Special conditions not-for-profit entities must satisfy for income tax exemption
Not-for-profit entities that fall under the categories listed in Division 50 of the Income Tax Assessment Act 1997 (ITAA 1997) must satisfy special conditions for their ordinary and statutory income to be exempt from income tax.
Taxation Ruling TR 2015/1, which was released by the Australian Taxation Office (ATO) on 25 February 2015 (Ruling) considers two special conditions that income tax exempt entities must satisfy. These conditions are that:
- the entity must comply with all the substantive requirements in its governing rules (governing rules condition); and
- the entity must apply its income and assets solely for the purpose for which the entity is established (income and assets condition).
The Ruling requires that these two conditions must be satisfied at all times during the year for an entity’s ordinary and statutory income to be exempt income under Division 50 of ITAA97. If an entity is in breach of either or both of the conditions, the ordinary and statutory income of the entity will not be exempt from income tax.
The Ruling applies to the following entities eligible for exemption from income tax under Division 50 of ITAA97:
- registered charities;
- scientific institutions;
- public educational institutions;
- funds established to enable scientific research;
- societies, associations or clubs established for the encouragement of science;
- societies, associations or clubs established for community service purposes;
- employee associations or employer associations; and
- funds contributing to other funds (i.e. ancillary funds).
Governing Rules Condition
The Ruling provides that the governing rules of an entity are the rules that:
- authorise the actions, affairs and policy of the entity;
- direct what an entity is required and permitted to do; and
- provide what those who control the entity are required and permitted to do in respect of the entity.
The governing rules of an entity are generally found in the written documents that established the entity. For example, in a constitution, trust deed or statement of purpose. However, the governing rules of an entity may also be found in other sources, for example, legislation and common law.
An entity is required to identify all of its governing rules before it can then consider what the ‘substantive’ requirements are in those rules and whether they have complied with those substantive requirements.
The Ruling provides that the 'substantive' requirements in an entity's governing rules are the rules that define the entity’s rights and duties. They give effect to the purpose of the entity, set out the criteria for admission as a member of the entity, set out the powers and duties of directors and officers of the entity and require the preparation of financial statements.
Those requirements in an entity’s governing rules that are not substantive requirements are procedural requirements. They include how a particular meeting is to be conducted, how a member may vote at a meeting by proxy and the format in which a register of members is to be maintained.
Only the substantive requirements in an entity’s governing rules must be complied with to satisfy the governing rules condition.
Income and Assets Condition
The Ruling provides that in determining whether an entity’s income and assets are applied solely for the purpose for which the entity is established one must consider the following questions:
- What is the purpose for which the entity is established?
- Has the entity applied its income and assets solely for the purpose for which the entity is established?
What is the purpose for which an entity is established?
To determine the purpose/s for which an entity is established requires consideration of the entity’s governing rules and its activities since formation as well as its policies, finances and administration.
The Ruling states that the income and assets condition will not be breached merely because the entity has an incidental or ancillary purpose. A charity may have purposes that, if considered in isolation would be non-charitable, however are incidental or ancillary to that charity’s purpose. For example, in Federal Commissioner of Taxation v The Triton Foundation (2005) 147 FCR 362 the court found that where an entity’s essential purpose was to promote a culture of innovation and entrepreneurship for the ultimate benefit of Australian society, the purpose of giving assistance to inventors, although beneficial to them, was ancillary to its principal object.
Has the entity applied its income and assets solely for the purpose/s for which the entity is established?
‘Apply’ refers to an entity making use of all of its income and assets solely for its purpose/s.
The Ruling states that the use of the word ‘solely’ refers to an entity applying its income and assets exclusively for the purpose or purposes for which the entity is established.
Although this test is strictly applied, the ATO accepts that insignificant applications of an entity’s income and assets other than for the purpose for which the entity is established may be acceptable, depending on the amount and frequency of the misapplication.
For example, the Ruling states that a payment of $60 by the treasurer of an entity for cleaning of their private residence, where no other misapplication of funds was made in the same income year, is an insignificant misapplication as the amount is immaterial and the misapplication is an isolated incident. In this scenario, despite the misapplication, the entity will satisfy the income and assets condition.
Consequences of Breaching these Conditions
Both the governing rules condition and income and assets condition must be satisfied at all times during the income year for an entity’s ordinary and statutory income to be exempt income under Division 50 of ITAA97. A breach of either of the conditions can result in the entity losing its income tax exemption in that income year.
However, the Ruling provides that the ATO does not consider it appropriate to allocate resources to taking compliance action where the entity does not satisfy either the governing rules condition, or the income and assets condition, and:
- corrective action has been taken by the entity in relation to the breach or misapplication within a reasonable time;
- the corrective action has resulted in, or will result in, the entity being placed in the position it would have been in had the breach or misapplication not occurred; and
- the entity notifies the ATO.
What does this mean?
We recommend that entities ensure they understand the basis on which they are exempt from income tax and continually review their activities and policies to ensure that they are consistent with their governing documents.
Please contact us should you wish to have your governing documents reviewed or obtain advice on your activities and applying your income and assets in accordance with your purposes.
Matthew Payne, Partner
Karen Keogh, Partner - National Pro Bono Leader