Deregistration of charities
An officials’ issues paper, Clarifying the tax consequences for deregistered charities, was released in July 2013. The paper discussed problems with the current tax treatment of deregistered charities, and suggested a possible solution for clarifying the tax consequences for these entities by prescribing in legislation rules to deal with their new tax-paying status.
A “deregistered charity” refers to an entity that has been removed from the Charities Register by the Department of Internal Affairs – Charities Services (formerly the Charities Commission).
In general, an entity must be registered with the Charities Services in order to qualify for the income tax exemption for charities in sections CW 41 and 42 of the Income Tax Act 2007. Registered charities are also entitled to an exemption from fringe benefit tax, and are treated as “donee organisations”, which means that donors are entitled to some form of tax relief on donations made to these entities.
Recent high-profile cases involving deregistered charities, particularly when the entity continues in existence, have shown that these entities can face a range of complex tax consequences that can be retrospective, transitional and prospective in nature. These consequences give rise to questions such as when the entity should start its life as a tax-paying entity; how the entity should treat its depreciable property or financial arrangements when it becomes a tax-paying entity, and what tax provisions should apply to the entity going forward.
Currently, the nature and extent of the potential tax consequences ultimately depend on the underlying reason why the entity was deregistered. These consequences may be more onerous (and may involve retrospective tax liabilities) if the deregistered charity is found never to have had a “charitable purpose” or to have ceased being charitable in purpose at some time in the past, compared with the situation when a deregistered charity has simply failed to file the required annual return with Charities Services.
Consultation on the officials’ issues paper confirmed that the current tax law as it relates to deregistered charities is neither comprehensive nor robust – that is, it does not adequately deal with the full range of tax consequences involving deregistered charities and, in some cases, does not achieve the desired policy intentions.
Two major policy changes arose from consultation which led to the suggested solution in the issues paper being modified.
- The first change extinguishes any retrospective tax costs for deregistered charities (and their donors) that have acted in good faith and have been compliant.
- The second change imposes an additional tax cost on deregistered charities that have not divested themselves of their assets or income that they had accumulated as a charity, within 12 months of the deregistration date.
The new legislative rules proposed in the bill will:
- clarify how the general tax rules (including the income tax, fringe benefit tax and donations tax relief regimes) apply to deregistered charities;
- establish the opening values of assets or consideration for any financial arrangements held by a deregistered charity when it becomes a tax-paying entity;
- prescribe specific timing rules for the application of the taxing provisions; and
- outline new requirements for the treatment of the accumulated assets of deregistered charities.
The new rules are aimed at clarifying the tax law so that deregistered charities and their donors have a greater level of certainty as to their tax obligations, and to protect the integrity of the revenue base by ensuring the tax concessions that apply to charities are well-targeted and policy intentions are met. This includes, for example, ensuring that if an entity has claimed tax exemptions as a charity and has accumulated assets and income, these assets and income should always be destined for a charitable purpose.
For the majority of deregistered charities that have in good faith tried to meet their registration requirements, the proposed new rules should provide them with greater certainty about their tax obligations after deregistration. On the other hand, the very small minority of deregistered charities that have wilfully refused to meet their registration requirements could still face onerous tax consequences (including retrospective tax liabilities) under the new proposed rules.
The amendments will generally apply from 14 April 2014. There is one exception to this, which relates to the new requirement for accumulated assets of deregistered charities, for which there is a split application date. This rule will apply from:
- 14 April 2014 for entities which choose to voluntarily deregister; and
- 1 April 2015 for entities which are deregistered by Charities Services.
CLARIFYING HOW THE GENERAL TAX RULES APPLY TO DEREGISTERED CHARITIES
(Clauses 104 and 107)
Summary of proposed amendments
Clause 107 introduces new section HR 11 of the Income Tax Act 2007 which clarifies how a deregistered charity should establish its initial tax base – such as the opening values of its assets and consideration for its financial arrangements.
Clause 104 removes charitable trusts which lose their charitable status from the operation of section HC 31 of the Income Tax Act 2007.
