Report to the Treasurer and Minister of revenue - by a committee of experts on tax compliance

Bill Birch Treasurer

Report to the Treasurer and Minister of revenue

By a committee of experts on tax compliance

Chapter 4 -
Charities and Other Tax-Exempt Entities

Introduction

4.1 The committee has some concerns regarding tax-exempt organisations. These are first, the appropriateness of the current broad tax exemption for charities and other non-profit organisations; secondly, the ability of tax-exempt organisations to earn business income free of tax, giving them a competitive advantage over other business operators; and finally, the exemption from taxation in certain circumstances of compensation paid to employees of certain charities and tax-exempt organisations. There is a fourth concern: exploitation of the charitable exemption in order to create asymmetrical tax avoidance schemes that permit arbitrage between taxpayers and tax-exempt entities. The committee addresses this concern at para 6.115.

4.2 The government assists some organisations that act for the benefit of the public by exempting them from income tax. These organisations are generally charities under the common law definition, and provide services which would otherwise be under-supplied in a free market, and might need to be supplied directly by the government. Examples include health care and education. In some circumstances, this assistance has been achieved by exempting private sector suppliers from income tax.

Scope of the tax exemption

4.3 The exemption for charitable and other tax-exempt entities is provided largely by section CB 4 of the Income Tax Act 1994. This exemption includes:

  • Non-business income derived by a trust, society or institution established exclusively for charitable purposes.
  • Business income derived by such a charitable body, subject to certain exceptions.
  • Income derived by an amateur sports body.
  • Income derived by a veterinary club or a herd improvement society.
  • Income derived by any society or association established substantially or primarily for the purpose either of promoting or encouraging approved scientific or industrial research or for advertising, beautifying, or developing any local areas so as to attract trade, tourists or population.

4.4 The committee has some specific concerns with certain tax-exempt entities, namely sports bodies, and sick, accident or death benefits funds.

Amateur sports bodies

4.5 A principle of income tax law states that taxpayers cannot profit from trading with themselves. This concept, known as the mutuality principle, has been extended to clubs and other associations trading with their members. In keeping with this principle, the taxable income of such bodies should not include receipts from members, such as subscriptions and donations, or income from the sale of goods to members.

4.6 The application of the mutuality principle is, however, affected by statute. Section HF 1 of the Income Tax Act 1994 abolishes this principle unless rebates are provided to the members in proportion to their dealings with the relevant bodies. It is the impression of the committee that tax practice may at times be at variance with this statutory provision.

4.7 Section CB 4(1)(h) provides a tax exemption for income derived by 'any society or association - established substantially or primarily for the purpose of promoting any amateur game or sport if that game or sport is conducted for the recreation or entertainment of the general public'. The committee is concerned that this exemption is being applied more widely than would appear to be allowed under the statute.

4.8 Considering that private sporting bodies generally provide a service that benefits only their members rather than the general public as is required under the statute, and that sporting bodies that provide sport for public entertainment are generally commercial and profitable operations, the committee questions whether the current application of this tax exemption is too wide. The committee notes that a better approach to amateur sports bodies may be to tax them on their net income, subject to the general de minimis rule in section DJ 17, which is designed to reduce compliance costs by providing that those non-profit bodies with net income below $1,000 need not file a tax return.

4.9The committee recommends that the government should review the law and the practice of granting the exemption and determine whether the practice of granting the exemption is consistent with the law, and whether the law is consistent with the policy intent. If inconsistency is found, the government should rectify the law and the practice in accordance with the policy.

4.10 In other words, if the policy is that the exemption should apply to private sports clubs, as it appears to apply in practice, the law should be redrafted appropriately. If the policy is that the exemption should apply only to organisations providing sport for the benefit of the public, as the law is drafted, the practice of granting the exemption should be applied consistently with that policy.

4.11 The committee also recommends that the threshold in section DJ 17 should be reviewed to ascertain whether this threshold is sufficiently high enough to meet its objective of reducing compliance costs.

Sick, accident or death benefit funds

4.12 The committee has concerns with another tax-exempt entity, the sick, accident or death benefit fund (SAD fund). Income derived by a SAD fund is exempt from tax under section CB 5(1)(i)81. SAD funds are defined in section CB 5(2) as funds established for the benefit of the employees of any employer, or the members of any incorporated society, and the surviving spouses and dependants of any such employees and members.

4.13 The income tax exemption for SAD funds is anomalous in terms of current tax policy. In particular, it provides concessions that are not available for other forms of savings, such as superannuation funds and bank accounts, where tax must be paid on earnings from savings. The exemption for SAD funds is also inconsistent with the treatment of insurance policies for protection against sickness, accident or death. The earnings on contributions or premiums paid on these insurance policies are taxable.

4.14 The exemption itself is surprisingly open-ended. There is, in fact, nothing requiring a SAD fund to be established for protection against sickness, accident or death. As noted above, the definition of a SAD fund simply refers to any fund established for the benefit of employees or members of an incorporated society including surviving spouses and dependants. The exemption effectively allows earnings on personal savings to be exempt from tax. An investment in a SAD fund, therefore, confers private benefits. There seems to be no public policy justification for the existing exemption of the investment earnings of a SAD fund.

