Taxation

This page covers the basic taxation requirements and issues facing New Zealand philanthropists and grantmakers.

Current state of play

Philanthropy New Zealand takes an active interest in the tax environment within which philanthropic and grantmaking organisations have to operate. We keep members informed of any significant changes proposed to that environment, and act as advocate on behalf of members when relevant issues require us.

At the present time, any philanthropic and grantmaking organisation not incorporated by Act of Parliament or operating as an incorporated body (i.e. as a company or a society), has a relatively unregulated environment both in terms of its governance structure, and its ability to manage its affairs.

Charitable trusts in particular have virtually no constraints upon their activity, having no registration or annual filing requirements, and frequently no nominated beneficiaries to hold the trustees to account. Where an organisation carries on its activities through a company or incorporated society structure, once the routine compliance requirements of the establishing statute are met, there is no effective public oversight of the charitable activity.

While there is a one-off requirement to demonstrate charitable purpose if an organisation is seeking exemption from income tax, even the Inland Revenue Department has no process for ensuring such purposes are maintained over time.

However, this is all about to change.

Charities Commission

The Charities Commission became a reality on 1 July 2005. It is a government body that will administer a new framework of registering, reporting and monitoring of "charitable entities".

A charitable entity is any society, institution and trust that is established and maintained for charitable purposes, and is not carried on for the private pecuniary profit of any individual. The charitable purposes test is the same as set out in current income tax legislation, namely:

• the relief of poverty
• the advancement of education
• the advancement of religion
• any other matter beneficial to the community.

The Commission is required to determine that the objectives of any organisation applying for registration meet the charitable purposes test, and through the medium of an annual return will monitor the organisation's continued adherence to that test.

Financial information will also need to be filed, and the form and content of that information is currently being considered by the Ministry of Economic Development as part of their wider review of financial reporting standards.

Registration will be voluntary, but will be a precondition for tax exempt status. There will be no "grandfathering" of tax exempt status, and all organisations currently qualifying for the charitable exemption in the Income Tax Act will need to register with the Charities Commission to retain that status.

Visit the Charities commission for more information.

Taxation

For many members, the decision whether or not to register with the proposed Charities Commission will be greatly influenced by their tax status.

Tax has an impact upon philanthropic and grantmaking organisations in two ways. First, an organisation may be exempt from paying income tax on its income by virtue of being established for charitable purposes. Second, an organisation may qualify for approved donee status, which entitles the maker of any donations to the organisation to obtain tax relief, either by way of rebate or deduction.

Tax exemption

Regardless of its objectives, a philanthropic and grantmaking organisation always commences as a person for tax purposes and is generally subject to the same taxation rules and requirements as other persons.

However, the income an organisation earns may be exempt from income tax, either under section CB 4(1)(c) or (e) of the Income Tax Act 1994, or alternatively, under the rewritten equivalent, section CW 34(1) and 35 of the Income Tax Act 2004.

Income qualifying for this exemption is any amount derived in trust for charitable purposes or derived by any society or institution established and maintained exclusively for charitable purposes, and not carried on for the pecuniary profit of any individual. In the case of business income, this can only be applied for charitable purposes in New Zealand.

To meet the charitable purposes test, the organisation's objectives must contain one or more of the charitable purposes set out above. In addition, wide public benefit or good from the trust's activities is necessary. An organisation established solely to benefit a discrete membership (such as engineers) and not the wider public is therefore unlikely to be accepted by the IRD as charitable.

All philanthropic and grantmaking organisations would normally be expected to qualify as charitable, but their position still needs to be reviewed on a case-by-case basis. For example, grants made to sporting organisations may taint an organisation as not being "exclusively for charitable purposes" since the advancement of sport is not a charitable purpose.

Accordingly, current practice is for the organisation to apply to the Inland Revenue Department (IRD) for positive confirmation that it qualifies for exemption. The IRD will review the organisation's rules or constitution for evidence that the objectives include charitable purposes. In addition, they will always require that the rules of the organisation:

• prohibit individuals associated with the organisation from obtaining any personal benefit from the organisation
• restrict distributing surplus assets in the event of winding up
• cannot be changed to allow funds to be applied in other ways.

If satisfied, the IRD will issue a letter confirming the application of the Income Tax Act. While not a legal requirement, it is good practice for organisations to obtain this written confirmation, because:

• It will provide certainty for both the organisation and the IRD, and avoid costly arguments should the IRD challenge an unconfirmed charitable status at a later date.
• It will hasten the process of obtaining an exemption certificate from resident withholding tax if the IRD have already ruled on the matter.
• It may be an audit requirement of the organisation to have tax exempt status confirmed.

Application to trusts

Charitable trusts are a structure favoured by many philanthropic and grantmaking organisations. As a general rule, exemption from income tax only applies to income earned by a trust which is not distributed by way of grants or donations in the year it is earned or within six months of year-end. Such income is taxed (or in this case, is tax exempt) in the hands of the trustee, and may then be distributed to beneficiaries free of tax in their hands after the expiry of six months after balance date.

On the other hand, income earned by a trust which is distributed to beneficiaries within this time frame is taxed in the hands of the recipient (this is referred to as "beneficiary income"). Unless the recipient is, itself, tax exempt, then the trust is liable to pay tax on such income as agent of the recipient.