All charities which are removed from the Charities Register from 14 April 2014 will have greater certainty about their income tax obligations when they enter the tax system.
New section HR 11 sets out how an entity which has ceased to meet the requirements to derive exempt income under sections CW 41 or CW 42 should:
- establish the cost base for its property – specifically premises, plant, equipment and trading stock;
- establish the consideration for any financial arrangements; and
- value prepayments it has made.
These tax base calculations are required to be undertaken on and after the date that a deregistered charity ceases to derive exempt income.
Section HC 31 has been consequentially amended so that it no longer applies to a charitable trust that has lost its charitable status. Instead, new section HR 11 will set out the initial tax base for all charities which come into the tax base.
Currently, section HC 31 of the Income Tax Act 2007 provides for the tax consequences for trusts that enter the tax base, but not corporate entities. Section HC 31 is further limited because it does not cover all assets that may be held by a deregistered charity – for example, prepayments.
New section HR 11 applies on and after the day that a deregistered charity ceases to meet the requirements to derive exempt income under section CW 41 or section CW 42. This point in time is referred to as the “date of cessation”. The date of cessation is used to trigger the tax base calculations in the year the entity becomes a tax-paying entity but may also apply for each subsequent income year that the deregistered charity ceases to meet the requirements to derive exempt income under sections CW 41 or CW 42.
The following examples illustrate how and when the tax base calculations are to be undertaken.
Example: Depreciable property
Charity A was registered as a charitable entity in 2008. That same year, Charity A purchased office furniture for $50,000 (GST exclusive) during the first month of the 2008 tax year. In 2013, Charity A was deregistered because it was found by Charities Services to have been non-compliant with its constitution since it was registered. Charity A still owns the office furniture at the date of deregistration. The depreciation rate for office furniture is 19.2%.
Charity A must file an income tax return for each year starting from the 2008 year.
Under new section HR 11(2) the cost of premises, plant, equipment, and trading stock is the value that would be used at the “date of cessation” under the general tax rules if section CW 41 or section CW 42 never applied. Under the general tax rules, office furniture must be depreciated each year it is used in the business of Charity A. Therefore, the cost of office furniture for each year from 2008 to the present day is as follows:
|Opening value ($)||50,000||40,400||32,643||26,376||21,312||17,220|
|Year-end balance ($)||40,400||32,643||26,376||21,312||17,220||13,914|
Charity A will introduce the asset into the tax base at $50,000 and recognise a depreciation charge of $9,600 in its 2008 income tax return.
Example: Financial arrangement
Assuming the deregistration facts as above, Charity A had loaned $100,000 to person X in 2008. The loan was repayable on demand and interest was 10% per annum compounding. No loan repayments were made.
Under new section HR 11(3), Charity A is required to account for this loan under the financial arrangement rules in each of the years that it had ceased to meet the requirements of sections CW 41 or CW 42. It must also calculate an opening value using the formula in new section HR 11(4). The calculations are as follows:
|Opening value ($)||100,000||110,000||121,000||133,100||146,410||161,051|
|Year-end balance ($)||110,000||121,000||133,100||146,410||161,051||177,156|
In 2008 the opening value would be $100,000 and the closing value would be $110,000. Charity A would account for $10,000 accrued interest income in its 2008 income tax return.
FROM WHICH POINT WILL A DEREGISTERED CHARITY BE SUBJECT TO TAXING PROVISIONS
(Clauses 27 and 123(8))
Summary of proposed amendments
Clause 27 amends section CW 41 of the Income Tax Act 2007.
Clause 123(8) inserts a new definition of “final date of decision” in section YA of the Income Tax Act 2007.
The amendments to section CW 41 ensure that entities which are removed from the charities register will continue to be tax-exempt until the date of “final decision”, so long as they have acted in accordance with their constitution or other information supplied to the Charities Services, since registration.
The amendments should help to ensure that a large majority of deregistered charities do not face retrospective tax consequences.
The amendments to section CW 41 provide that:
- income derived by a deregistered charity in a specified period is treated as exempt income; and
- a deregistered charity is a “tax charity” (as defined in section CW 41 (5)) for the specified period.
