Traditionally, entities cannot be tax exempt unless they are operated principally in Australia, are prescribed as exempt in the Income Tax Assessment Act 1997 (‘ITAA’) or are a deductible gift recipient (‘DGR’).
The introduction of this Tax Laws Amendment (Special Conditions for Not-for-profit Concessions) Bill 2012 (‘Bill’) into Parliament, follows the Commonwealth Government announcement in its 2009-10 Budget that it would amend the ‘in Australia’ special conditions under Division 50 of the ITAA to ensure that Parliament retains the ability to fully scrutinise those organisations seeking to pass money to overseas charities and other entities.
Outline of the Bill
The main purpose of the Bill is to restate and standardise the special conditions for tax concession entities.
It attempts to achieve this purpose as follows:-
- Re-stating the ‘in Australia’ special conditions for income tax exempt entities
- Standardising the other special conditions entities must meet to be tax exempt
- Standardising the term ‘not-for-profit’ (‘NFP’), replacing the defined and undefined uses of ‘non-profit’ throughout the tax laws.
- Codifying the ‘in Australia’ special conditions for DGRs
Intention behind the current legislation
Fundamentally, the legislation aims to ensure the proper operation of NFP entities and their use of public donations and funds.
The ‘in Australia’ special conditions were introduced with the purpose of addressing tax avoidance arrangements which could use charitable trusts and other NFP organisations to shift untaxed funds overseas. These conditions also operate to minimise the risk of tax exempt entities financing terrorist organisations and engaging in money laundering.
Consequently, charities were only able to pass funds to an overseas charity that was endorsed as DGR, or an entity specifically prescribed into the regulations.
Flaws in the interpretation and application of the current legislation
There has been considerable concern as to whether the current laws are achieving the objectives of ‘in Australia’.
The High Court of Australia’s (‘HCA’) decision in Federal Commissioner of Taxation of the Commonwealth of Australia v Word Investments Limited (2008) 236 CLR 204 (‘Word Investments’) highlighted that the current legislation was failing to meet its original objectives. In that case, the HCA found that charities were considered to be pursuing objects ‘principally in Australia’ if they merely operate to pass funds within Australia to another charity that conducts its activities overseas.
This failed to encompass the Commissioner of Taxation’s (‘Commissioner’) interpretation of the special conditions, which required that the entity must, firstly, have a physical presence in Australia, and secondly, (to the extent it has a physical presence in Australia) must incur its expenditure and pursue its objectives principally in Australia.
Rationale behind the amendments
The amendments aim to ensure that any tax concessional money stays within the exempt entity framework and gets used principally in Australia for the broad benefit of Australians, instead of being passed on through entities and spent overseas (with the exception of the authorised categories).
How has the law been changed?
The new law reverses the effect of the decision in Word Investments.
Under the new amendments, DGRs will be subject to a stricter threshold when applying the ‘in Australia’ test.
The new legislation also complies with the Financial Action Task Force (FATF) recommendations to combat the misuse of NFP organisations for the purpose of terrorist financing.
Meaning of ‘principally in Australia’
The replacement of ‘expenditure’ test with an ‘operates’ and ‘pursues its purposes’ based test highlights that a wide range of circumstances will now be considered when determining whether an entity is ‘principally in Australia’. This is supported by the examples provided in the Explanatory Memorandum to the Bill. It is no longer the case that the destination of an entity’s expenditure is a primarily determinative indicator as to whether an entity satisfies this special condition.
The courts must now conduct a balancing test when considering all the surrounding circumstances, and in doing so, there are certain distributions that can be disregarded (s 50-50(5)) and others which must be taken into account (s 50-50(4)).
Factors for consideration include:
- What assets the organisation has in Australia
- What employees the organisation has in Australia
- If an organisation conducts activities offshore, whether such activities are in the pursuit of the purposes in Australia
To be operating principally in Australia, an entity will be expected to be an Australian resident or have a sufficient connection and presence in Australia. Generally the test for residency of a non-individual entity is the location of the entity’s central management and control.
A branch will not satisfy the ‘in Australia’ test, as it is not set up as a separate legal entity. However, if the entity is established or incorporated in Australia to undertake the branch’s activities, it would satisfy the test.
Where an entity provides money or property to other entities that are not entitled to become income tax exempt, the use of those funds by those other entities should be taken into account when determining whether or not the entity giving the money has met the ‘in Australia’ special conditions. If the latter entity is a tax exempt entity, this requirement need not be satisfied. This is to ensure that an entity cannot avoid taking account of the relevant circumstances by having another entity conduct activities that the primary entity cannot do itself.
