1 June 2011 (last updated 4 April 2012)
Following the announcements on Budget Night of the intention of the Federal Government to tax the unrelated commercial activities of charities, the Commonwealth Government has now released the Consultation Paper “Better Targeting of Not-For-Profit Tax Concessions“. This Consultation Paper provides some clarity regarding the Government’s intentions. However, there is still a great deal of uncertainty regarding how the measures will apply, and what structural changes will be forced upon NFPs as part of the process.
A copy of the Consultation Paper is available at: www.treasury.gov.au/ConsultationsandReviews/Consultations/2011/Better-Targeting-of-Not-For-Profit-Tax-Concessions
Government reasons for the change
The reforms are intended to encourage NFPs to direct profits generated by “unrelated commercial activities” back to the charitable activities of the NFP. The intent is to tax these profits where they are not directed back to charitable activities, so as to:
- Ensure a level playing field between the various for profit and NFP enterprises; and
- Protect the assets of a charity (which the Government deems to be “community assets”) from unnecessary commercial risk. (NB: This is a puzzling development, as it implies a sense of public entitlement to these assets. Many of these assets, such as church assets, have been acquired through voluntary giving from members or adherents).
The Government has indicated that the changes will not affect:
- “related commercial activities”;
- Passive investment activities; or
- Small scale or low-risk activities.
Issue 1: Is a level playing field desirable or fair?
A “level playing field” immediately resonates with the Australian way of life.
However, as charities do work that is “beneficial to the community” (this is a condition of them being a charity), historically they have been given tax concessions to assist in funding their charitable activities.
The introduction of an “unrelated business tax” would be a significant change, and Australian’s (and particularly charities) must now take the opportunity to participate in this consultation process, so that all view points are taken into account before the legislation is finalised.
Issue 2: What is a “related commercial activity” or “low-risk activity”?
The proposed changes will not affect commercial activities of a NFP that “directly further the NFP entity’s altruistic purpose” (related commercial activities). The Consultation Paper refers to similar principles in:
- The UK (activities exercised in carrying out the primary purpose of the NFP);
- The USA (conduct which is not substantially related to the charitable purposes of the NFP);
- Canada (businesses linked to the NFP’s purpose, and subordinate to that purpose);
- Ireland (a test similar to the UK mentioned above); and
- South Africa (integral and directly related to the principal object of the NFP, substantially at cost-recovery and not resulting in unfair competition to other commercial operators).
The Consultation Paper indicates that each of the above definitions are appropriate having regard to the Government’s policy intent. Of these options, we consider the South African option to be the most problematic for NFP’s, particularly given the “cost recovery” and “no unfair competition” principles.
The Consultation Paper also indicates that ancillary commercial activities (where the activity tends to assist, or go naturally with, the achievement of the charitable purpose) would also be exempt.
The Government indicates that it also intends to prevent charities from engaging in “non-primary purpose trading where there is a significant risk of loss of assets to the charity” (para 50)
Depending on how “related commercial activity” is ultimately defined, a small amount of comfort can be taken for NFP’s where their specific commercial activities are either directly related to their charitable purposes, or ancillary to those charitable purposes, as long as they are profit making, in that those commercial activities appear to be unaffected by these changes.
However, all other commercial activities (other than passive investment, small scale or low risk activities) will be affected by these changes.
An example of the unintended impact of these changes is where a charity seeks to maximise the value of surplus land (that may have been gifted to it or built on the back of much volunteer effort) to better fund its chartable work. Such a development would seem to be an unrelated commercial activity, and tax may be payable on any retained profit. Given the staged nature of such developments, it is likely that profits would be retained to fund the further stages.
Would the “low-risk” limitation prevent a charity from conducting a business that may be loss making for a period of time? Charities have been known to take on struggling (loss making) businesses because they believe that the business delivers benefit to the community. Such a limitation may prevent a charity from doing so.
Issue 3: What happens to Unrelated Commercial Activities?
