2014 changes to tax rules address the tax consequences for entities that are removed or deregistered from the charities register, including by voluntary request.

Sections CV 17, CW 41, CW 42, HC 31(1B), HF 11 (3), HR 11, HR 12 and YA 1 of the Income Tax Act 2007

New tax rules have been introduced to address the tax consequences that arise for entities that are removed (or deregistered) from the charities register administered by the Department of Internal Affairs – Charities Services. This includes entities which voluntarily request to be removed from the charities register.

The new rules clarify when a deregistered entity should start its life as a taxpaying entity, how the entity should treat its assets and liabilities when it becomes a tax-paying entity, and what tax provisions should apply to the entity in the future. The rules also clarify the tax consequences for donors that have made donations to these entities.

Background

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.

In general, an entity must be registered with the Charities Services 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.

Several high-profile cases involving deregistered charities, particularly when the entity continues in existence, showed that these entities faced a range of complex tax consequences that can be retrospective, transitional and prospective in nature. These consequences gave 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 in the future.

The way the tax rules were written meant that it was possible for a charity to be deregistered and to face retrospective tax liabilities even if it had been fully compliant with its rules that Charities Services had previously approved. This was possible if the rules were later interpreted to mean the entity's purposes were not in fact charitable, whether this was due to a change in jurisprudence or otherwise.

The nature and extent of the potential tax consequences ultimately depended on the underlying reason why the entity was deregistered. These consequences were more onerous (and involved retrospective tax liabilities) if the deregistered charity was found never to have had a "charitable purpose" or had ceased being charitable in purpose at some time in the past, compared with the situation when a deregistered charity had 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 related to deregistered charities was neither comprehensive nor robust, that is, it did not adequately deal with the full range of tax consequences involving deregistered charities and, in some cases, did not achieve the desired policy intentions.

The new rules are aimed at clarifying the tax law so that deregistered charities and their donors have greater certainty about their tax obligations. The changes also 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 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 rules.

The issues paper also highlighted an asymmetry in the requirements relating to the assets of deregistered charities. Although there was a requirement for a deregistered charity that "winds up" to distribute its assets and income to charitable purposes, there was no such requirement when a deregistered charity continued its operations. After deregistering, an entity could alter its constitution to allow distribution for non-charitable purposes. The new rules also address this anomaly.

Key features

  • New section HR 11 prescribes how a deregistered charity should establish its initial tax base - such as the opening values of its assets and consideration for its financial arrangements.
  • Amendments to section CW 41 ensure that entities which are removed from the charities register will continue to be tax-exempt either until the day on which the entity does not comply with its rules (as these appear on the charities register) or the "day of final decision".
  • A definition of "day of final decision" is contained in section YA 1. The day of final decision is the later of the day the entity is removed from the charities register or the day on which all reasonably contemplated administrative appeals and Court proceedings, including appeal rights, are finalised or exhausted in relation to the person's charitable status.
  • New section HR 12 imposes a tax on net assets of the entity which are held 12 months after the day the entity is no longer exempt from tax under sections CW 41 or CW 42.
  • New section CV 17 provides that any amount of income arising under new section HR 12 will be income of the entity for the income year that is 12 months after the day of final decision.
  • The definition of "charitable organisation" in section YA 1 has been widened to include an entity which has been removed from the charities register but only for a specified period. This amendment ensures that deregistered charities can in certain circumstances still qualify for an FBT exemption even if that entity is later deregistered.
  • An amendment to section LD 3(2) 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.

Application dates

The new rules generally apply from 14 April 2014. There is one exception to this, which relates to the new tax on the net assets of deregistered charities, for which there is a split application date. This new tax on net assets applies from:

  • 14 April 2014 for entities which choose to voluntarily deregister; or
  • 1 April 2015.

Detailed analysis

Clarifying how the general tax rules apply to deregistered charities

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. To acknowledge that some entities which are deregistered continue to operate as charities, albeit no longer as tax exempt charities, the term used in the legislation is a "non-exempt charity".

Section HR 11 sets out how an entity which has ceased to meet the requirements to derive exempt income under section 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 be eligible to derive exempt income under section CW 41 or 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 section CW 41 or CW 42.

For the purposes of applying section HR 11, a deregistered charity may use information from their annual returns contained on the Charities Register, if they have no other information that is more readily available.

Section HC 31 has been consequentially amended so that it no longer applies to a charitable trust that has lost its charitable status (see section HC 31(1B)). Instead, new section HR 11 will apply to all charities which come into the tax base.

The following examples illustrate how and when the tax base calculations are to be undertaken.

Example 1 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 rules. This non-compliance has been occurring since 2008. 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 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:

Year 2008 2009 2010 2011 2012 2013
Opening value ($) 50,000 40,400 32,643 26,376 21,312 17,220
Depreciation ($) 9,600 7,757 6,267 5,064 4,092 3,306
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 2 Financial arrangement rules

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 section 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:

Year 2008 2009 2010 2011 2012 2013
Opening value ($) 100,000 110,000 121,000 133,100 146,410 161,051
Interest ($) 10,000 11,000 12,100 13,310 14,641 16,105
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.

