To be or not to be a mutual association: Inland Revenue proposal to hit not-for-profits

By Phillip Claridge & Alex Mitchell
 

Unless you have been closely tracking the tax system’s off-again, on-again, relationship with the not-for-profit (NFP) sector, following Budget 2025 you would be forgiven for thinking that income tax changes are off the table for NFPs. Unfortunately, this is not the case.

While the Minister of Finance Nicola Willis has ruled out taxing charities - for now - Inland Revenue is consulting on a revised approach for NFPs that do not have a specific tax exemption. The proposed change may not be on the radar for most NFPs because it is buried in the technical analysis included in a draft Inland Revenue Operational Statement that is currently out for consultation.

If adopted, the change would result in member subscriptions (fees) that are currently exempt becoming taxable income for many NFPs. We expect this would result in new tax liabilities for many entities that are currently practically exempt from income tax.

Who will be impacted?

The changes may impact any NFP that does not have an income tax exemption. These could include clubs, advocacy groups, political parties, professional bodies/associations, trade unions, residents’ associations, body corporates for unit title developments and industry councils.

Charities and other income tax exempt organisations should not be impacted (many amateur sports clubs qualify for a specific income tax exemption so shouldn’t be impacted).

How are not-for-profits taxed now?

Setting aside income tax exempt NFPs, many NFPs are subject to income tax under a modified version of the common law ‘mutuality principle’. In a tax context, these NFPs are often referred to as ‘mutual associations’.

In simple terms, the mutuality principle is the idea that a person cannot derive taxable income from dealing with themselves. That is, you cannot derive income by selling yourself something. By extension, a group of people acting together for a common purpose also cannot derive income from transacting with themselves. 

A simple example of this is a book club. Imagine the members each contribute a small amount to cover the cost of snacks when they meet. It does not make sense to say those contributions are taxable ‘income’ of the club, nor are any residual amounts returned to members taxable to them. The book club members are simply spending their own money on themselves, and then getting the ‘change’ back.

This basic principle has been applied by the Courts to larger and more complex organisations that still retain a core element of mutuality. Under the principle of mutuality, where a group of people contribute to an activity or fund for their mutual benefit, any surplus from transactions within the circle of membership should not (in theory) be subject to income tax.

For many years New Zealand’s tax legislation has overridden most practical effects of the mutuality principle described above. In summary, under these modified rules:

1. Mutual transactions are taxed under normal principles (i.e. the mutuality principle is overridden by legislation) except for member subscriptions that are an obligation of membership and condition of maintaining membership;
2. Mutual organisations can obtain a deduction for rebates paid to members in relation to member transactions.

In a nutshell, this means:

1. ‘Member’ activities, being the receipt of subscription income and provision of related member benefits, are not subject to income tax (the mutuality principle is retained).
2. ‘Commercial’ or ‘trading’ activities of a mutual association are subject to income tax in the first instance. This can include trading with members, for example payments by members to attend conferences.

The exception for member subscriptions is important as subscriptions are a primary source of funding for most mutual NFPs.

What is changing?

Inland Revenue’s draft guidance proposes a subtle interpretive change. This is based on Australian case Coleambally Irrigation Mutual Co-operative Ltd v FCT (2004) (Coleambally), which Inland Revenue believes New Zealand Courts would follow.

Under the new approach, NFPs with constitutions or governing documents that prevent funds from being distributed to members will no longer qualify as mutual associations for income tax purposes. This is despite the fact that the funds might have otherwise been used to further the collective objectives of the members throughout the life of the organisation. This might seem like a minor point, however many NFPs have constitutions or rules that prevent assets being distributed to members in the event of a windup. Instead the assets are usually required to be passed to another NFP with similar objects or a charity.

As a consequence New Zealand’s modified mutuality rules would no longer apply to many NFPs, and subscription income would generally be taxed. This would move most NFPs from being practically exempt from income tax (because they have little or no income other than subscriptions), to being taxed on all income under normal tax rules. The draft guidance indicates Inland Revenue would only enforce the new approach prospectively.

For many NFPs, this proposal will come as a surprise, particularly because it upends over 50 years of established practice and turns on an Australian tax case decided 20 years ago. At the time the Coleambally decision was a surprise, and differed to the Australian Tax Office’s own guidance on the matter. Given the disruption it would have caused, the Australian Parliament passed legislation shortly afterwards retrospectively reversing the decision. If Inland Revenue does not change the interpretative position currently proposed, serious consideration should be given to adopting a similar approach here. 

What should NFPs do?

NFPs need to understand how they may be impacted by the proposed change. If you have any questions on the what the change could mean for your NFP or are considering making a submission, please contact your usual Deloitte advisor. Inland Revenue is accepting submissions on the draft guidance at until 25 June 2025.