The specified period in question starts from the date the entity is registered on the charities register, and ends with the earlier of two dates. These dates are:
- the day on which the entity fails to act in accordance with its constitution, or other information supplied to Charities Services at the time of applying for charitable status; or
- the day of final decision.
A new definition of “day of final decision” is included in section YA 1. It is the later of two dates, namely:
- the day the entity is removed from the charities register; or
- the day on which that entity exhausts all disputes and appeals its charitable status.
Under current law, tax consequences on deregistration may be quite onerous and may involve retrospective tax liabilities if a deregistered charity is found never to have had a “charitable purpose” or ceased being charitable in purpose at some time in the past. In some cases, however, these entities will have been acting in accordance with their constitutions, but there may simply have been a slight change in jurisprudential interpretation of what is “charitable” and what is not.
The amendments to section CW 41 should afford entities a greater level of certainty that, for tax purposes, they should be able to rely on the decision made by Charities Services to recognise that entity as charitable in purpose. This protection, however, only applies when the deregistered charity has acted in accordance with all the information and evidence that Charities Services used to make its registration decision. If an entity has ceased to act in accordance with the evidence or information provided to Charities Services, then that entity should not be able to take advantage of the decision to register it.
Therefore, entities that have continued to be compliant with their constitutions and other supporting information provided at the time of registration will not be liable for tax in periods before they were deregistered, and if they dispute their deregistration, not before the date their dispute is finally decided.
As under current law, a small number of entities could face a retrospective tax liability when they are deregistered.
REQUIREMENTS FOR DEREGISTERED CHARITIES WITH ACCUMULATED ASSETS
(Clauses 19 and 108)
Summary of proposed amendments
Clause 108 inserts new section HR 12, which is intended to encourage deregistered charities to distribute their accumulated assets and income to charitable purposes within 12 months of being deregistered. If the entity chooses to retain the assets and income it has accumulated, it will be required to include the value of its net assets on hand as an amount of income which will be subject to tax.
Clause 19 inserts new section CV 17, which sets out that any amount of income arising under new section HR 12 will be considered as income of the entity in the income year after the income year in which the entity is deregistered.
New sections CV 17 and HR 12 provide that an entity has an amount of income equal to the greater of zero or the value of its net assets held at the time that is 12 months after the date of deregistration, subject to some adjustments.
These adjustments carve out certain assets, which reduce the net assets balance that will be subject to tax. The items carved out are:
- any assets distributed to charitable purposes in the 12 months after the entity is deregistered; and
- any assets (not including money) gifted or left to the entity while it was deriving exempt income.
New section HR 12 has a split application date. It generally applies from 1 April 2015, but applies from 14 April 2014 for charities that choose to voluntarily deregister.
Current tax law (legislation and case law) supports the ability of charities to accumulate their income for future use, and no symmetry is required between the income tax exemption and the payments towards charitable purposes, either in amount or timing. Although there is a requirement for deregistered charities which cease to operate to distribute their assets and income to charitable purposes, there is no such requirement when deregistered charities continue to operate.
The Government believes that the assets and income of a charitable entity with tax-exempt status should always be destined for a charitable destination, irrespective of whether the entity ceases to exist or not. However, if a deregistered charity continues in existence, the Government considers that the value of the deregistered charity’s net assets (assets minus liabilities) should be subject to income tax. The imposition of tax in this instance is consistent with the current policy intentions underlying the charities-related tax concessions. In other words, the tax concessions should only be available to bona fide charities and deregistered charities should be held to account for the assets and income they have built up while they enjoyed the benefit of the tax concessions.
For reasons of fairness, however, deregistered charities should be given time to apply any assets or income to charitable purposes before the imposition of any tax, and an adjustment should be permitted for any donated assets as these assets were not funded by non-taxed income or through a tax-preferred source.