This should not normally be a significant risk assuming that the trust, in making grants and donations, is fulfilling its charitable objectives. However, since the Income Tax Act does not contain any rules deeming that distributions must come from current-year trust income, when there is uncertainty as to whether a recipient is tax-exempt, it may be desirable to treat grants as being sourced from prior-year "tax paid" income of the trust, or from capital gains.

Issues

In attempting to maximise the return on funds invested, some income tax planning issues arise for all philanthropic and grantmaking organisations:

• It is advisable to hold an exemption certificate from resident withholding tax (RWT). While mechanisms exist for the recovery of incorrectly deducted RWT, the organisation may as well let interest compound on the larger, before tax, amount.
• The charitable tax exemption is only for New Zealand. Income earned overseas (such as interest, rent or dividends) will normally be taxed in the other jurisdiction, with a credit being available in the organisation's New Zealand tax return to ensure the organisation is not double-taxed. However, if the organisation is exempt from New Zealand tax the credit is wasted. This is because foreign tax paid is not refundable in cash under New Zealand tax law. It can only be used to offset New Zealand tax payable on the same income. Accordingly, the organisation bears the tax as another overhead expense.
• It is advisable to invest directly rather than through a company or unit-trust structure. The charitable tax exemption only applies to income earned by the organisation, not to income earned by entities in which the organisation invests. If a "normal" taxpayer invests in a company, and receives a dividend out of tax paid company profits, it will also receive an imputation credit representing its share of company tax paid. That credit can be used to reduce the tax payable by the investor on the dividend. However, like foreign tax credits, an imputation credit only operates to reduce tax payable by the recipient of the dividend. If no tax is payable, the imputation credits are effectively lost.

Members should, of course, always take specific professional advice on such matters before committing themselves to any particular course of action.

Imputation credits and charities

Income derived by a charity is exempt from income tax under sections CW 34 and CW 35 of the Income Tax Act 2004. It is therefore clear government policy that charities should not be subject to income tax. This policy is, however, being frustrated in the case of dividend income received by a charity.

When a charity owns a business, the business profits are exempt from tax. In the case of bank deposits and other investment in fixed interest securities, charities can obtain a certificate exempting them from resident withholding tax on interest. Where interest withholding tax is deducted, it is refundable to the charity.

The same cannot be said about dividends from New Zealand companies. Companies pay dividends to their shareholders as a distribution of tax-paid profits. To avoid those profits being taxed a second time in the hands of the shareholder, the shareholder receiving the dividend is given a credit, known as an imputation credit. This represents the tax already paid by the company on that part of the profit distributed to the shareholder. In effect, the income tax paid by the company is being recycled through the tax return of the investor thereby cancelling out the tax payable by the shareholder on the dividend.

Unlike interest withholding tax, however, this credit is not refundable. If the credit exceeds the income tax payable it must be carried forward and used in a later year. As a result, if the recipient is a charity and does not pay tax, the credit is wasted. The income received by the charity therefore remains an after-tax receipt, contrary to the clear policy intent that charities should be free of income tax.

This skews the investment decisions of charities away from domestic equities, since there is an advantage to be gained by investing in any form of income that is received tax-free, or with refundable tax credits. Dividends meet neither of these criteria.

The obvious remedy is to allow charities to claim a cash refund of all imputation credits attached to their dividend income.

This proposal was last considered by Government in its discussion document "Tax and charities" published in June 2001 by the Policy Advice Division of the Inland Revenue Department. It was rejected on the grounds that because the cost of such a measure was potentially high, significant savings would have to be made in other areas of the tax treatment of charities before such a measure could be considered.

The report stated that although Government did not intend to address the issue at that time, once they had more information on charities' activities, it would be in a better position to assess the relevant fiscal cost.

Philanthropy New Zealand observes that the existence of the Charities Commission should now allow that process to move forward, and while not quite reaching the level of a firm commitment, we consider the Government's comments have left the door open for a further review of the position.

Imputation credits

Philanthropy New Zealand would like to see a law change to enable imputation credits to be returned to charitable organisations by way of refund or supplementary dividends. Government has already addressed the matter in the case of foreign investors by the introduction of the foreign investor tax credit regime. Philanthropy New Zealand considers that New Zealand charitable organisations have as much entitlement to benefit from company imputation tax credits as foreign investors, and is working hard to keep this issue on the Government's radar screen.

This has involved considerable research and relationship building to ensure that the issue can be discussed constructively. We have gained an undertaking that the issue will be reconsidered by Government once there is sufficient data available from the proposed Charities Commission to understand what the financial impact would be on Government.

Tax relief on donations

Tax relief is available for individuals and certain companies making gifts of cash to "approved donee organisations". In the case of organisations operating within New Zealand, any organisation established exclusively for the provision of money for charitable, benevolent, philanthropic, or cultural purposes, qualifies once the approval of the Commissioner of Inland Revenue has been obtained. It will then be placed on the register of approved donees held by IRD and may advertise that donations qualify for tax relief.

Where an organisation wants to operate outside New Zealand, approved donee status must be granted by Parliament. The list of organisations with such approval is contained in section KC 5 of both the Income Tax Act 1994, and 2004.

Existing approvals will continue now the Charities Commission is established, and IRD will continue to issue approved donee status. How the IRD and the Charities Commission will interact is not yet known.

GST

It will not normally be possible for a philanthropic and grantmaking organisation which derives only investment income to register for GST. Only if it were carrying on some activity which involved the supply of goods or services (the supply of money is not a good or service for GST purposes) could it register.

Philanthropy New Zealand thanks BDO spicers tax consultant, Colin Jones, for this material.