Clarifying the tax consequences for deregistered charities
Inland Revenue released an officials’ issues paper “Clarifying the tax consequences for deregistered charities” on 18 July 2013. This paper discusses the problems with the current tax treatment of deregistered charities and considers possible solutions for clarifying the tax consequences of deregistration for these entities.
On 1 February 2007, the Charities Act 2005 introduced a system for registering charities. Registration under the Charities Act is voluntary and non-registration does not mean an entity is not charitable in purpose. However, from 1 July 2008 registration as a charity became an additional requirement for a charity to rely on the charitable exemptions from income tax in the Income Tax Act 2007. Before that date, a charity may have received confirmation from Inland Revenue that it was entitled to the charitable income tax exemptions or may have self-assessed its eligibility for those exemptions.
Registration under the Charities Act 2005 is not necessarily a permanent status. Charities Services or its predecessor, the Charities Commission, has deregistered over 3,900 charities since the Charities Register opened for registrations. The vast majority of these charities were deregistered for failing to file an annual return (2,489). Voluntary deregistration accounts for most of the remaining deregistered charities (1,375). However, charities were also deregistered due to having a non-charitable purpose (34), failing to produce evidence of a charitable purpose (7), failing to meet registration requirements (4), and due to serious wrongdoing (3).
Deregistration from the Charities Register means that an entity is no longer entitled to the charitable income tax exemptions in the Income Tax Act 2007. Following deregistration an entity will become subject to the general tax rules that apply to an entity of its legal form and undertaking its activities.
An issue that arises on deregistration is when the change from tax-exempt entity to tax-paying entity occurs. When an entity transitions from tax-exempt entity to tax-paying entity will depend on the reason for deregistration.
When deregistration is due to an entity failing to file an annual return or voluntarily deregistering, the entity will become subject to income tax from the effective date of deregistration. Generally, this will mean that tax provisions will have prospective application to the entity. Activities undertaken before deregistration will generally remain tax exempt and only activities arising after deregistration will give rise to income tax obligations. This is a reasonably fair outcome as income tax obligations are all prospective. However, the entity may find that as its activities were structured in the context of it being tax-exempt, that the manner in which it conducts those activities are not optimal for a tax-paying entity. A deregistered charity could find itself on the wrong side of the tax avoidance rules if it sort to restructure itself to take account of effect of income tax on its activities.
When deregistration results from a finding that the entity lacks a charitable purpose, the income tax provisions will have retrospective application, potentially back to the date that the entity was established. This is because to be eligible for the income tax exemptions for charities, an entity must be both a registered charity and have a charitable purpose. A finding that an entity lacks a charitable purpose means it was never entitled to the tax exemptions for charities despite being initially a registered charity. This retrospective application of taxing provisions to an entity that may have been in existence for several years and considered itself to be tax-exempt due to being a registered charity will likely have a serious financial impact on the entity. As well as having tax liabilities for its previous activities for which it will not have provided, it may also have significant use of money interest exposures on those liabilities. In these circumstances, Officials are proposing that where an entity had received confirmation from Inland Revenue of its charitable status before 1 July 2008 the tax provisions would only apply from that date.
Another group of entities are those that came in to existence after 1 February 2007, and therefore, never received Inland Revenue confirmation of their charitable status, but were initially registered as a charity only to be subsequently deregistered for a lack of charitable purpose. These entities are potentially subject to tax back to their date of formation. Officials acknowledge that reasons of equity and consistency suggest that where an entity has acted in good faith and complied with all registration requirements that liability for income tax should only commence on the date of deregistration. However, Officials are also concerned with protecting the revenue base and the integrity of the charities registration process and seek submissions on when tax provisions should apply in these circumstances. It would seem that where an entity has acted in good faith and fulfilled all its obligations under the Charities Act 2005 that its liability for income tax should only arise on deregistration. At some stage Charities Services has considered it charitable and the entity has done all that is required of it in terms of the Charities Act 2005 and the Income Tax Act 2007 to obtain tax-exempt status to the best of its knowledge. It seems unduly onerous for such an entity to incur retrospective tax liabilities due to someone else’s error.
