to reapply for such approval from the Commissioner. However, those Charities will be required to register with the Charities Commission (and will be subject to ongoing monitoring by the Charities Commission). Failure to register will result in that entity forfeiting its tax-exempt status, although surprisingly it appears that such a failure will not necessarily result in forfeiture of the entity’s donee status.
Process for tax-exempt status
Historically, the Commissioner has, if requested to do so, provided Charities and businesses carried on by Charities with an informal approval that the relevant entity is exempt from income tax on the basis of the activities of the entity (as described in its foundation document). Contrary to popular belief, the Commissioner’s approval is not binding, nor is it strictly necessary to obtain such approval before claiming tax exempt status. However, this approval has provided considerable comfort to Charities that, so long as they operate within the confines of their foundation documents, they can have some certainty their income will be tax exempt. A Charity could also obtain a binding ruling in this regard under Part VA of the Tax Administration Act 1994, but in practice the binding ruling option was rarely used by Charities as it can be very costly and time consuming.
What was originally proposed?
The Charities Act and the Charities Commission was supposed to be a “one-stop shop”2 which provided for all of the legislative requirements of Charities. Registration with the Charities Commission was expected to afford tax-exempt status. While the Commissioner was to maintain an independent “audit role”, this was not to include the day-to-day assessment and handling of Charities. Once a transitional period passed, the Commissioner was to cease to be the primary assessor of tax-exempt status.
What has been delivered?
The Charities Act falls short of the “one-stop shop” promised by the Government. While the Charities Commission may consider whether an entity qualifies for registration under the Charities Act, registration does not mean that an entity is automatically tax exempt. Tax-exempt status is still something to be independently judged by the Commissioner by reference to the tests contained in the Revenue Acts.
In other words, registration under the Charities Act gives no guarantee that a Charity will be tax exempt. Instead, registration is merely a necessary prerequisite to the tax-exempt status being afforded by the Commissioner.
To date, the Commissioner has not released any public comment on his view as to how new Charities can confirm their tax-exempt status. It is unclear whether the Commissioner will continue in his informal approval process or whether he will adopt a policy that a registered Charity will be automatically tax exempt. While such a policy would be highly desirable from a Charity’s perspective, it is unlikely to be adopted because the tests used by the Charities Act and the Revenue Acts can be different. For instance, where a Charity derives business income, the Income Tax Act imposes additional requirements on Charities before that income can be exempt from tax.
Can subsidiaries of a Charity register?
An interesting issue arises as to whether entities, which carry on business on behalf of or for the benefit of Charities, can or in fact need to register with the Charities Commission.
Charities frequently establish wholly-owned subsidiaries to carry on business activities, the profits from which are distributed by the subsidiary to the Charity. Currently the business income derived by such a subsidiary is typically viewed as being exempt from tax on the basis that it is derived by the subsidiary “on behalf of or for the benefit” of the Charity. In other words, the tax exemption focuses on the use to which the business income will ultimately be applied for rather than whether the subsidiary itself was established and maintained for charitable purposes.
By contrast, the Charities Act focuses on whether the purposes of the subsidiary are charitable. As a result subsidiaries of a Charity will not be able to register with the Charities Commission unless they are themselves established and maintained exclusively for charitable purposes. In our experience the constitutions for such subsidiaries often fail to include any express reference to a “charitable purpose” and consequently it is unlikely that such entities will be able to register.Upon initial examination, subsidiaries of a Charity may be alarmed by a suggestion that they will be unable to register. While that concern is well founded (i.e. as a general principle an entity which currently relies on the charitable tax exemption will be unable to rely on the exemption in the future if it has not registered with the Charities Commission), it appears that a subsidiary of a Charity may be in a somewhat unique position.
The tax exemption for business income does not appear to require that each entity relying on the tax exemption be registered – instead all that is required is that the relevant Charity is registered with the Charities Commission. Therefore in our view, a subsidiary of a Charity should be able to continue to rely on the tax exemption provided that the Charity for whose benefit the subsidiary derives the business income (i.e. the shareholding Charity) has itself been registered. We will continue to monitor developments in this area as the new regime is implemented.
Imposition of gift duty
The Charities Act also makes changes to the Estate and Gift Duties Act 1968 (the Gift Duties Act). These changes may mean that settlements that create charitable entities are no longer exempt from gift duty. The amendment adds to the current wording of section 73 of the Gift Duties Act, the requirement that at the time that the gift is made the entity receiving it be registered as a charitable entity under the Charities Act. As many charitable trusts will be established by settlement before registration this could mean that the amount settled on the trust will not be exempt from gift duty. While this may not pose significant problems where a nominal sum is settled on a trust (as is often the practice), it will be important that charitable trusts are not declared over large assets or sums, before registration is effected.
[Amendments to the Revenue Acts are not expected to apply until 2007, although a specific date is yet to be set.]
The Charities Commission will not approve donee status
When the Charities Bill was first drafted it was proposed that the Charities Commission would also approve entities as “donee organisations” and that this approval would not be subject to review by the Commissioner. In general terms, donee organisations are those established for charitable, benevolent, philanthropic or cultural purposes within New Zealand and certain named organisations, of this type, specified in the Income Tax Act 2004. Donee status for an organisation means that a company who makes a donation to that organisation qualifies for a tax deduction and a person who makes a donation to that organisation may qualify for a tax rebate.
As this approval process was not included in the Charities Act, the Commissioner will continue his role in administering the approval of donees.
A checklist of things to consider before the registration regime commences
- Keep watch for any general statement from the Commissioner on the tax-exempt status of Charities
- Make sure your office holders are aware of the need for the Charity to comply with the requirements for registration under the Charities Act as well as the requirements for tax-exempt status under the Revenue Acts. Some of these requirements include:
- reviewing your Charity’s foundation documents for compliance with the tests included in both the Charities Act and Revenue Acts
- ensuring that all your activities are consistent with those described in your foundation documents
- confirming that your Charity can satisfy the other obligations of registration under the Charities Act (e.g. ensuring that all officers are not disqualified).
- When establishing a new charitable trust, settle only a nominal amount before the trust is registered with the Charities Commission.
- Make sure you are aware of the tax pitfalls described in this Counsel.
The tests for tax exemption
As the tax exemption tests are complicated, it is easy to inadvertently fall outside of them. With the introduction of the Charities Commission, we anticipate that Charities will need to pay greater attention to these tests. Some of the more common mistakes to be aware of include:
- That the Charity must not be carried on for the private pecuniary profit of any person. While this rule does not explicitly apply to trusts (it applies to societies and institutions established and maintained for charitable purposes) it is still a good test for whether a trust is in fact charitable.
- That a Charity that derives business income only carries out its charitable purposes within New Zealand. Any business income derived by a Charity is only exempt to the extent that the Charity carries out its charitable purposes within New Zealand.
- That no person with some control over any business carried on by or for a charitable entity is able to direct or divert an amount from that business to their own advantage. An exclusion exists for services provided by the person to the Charity, in carrying on the business of the person if that person is in professional public practice.
Sample forms for registration and annual return are available on the Charities Commission website.3 These forms specifically question the activities of charitable entities in order to elicit information on activities conducted outside New Zealand and benefits provided to persons involved with Charities. These questions reflect the tests for tax exemption and are clearly targeted at the requirements of the Revenue Acts.