4.15 The committee recommends that the income tax exemption in section CB 5(1)(i) for trustees of SAD funds should be repealed.

Business income derived by tax-exempt entities

4.16 Business income derived by charities is exempt from tax under section CB 4(1)(e). However, some charities may engage in business activities unrelated to the charitable purpose for which they are provided a tax exemption. This exemption gives charities a competitive advantage over taxpaying business competitors.

4.17 The committee recommends that the government should review the tax treatment of charities and other tax-exempt entities that engage in commercial activities unrelated to their purposes. No reason exists in principle why business income, unrelated to the core purpose, should not be taxed. An unrelated business could include the operation of a manufacturing business, but it would not include such business operations as hospitals, where the business of the charity is central to its purpose, unlike business operations used to fund other charitable activities.

4.18 Contributions, investment income, and income earned from occasional fund-raising activities, even if they are commercial activities should not be affected. The proposal should apply only to continuous and regular commercial activities that are not related to the charitable or exempt purpose of an entity.

4.19 The committee notes that the United States taxes 'unrelated business income' of exempt organisations. The government may wish to refer to the relevant United States legislation in designing rules for New Zealand.82

Compensation of employees of charities and tax-exempt organisations

4.20 The committee notes that, in certain circumstances, the compensation paid to employees of certain charities and tax-exempt organisations 83is not taxed. These instances are first, fringe benefits provided to the employees of charitable organisations, and secondly, the earnings of a superannuation scheme established for the benefit of the employees of certain charities.84

4.21 Both circumstances involve tax exemptions for the income earned by, or for the benefit of, employees rather than the tax-exempt organisation itself. Employees of tax-exempt organisations are generally taxed on their monetary remuneration, as they should be, because that is income earned by an individual rather than a charitable organisation. At present, the law exempts benefits provided by a charitable organisation to its employees from fringe benefit tax. This treatment is unjustified because these benefits are a form of compensation to the employees, and fringe benefit tax is intended to be a substitute for the income tax that would otherwise be paid by the employee, if the fringe benefit were taxable as ordinary salary and wages.

4.22 The committee recommends that the exemption from the fringe benefit tax in section CI 1(m) for benefits provided by charitable organisations to their employees should be repealed.

4.23 The committee notes that in Presbyterian Church of New Zealand Beneficiary Fund85,it was held that income earned on the superannuation scheme of employees of a charity should not be taxed because the superannuation scheme furthered the charitable purpose of the employer. The committee considers that the more important consideration in the taxation of superannuation schemes is the fact that income earned by the scheme accrues for the benefit of individual employees, which in principle should be taxable, notwithstanding the tax-exempt status of the employer. As discussed earlier, the government moved some years ago to remove the tax benefit from investment in superannuation schemes to ensure that they are not favoured over other forms of investment or compensation for the benefit of individuals.

4.24 The committee recommends that superannuation schemes for the benefit of employees should not have charitable status, and therefore, the earnings of the superannuation scheme should not be exempt from tax.

4.25 In summary, the committee recommends:

    The law and practice relating to the income tax exemption for amateur sports bodies should be reviewed.

    The threshold in section DJ 17 should be reviewed to ascertain whether this threshold is sufficiently high enough to meet its objective of reducing compliance costs.

    The income tax exemption in section CB 5(1)(i) for trustees of sick, accident and death benefit funds should be repealed.

    Charities and other tax-exempt entities that engage in commercial activities unrelated to their exempt purpose should be taxed on the net income derived from those activities.

    The exemption from fringe benefit tax in section CI 1(m) for benefits provided by charitable organisations to their employees should be repealed.

    Superannuation schemes for the benefit of employees should not be eligible for charitable status.

4.26 The committee envisages that any initiatives that the government may take would proceed through the generic tax policy process. In this way affected bodies would have the opportunity to comment.

Footnotes

81 Not being income derived from any business carried on by, or on behalf of, or for the benefit of the trustee.
82 The boundary between what income is taxable and what income remains exempt would need to be carefully drawn to provide certainty and to achieve the policy objective of the reform. In principle, the committee envisages the boundary being drawn between active business income that is unrelated to the exempt purpose of an entity and other income.
83 As defined in section OB 1 (exempt from fringe benefit tax (FBT) under section CI 1 (m)), Income Tax Act 1994
84 Presbyterian Church of New Zealand Beneficiary Fund v CIR (1994) 16 NZTC 11,185
85 (1994) 16 NZTC 11,185

Footnotes

81 Not being income derived from any business carried on by, or on behalf of, or for the benefit of the trustee.
82 The boundary between what income is taxable and what income remains exempt would need to be carefully drawn to provide certainty and to achieve the policy objective of the reform. In principle, the committee envisages the boundary being drawn between active business income that is unrelated to the exempt purpose of an entity and other income.
83 As defined in section OB 1 (exempt from fringe benefit tax (FBT) under section CI 1 (m)), Income Tax Act 1994
84 Presbyterian Church of New Zealand Beneficiary Fund v CIR (1994) 16 NZTC 11,185
85 (1994) 16 NZTC 11,185