Once the date that an entity becomes subject to tax is established, it is then necessary to deal with the consequences of the transition from tax-exempt entity to tax-paying entity. This raises issues such as determining the opening value of depreciable property, the consideration for financial arrangements, and how distributions of income accumulated when the entity was tax-exempt are to be treated. The Income Tax Act already has provisions that deal with a charitable trust that ceases to be a charitable, and a trust or company that elects to become a Maori Authority. Generally, these provisions provide that the cost of depreciable property and trading stock on the date of the change in tax status is the value it would have had had the trustee always been subject to income tax. Officials are proposing that these rules be further developed and expanded to deal with deregistered charities in general and are seeking submissions on how this should be done.
One area of concern for Officials is that a deregistered charity can apply its assets (including accumulated income) towards non-charitable purposes without giving rise to a taxable event. Some countries have dealt with this issue by requiring deregistered charities to apply their accumulated “charitable income and assets” to charitable purposes or be subject to income tax on them, or require the deregistered charity to transfer the assets to another charity. Officials are seeking submissions on how accumulated income and assets of a deregistered charity should be treated.
Identifying a deregistered charity’s income tax liabilities from its historical activities can be a drawn out and complex process. A deregistered charity’s activities will not often conform to normal commercial activities and it will have structured itself and its transactions without regard to the tax outcomes. Issues can arise whether its business-like activities were a business as the entity may have lacked a profit motive in conducting them. This can be a two-edged sword as in some circumstances a deregistered entity may wish to argue that its activities amount to a business to assist with the claiming of deductions for its expenditure. However, in other circumstances it may be beneficial to assert there is no business; for example, where an entity’s “income” would be a non-taxable capital receipt in the absence of a business or where the finding of a business of dealing or developing land would result in the tainting of other land holdings. It can also be problematic determining whether grants and other payments made to the entity should be characterised as taxable income. Further issues can arise due to provisions in the Income Tax Act dealing with government and local body grants applying once the entity becomes a tax-paying entity and having tax consequences that were not anticipated when the entity received and spent those grants. A particular issue arises with suspensory loans made to the entity when it was tax-exempt that later convert to a grant after the entity is deregistered resulting in debt remission income for the entity that was not foreseen when the loan was made. It would have been useful if the paper had considered some of these issues, in particular those relating to grants and suspensory loans.
Officials are proposing that any legislative changes take effect from the 2014-15 income year, which means that any new rules will not apply to the 3,900 existing deregistered charities. Given the large number of deregistered charities and Officials expectation that the number of charities deregistered going forward will be much smaller due to Charities Services changing its deregistration policy around non-filing of annual returns, it would appear that the problems identified are largely historical. This suggests retrospective application of at least some of the changes may be appropriate. The consequences of a charity being deregistered should have been addressed at the time that the registration requirement for tax-exempt status was introduced.
There is a potential flow on effect of a charity being deregistered for those who have donated cash to the entity and claimed tax relief for that donation through claiming either a tax credit or a deduction. Deregistration of an entity does not necessarily mean that it loses its donee organisation status as this status is not dependent on being a registered charity. A deregistered charity may retain donee status due to having benevolent, cultural or philanthropic purposes. If the deregistered charity is not eligible for donee organisation status, the donors to that entity were not entitled to the tax relief claimed for their donations to it. Under current tax law, Inland Revenue can reverse previously claimed tax relief for those donations. In deciding whether to reverse tax relief for donations Inland Revenue takes into account a number of factors, including the circumstances of the entity’s deregistration, the donor’s knowledge of those circumstances, Inland Revenue resource constraints, and the impact on compliance and the integrity of the tax system. Officials are not proposing any change to this process, but are seeking submissions on specific circumstances where reversal of donations tax relief is appropriate.
Submissions close on 23 August 2013. For more information, contact your usual Deloitte tax advisor.
Tax Alert August 2013 contents:
- Tax Alert - August 2013
- Clarity, controversy, or both: Inland Revenue’s finalised guidance on tax avoidance
- Succession and divestment
- Clarifying the tax consequences for deregistered charities
- Research and development expenditure: Deja vu?
- Bloodstock investors finish down the track
- A necessary review of allowances
- Deloitte announces new tax partner