From 1 July 2012 (originally 1 July 2011), all unrelated commercial activities will be taxable (a transitional period is proposed for pre-existing unrelated commercial activities, see Issue 3).
The Consultation Paper proposes three options for implementing this reform:
- Option 1 – Unrelated commercial activities are undertaken in a separate legal entity, which is then taxed in the same manner as for other commercial entities (i.e. at the company tax rate, paid by instalments through the PAYG scheme). However, through utilising franked dividends, DGR endorsements or trust distributions, payments to charitable entities would not be taxed. The intent is to tax any profit that is retained within the commercial entity (such as profit used to build the business). This option appears to be the Government’s preference.
- Option 2 – Unrelated commercial activities are undertaken in a separate legal entity, however tax is not paid until the end of each year, and then only on profit retained within the commercial entity. This option does not appear to be the Government’s preference, because it would require significant legislative amendment to existing taxation principles.
- Option 3 – Unrelated commercial activities are retained within the NFP’s existing entity. However, the activities would need to be accounted for separately, and tax paid on any profit not directed towards charitable activities. This option is also not preferred by the Government. The Government anticipates that it would be costly to administer, would place higher compliance costs on the NFP and would not provide adequate transparency for Government.
What this means is that the Government is considering imposing structural change upon NFP’s, and particularly preventing NFP’s from carrying out unrelated commercial activities within their existing corporate structure. This imposition will apply to all unrelated commercial activities commenced after 10 May 2011.
The Government acknowledges that these structural changes will come at a cost to NFP’s, and that the changes are also dependent upon agreement with State and Territory governments (particularly with regard to the imposition of stamp duty on any structural change).
If your NFP is considering embarking upon an unrelated commercial activity, you need to understand that this activity may be forcibly removed from within your existing corporate structure with unknown cost consequences.
Issue 4: What are the transitional arrangements?
Where an unrelated commercial activity exists before 10 May 2011, there will be a transitional period for the NFP to transition across to the new framework (including transitioning the unrelated commercial activity into a separate commercial entity).
The time frame for this transition is still unclear. However, the Consultation Paper suggests that a shorter transition period would better meet the Government’s aim of creating a “level playing field”. NFPs should not assume that there will be a lengthy transitional period.
Additionally, where an existing unrelated commercial activity changes (such that it becomes a new entity), the transitional arrangements might cease to apply. Examples of such changes include:
- Changes or increases in the goods or services being delivered (including a change in the market);
- Changes in the customer base;
- Changes in the method of selling the goods or services;
- Changes in the location from which the goods or services are delivered;
- Changes in Intellectual Property rights (such as change in trade marks, patents or royalty arrangements);
- Changes in the numbers of employees or contractors;
- A period of dormancy in the unrelated commercial activity;
- Acquiring or amalgamating with another entity.
Until we have seen the legislation for these amendments, an NFP should exercise caution before embarking on any of the above changes, given the potential it could have on the application of the transitional period.
What about a charity that has started spending money on developing its surplus land but it is not yet on the market? It is unclear whether such an existing unrelated commercial activity will benefit from the transitional arrangements?
Where to from here?
The closing date for submissions on the Consultation Paper is 8 July 2011. We urge NFPs to consider how these changes may effect their existing or intended activities and lodge submissions with Treasury, so that the concerns of the NFP sector are heard and taken into account. If you would like us to assist with an assessment of how the changes may effect your organisation or in preparing your submission please contact us.
Additionally we would encourage you to let your views be known to your local member of Federal parliament.
It goes without saying that we are entering a period of great uncertainty for NFPs. Until there is greater clarity on these issues, NFPs need to exercise caution when considering embarking on unrelated commercial activities, or changing existing unrelated commercial activities.
We will continue to monitor these developments.
If you have a query regarding unrelated business tax or UBIT reforms, contact us
Contact our Business Development Team for an appointment with one of our Brisbane not for profit lawyers, call (07) 3252 0011.