Not For Profits – Maintaining Income Tax Exempt Status

msi - nfp tax exemptionBy David Ferguson, MSI Ragg Weir, Accountants, Melbourne.

A recent Tax Office ruling has highlighted the need for not for profit (NFP) organisations to regularly review their activities in order to maintain income tax exempt status.

The ruling, TR 2015/1, provides the Tax Office’s view on two special conditions that were added to the NFP rules in amending legislation passed under the previous Labor Government.

The two special conditions considered in the ruling that an NFP must satisfy are:

  • the NFP must comply with all the substantive requirements in its governing rules (governing rules condition), and
  • the NFP must apply its income and assets solely for the purpose for which the entity is established (income and assets condition).

The Governing Rules Condition

The ruling states that the “governing rules” of an entity are the rules that direct what the entity, and those that control it, are required and permitted to do.

To establish what the governing rules of an entity are, the NFP must consider all of the various sources in which governing rules may be found. The written documents under which an entity was formed will usually be the main source of the NFP’s governing rules. There may also be other sources (e.g legislation) that comprise an entity’s governing rules.

The ruling states that a set of governing rules is divided into substantive requirements and procedural requirements. The substantive requirements of governing rules define the rights and duties of the entity, while procedural rules are those by which such rights and duties are applied and enforced. The substantive requirements include rules that give effect to the object or purpose of the entity, relate to the non-profit status of the entity, relate to the winding up of the entity and require financial records to be kept.

In order for an entity to be exempt from income tax for all of an income year, it must (among other things) satisfy the governing rules condition at all times during that income year. While an entity is in breach of the governing rules condition, its ordinary and statutory income will not be exempt from income tax.

Income and Assets Condition

The income and assets condition requires an entity to ‘apply its income and assets solely for the purpose for which the entity is established’. The ruling specifies that two questions are considered to determine whether an entity satisfies this condition:

  • what is the ‘purpose for which the entity is established’, and
  • has the entity applied its income and assets solely for the purpose for which the entity is established?

The ‘purpose for which the entity is established’ is determined by a consideration of all of the features of the entity. The main factors to be considered are the objects in the entity’s constituent documents, and the activities of the entity after its formation, up to the time at which the income and assets condition is applied. Other factors to consider include policies and plans, administration, finances, history and control, and any legislation governing the operation of the entity. An entity may have multiple purposes. Again, while an entity is in breach of the income and assets condition, its income will not be exempt from income tax.

The ruling explains the meaning of “apply” its income and assets “solely” for the purpose for which the entity is established. All of the entity’s income and assets must be used for the purpose and it must be used exclusively for that purpose.

The Tax Office accepts that the income of an entity will still be “applied” for the purpose for which the entity is established if the entity’s profits are accumulated, provided that the accumulation is consistent with the purpose for which the entity is established. The condition may still be satisfied despite a one-off misapplication of part of the income or assets of an entity, or if the amount misapplied is immaterial.

In light of the ruling, NFPs should have risk management procedures in place to regularly review activities so that income tax exempt status is maintained. Where changes in activities or new activities are proposed, consideration needs to be given to amending the governing rules.

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