Example: Taxation of tax-exempt accumulation
Charity A’s date of deregistration is 1 June 2013. The balance sheet for Charity A at 1 June 2013 is shown below.
|Land (donated)||$3,000||Shareholders’ equity||$3,150|
The net asset calculation will be $3,150; less the value of the donated land; less any assets and income distributed for charitable purposes within 12 months of the date of deregistration. The net assets value will be $150 ($3,150 less $3,000). Assume Charity A has a July balance date for tax purposes. Charity A would include $150 as income in its 2014 income tax return.
CONSEQUENCES OF DEREGISTRATION ON ELIGIBILITY TO BE A CHARITABLE ORGANISATION
Summary of proposed amendments
Clause 123(6) amends the definition of “charitable organisation” in section YA 1. It widens the definition of “charitable organisation” to include an entity which has been removed from the charities register, so long as it has acted in accordance with its constitution and other supporting information provided at the time of registration.
This amendment clarifies the FBT treatment for deregistered charities and largely mirrors the amendment to section CW 41 in clause 27 discussed earlier.
The definition of “charitable organisation” in section YA 1 is being amended to ensure that a deregistered entity can still be a charitable organisation for a specified period.
The period in question starts from the date the entity is registered on the charities register, and ends with the earlier of two dates. These dates are:
- the last day of the relevant quarter or income year in which the entity fails to act in accordance with its constitution, or other information supplied at the time of registration; or
- the last day of the relevant quarter or income year in which the final decision on the entity’s charitable status is made.
Despite being deregistered, an entity might still qualify to be a “charitable organisation”, if it is not carried on for the private pecuniary profit of an individual, and applies its funds wholly or mainly to charitable, benevolent, philanthropic or cultural purposes within New Zealand, or is listed in schedule 32 of the Income Tax Act 2007.
If a deregistered charity is no longer eligible for the FBT exemption, the FBT rules will apply to that entity in the same way as for income tax purposes. This means that deregistered charities that have complied with their constitution will lose their FBT exemption from the date of the final decision about their charitable status, and non-compliant entities from the date of non-compliance.
CONSEQUENCES OF DEREGISTRATION ON ELIGIBILITY TO BE A DONEE ORGANISATION
Summary of proposed amendments
Clause 110 amends section LD 3(2) of the Income Tax Act 2007 to confer donee status on an entity registered on the register of charitable entities under the Charities Act 2005. The amendment would ensure donors have a greater level of certainty that their donations tax relief will not ordinarily be reversed in circumstances when they have made a bona fide monetary gift and the entity they have donated to is later deregistered.
New section LD 3(2)(ab) ensures that monetary gifts that meet the requirements of a “charitable or other public benefit gift” in section LD 3(1) made to registered charities can still qualify for donations tax relief even if that entity is later deregistered.
A deregistered charity may still qualify for donee organisation status if it meets the other donee organisation requirements. If, however, the entity no longer qualifies for donee organisation status, donors will no longer be entitled to tax relief on their donations. Under current law, this will happen at the point at which the entity no longer satisfies any of the requirements to be a donee organisation. This could be in the past, which would give rise to retrospective consequences for donors.
Under current law, donors who have made cash donations to an entity after the point at which it no longer qualifies to be a donee organisation are technically not eligible for donations tax relief. In the case of individuals, this relief is in the form of a tax credit; in the case of corporate or Māori authority donors, in the form of a tax deduction. Inland Revenue has the ability to reverse previous tax relief claims that have been claimed incorrectly.
The Government accepts that Inland Revenue should be able to reverse tax relief in certain circumstances, but this power should not be used as a matter of course. In particular, this power should only be available in circumstances when a donor had knowledge at the time of claiming the relief that the entity did not satisfy any of the requirements to be a donee organisation, or when the donor was involved in fraud in relation to the donation and the donee organisation, or when the requirements substantiating that a bona fide monetary gift has been made are not met under general law.
The amendment should protect donors who have claimed donations tax relief in good faith, assuming that an organisation was a donee organisation.
6 A donee organisation is an organisation that is not carried on for the private pecuniary profit of an individual, and whose funds are applied wholly or mainly to charitable, benevolent, philanthropic or cultural purposes within New Zealand. The Income Tax Act 2007 also lists 108 donee organisations whose charitable purposes are largely carried out overseas.