Moreover, for a charity to make a gift, it would need to ensure that the entity receiving the donation had similar or identical purpose – otherwise the entity making the donation could no longer itself be considered tax exempt. ‘Similar purposes’ would include a charity giving to another charity, regardless of their individual charitable purposes. This test does not prevent a charity from utilising a different NFP as a means to carry out or give effect to its charitable purpose.
Exceptions to the ‘in Australia’ special conditions are provided for in s 995-1(1) and s 50-51.
Determining the ‘purpose’ of an entity
Registered entities must apply their income and assets solely for the purpose for which they are established.
When determining the purpose of an entity:
- Look to the stated purpose and objectives
- For established entities, look to the actual activities of the entity to see if there are inconsistencies with the purpose or objectives
It is imperative that an entity operates in a manner consistent with the substantive governing rules and purposes to remain eligible for a tax exemption. Merely having these rules will only determine its initial eligibility.
Breaches of procedural irregularities will not affect an entity’s continued entitlement.
Classifying an entity as NFP
The term ‘not-for-profit’ replaced ‘non-profit’ within the provisions of this Act.
In order to be classified as an NFP, an entity must satisfy the requirements set out under s 995-1(1).
A NFP entity’s constituent or governing documents or the operation of law prevent it from distributing profits or assets for the benefit of particular people. Any surplus made by an entity must be directed towards carrying out the entity’s purposes. That said, an NFP entity can distribute surpluses and assets to other NFP entities if the purpose of those entities is similar and the distribution is intended to help the NFP achieve its purpose. Distributions may also be made for genuine compensation for services provided to, or reasonable expenses incurred on behalf of the entity.
Government entities, such as public education institutions and public hospitals, as well as organisations such as trade unions and employee associations, tend to be tax exempt and subject to other special conditions despite not being NFP.
Under s 50-51(2)(c) and (d), overseas entities, or entities which are resident in Australia but operate and pursue their objectives principally outside Australia, which do not meet the ‘in Australia’ special conditions, but do meet other conditions to become tax exempt, may be prescribed in the regulations as income tax exempt entities in special circumstances. The decision is up to the discretion of the Governor-General in Council.
For foreign entities, this is subject to whether the entity is exempt from foreign income tax in the country in which it is a resident.
The Governor-General also has the discretion to set conditions on the exemption in order to ensure that it is not misused.
Deductible Gift Recipients (DGRs)
DGR includes both entities that are themselves deductible gift recipients and entities that are deductible gift recipients because they operate a public fund.
As mentioned above, DGRs will be subject to a stricter threshold when applying the ‘in Australia’ special condition. Instead of being ‘principally’ in Australia, DRGs are required to be ‘solely in Australia’ in order to receive a tax exemption (s 30-18(1)). That said, the majority membership of an Australian subsidiary by an overseas entity will not of itself contravene the ‘in Australia’ requirement.
A DGR does not fail to satisfy the above threshold if the overseas activities it conducts are merely incidental to the operations and pursuit of the entity’s purposes in Australia, or the overseas activities are minor in extent and importance when considered with reference to the operations and pursuit of the entity’s Australian activities (s 30-18(2)).
Entities that are DGRs under the category of ‘international affairs’ are exempt from the DGR ‘in Australia’ special conditions (s 30-18(5)). These DGR recipients include entities such as, overseas aid funds and developed country relief funds. The provision recognises that although some organisations are not operating in Australia, it is considered that they nonetheless further Australia’s overseas aid objectives and therefore contribute to Australia’s broad public benefit.
Entities on the Register of Environmental Organisations are also DGRs which are exempt from the ‘in Australia’ special conditions (s 30-18(7)). The Secretary to the Environment Department must make his or her decision about granting an exemption based on the requirements detailed in the regulations (s 30-19(1)).
If an organisation subject to the ‘in Australia’ special conditions operates a fund, authority or institution that is covered by the other two categories (i.e. international affairs or Environmental Organisation), the organisation need only consider its operations, ignoring the approved overseas component, when assessing the entity against the special conditions (s 30-18(6)).
If a DGR gives its money to another entity to further its purposes, it must also look to the final use of their money, property or benefits when considering whether it meets the ‘in Australia’ special conditions.
A fund, authority or institution established and maintained solely for the purpose of providing money for scholarships, bursaries or prizes to which s 30-37 of the ITAA 1997 applies, need only be established in Australia, and does not need to operate solely in Australia or pursue its purposes solely in Australia. Note however, that these scholarships, bursaries or prizes can only be awarded to Australian citizens or permanent residents for pre-approved courses.
Certain medical research institutions (as listed in the Bill) will be required to be established in Australia, but will be exempt from the remainder of the ‘in Australia’ special conditions on the basis that medical research is an international collaboration activity.