Point at which a deregistered charity will be subject to taxing provisions

The amendments to section CW 41 provide that income derived by a deregistered charity in a specified period is treated as exempt income. The specified period starts with the day they are registered on the Charities Register and ends with the earlier of the following days:

  • the day on which the entity does not comply with the its rules contained in the Charities Register; or
  • the day of final decision.

During the specified period the deregistered charity is treated as a "tax charity" under section CW 41(5).

A 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.

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 its rules (as these appear on the Charities Register). If an entity has ceased to act in accordance with its rules, then that entity should not be able to take advantage of registration.

Therefore, entities that have continued to be compliant with their rules 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.

Section HF 11(3) has also been amended to clarify that when a deregistered entity makes an election to be a Māori authority for tax purposes, the election takes effect on the day on which the entity does not comply with its rules contained in the Charities Register if the entity nominates that date in the notice.

Tax on net assets of a deregistered entity

The assets and income of a charitable entity should always be destined for a charitable destination, irrespective of whether the entity ceases to exist as a charity. However, if a deregistered charity continues in existence, the value of the deregistered entity'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 will be given time to apply any assets or income to charitable purposes before the imposition of any tax, and an adjustment will be permitted for any donated assets as these assets were not funded by non-taxed income or through a tax-preferred source.

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 on the day one year after the day of final decision.

Adjustments are made to carve out certain assets, which reduce the net assets balance that will be subject to tax. The assets carved out are:

  • any assets distributed or applied in the year after the day of final decision, for charitable purposes;
  • assets distributed or applied in the year after the day of final decision, in accordance with the entity's rules, (as those rules were contained on the Charities Register);
  • assets received from the Crown to settle a Treaty of Waitangi claim or in accordance with the Māori Fisheries Act 2004; and
  • any assets (not including money) gifted or left to the entity when it met the requirements to derive exempt income under sections CW 41 and CW 42.

Section HR 12 is intended to encourage deregistered charities to choose to distribute their assets for charitable purposes, rather than to retain them. The assets of an entity that has enjoyed tax-exempt status should always be destined for a charitable purpose, irrespective of whether the entity ceases to exist as a charity.

"Net assets" means the assets of the entity held on the day of final decision, less the liabilities of the entity on the day of final decision. An example of a liability would be the amount of tax which an entity would be liable to pay in relation to past years if it ceased to comply with its rules at some point before deregistration. Similarly, an entity might have incurred legal costs in disputing the decision to deregister it but not yet paid those amounts.

However, section HR 12(2) provides that the tax on net assets does not apply if the deregistered charity:

  • meets, on the day before the day of final decision, the requirements to derive exempt income under a provision in subpart CW (excluding section CW 41 or CW 42).
  • is re-registered on the Charities Register within one year of the day of final decision.

This provision ensures that the tax on net assets does not apply to entities which are still eligible for an income tax exemption, whether by virtue of another exemption, or because they have been reregistered as a charity.

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.

Example Taxation of tax-exempt accumulation

Charity A's date of deregistration is 1 June 2014. Charity A did not dispute its deregistration, and so this is also its day of final decision. The balance sheet for Charity A at 1 June 2014 is shown below.

Assets  
Cash                             $50
Inventory $300
Land (donated)           $3,000
Liabilities  
Loan                          $200
Equity  
Shareholders' equity    $3,150

The net assets calculation will be $3,150 less the value of the donated land and less any relevant adjustments such as assets and income distributed for charitable purposes or in accordance with the entity's rules 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 2015 income tax return.

Eligibility to be a charitable organisation for FBT purposes

A deregistered charity might continue to qualify for the fringe benefit tax exemption if it met other requirements to be a "charitable organisation".

Previously, if a deregistered charity was no longer eligible for the FBT exemption, the FBT rules applied to that entity in the same way as for income tax purposes. This meant that deregistered entities that were found to have stopped being charitable at some point in the past lost their FBT exemption from the date they ceased being charitable, and entities which were still charitable from the date of deregistration.

The definition of "charitable organisation" in section YA 1 has been amended to ensure that a deregistered entity can still be a charitable organisation for a specified period for FBT exemption purposes. 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 rules; or
  • the last day of the relevant quarter or income year in which the final decision on the entity's charitable status is made.

This means that if an entity has acted in compliance with its rules up until the time of deregistration, it will not face a retrospective FBT liability. If, however, the entity ceased being compliant with its rules, and was not eligible for an FBT exemption under other grounds, it will have an FBT liability from the first day of the quarter after the date of non-compliance.

Eligibility to be a donee organisation for donation tax relief purposes

Previously, a deregistered charity could still qualify for donee organisation status if it met the other donee organisation requirements.1 If, however, the entity no longer qualified for donee organisation status, donors would no longer have been entitled to tax relief on their donations. This could have occurred at the point at which the entity no longer satisfied any of the requirements to be a donee organisation. This could have been before the entity was removed from the Charities Register, which would have given rise to retrospective consequences for donors.

Section LD 3(2) of the Income Tax Act 2007 has been amended to confer donee status on an entity registered on the Charities Register. The amendment ensures 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.

The amendment should protect donors who have claimed donations tax relief in good faith, assuming that an organisation was a donee organisation.

1A 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.