2.1 This chapter discusses the nature of the charitable sector, and the reasons the government supports the sector through the tax system.

The purpose of charities

2.2 Organisations within the charitable sector take many forms, including companies and trusts. They use three main forms of fund raising: direct gifts, such as donations and other philanthropic giving; income from passive investment such as bank deposits; and income from business activity. The forms of charitable provision are direct grants or gifts of money, and the provision of goods and services for nil, or nominal, consideration.

2.3 The New Shorter Oxford English dictionary defines "charity" as, among other things:

"a trust, foundation, organisation, etc., for the benefit of others, especially of those in need or distress".

2.4 Examples of common charities in New Zealand today are churches, universities, play centres, welfare organisations, food banks and night shelters. The functions of these organisations indicate they have a wider purpose than that suggested by the dictionary definition. It could be said they are providing goods and services that are in some way "collective" in their benefit. In other words, they provide goods and services that confer a benefit to society over and above the benefits that the recipient or supplier may get from the arrangement. Organisations that exist primarily to provide a benefit to owners or members are not regarded as charitable, even if some residual funds are used in the provision of collective goods and services.¹

2.5 Although governments are the main suppliers of collective goods and services, some people will want to see more of certain goods and services being provided. Typically, they use the charitable sector as the main vehicle to provide them.

2.6 The charitable sector is perceived to be altruistically focused, reinforced by the fact that charities do not normally have shareholders and often rely upon volunteers. These factors may be an advantage in the minds of donors when they are deciding what type of entity to support. Often donors have little information about the uses to which their donations are put, partly because they are not the ultimate beneficiaries of the goods or services provided by the entity to which they have donated. In these circumstances, donors may feel more confident that a non-profit or charitable organisation will not take advantage of the lack of information about what happens to their funds to provide a lower than promised quality of output. However, these factors do not by themselves form a justification for governments subsidising such entities. The question therefore remains - why do governments subsidise the charitable sector, and in particular, why do they do so through the tax system?

Government support for greater private provision

2.7 Subsidising charities enables governments to further their social objectives, including by means of increasing support to disadvantaged members of society. One of the reasons governments provide subsidies to the private sector rather than simply increasing state provision is that it can result in a better targeting of resources. The donations people make to a charity provide an effective indicator of the extra goods and services people feel are needed. Subsidising charities also ensures that those members of society who do not donate to charities but who nevertheless benefit indirectly from charities are contributing through their general tax payments.

Support through the tax system

2.8 In the case of charities, the subsidy takes the form of an exemption from income tax that allows spending on charitable purposes to be made out of untaxed income. Further, the source of some of those funds that are spent is subsidised by the rebate or deduction for donations made to charities.

2.9 As already noted, a common feature of charities is that they provide a benefit to society over and above any benefit received by the recipient or supplier of the relevant goods or services. For example, the benefit to society of a charity running a soup kitchen is greater than the value of the meals provided there. This is what economists call a "positive externality". The presence of an externality is one of the few justifications for the use of subsidies through the tax system. A subsidy can be used to give some recognition to the supplier for the extra benefit that those activities provide to society generally.

2.10 Even so, there are several problems with using the tax system to recognise these extra benefits, and some of these problems are noted later. However, in the case of charities, these are mitigated to some extent by the fact that no private pecuniary profit can be made from charitable activities (and therefore from the tax exemption).

2.11 In respect of the donations subsidy, empirical studies² suggest that subsidies to donors encourage charitable giving, which is generally regarded as socially desirable behaviour. The government could provide its support directly to charities through grants. However, this would not provide a direct incentive for individuals to donate, and might result in less effective targeting of government assistance, particularly if the government grants were not matched to donations.

Concerns about using the tax system to support charities

2.12 Despite the advantages of using the tax system to support charities, there are a number of issues that governments need to take into account when using the tax system to provide this kind of support.

• In granting tax concessions, governments forgo tax revenues. This means that governments need to raise money from other sources, such as through increasing tax rates on non-exempt companies, goods and individuals, to reach their total tax revenue targets.
• Government subsidy by way of a tax exemption can encourage growth in inefficient ways. For example, even though the subsidy may result in more output of a particular good or service, the resources redirected to the subsidised activity to produce the extra output might have been used to greater effect in another activity. Thus there can be a net loss to society from a subsidy, although the size of any loss (or indeed gain) is difficult to quantify in a world of imperfect information.
• Unlike other forms of government expenditure, a subsidy through the tax system is not subject to direct control by the government. An exemption on income tax allocates tax expenditure in proportion to an organisation's income, not according to its needs or worth; a donation deductible from a donor's income results in both the amount and the recipient of the tax expenditure being chosen by the donor.
• Unlike other forms of tax expenditure, there is no direct ministerial scrutiny of the use to which the tax subsidy is put. In New Zealand, there is no formal process for registering charities, and there is ministerial involvement only when Parliamentary approval is required for donee status because the charity intends to operate overseas. Even in those cases, there is no government monitoring of whether a charity is continuing to meet the charitable purposes for which it was established.
• Moreover, the assistance granted to charities through the tax system is not transparent and, as such, disguises the total level of expenditure on different parts of the government's programme.

2.13 In light of these concerns, governments need to ensure that the support they have decided to give through the tax system is appropriately targeted, is transparent and has the scope for some ministerial or official review. These questions are a particular focus of the review and this discussion document.

International comparisons

2.14 Most countries provide support to charities through the tax system in one form or another. The appendix compares the current rules in New Zealand with the rules applying in the United Kingdom, Australia, the United States and Canada. These countries use definitions of "charitable purpose" that are similar to our own and provide similar assistance through the tax system. But all have significantly more developed registration and reporting arrangements, with approved registration being a common feature for those entities seeking tax assistance. In the United Kingdom, charities come under the purview of a Charities Commission. In the other cases, the arrangements are administered as part of the tax system, through their respective tax authorities.

2.15 Specific features of some of these countries are also discussed in subsequent sections of this discussion document as the proposals in relation to reporting and the definition of "charitable purpose" are outlined.

Summary of proposals

2.16 This discussion document contains more than one proposal for both the definition of "charitable purpose" and for increased reporting by charities. That is because the government's decision on the definition of "charitable purpose" will be influenced by feedback on reporting issues. Broadly, if the definition of "charitable purpose" can be modernised or narrowed, less stringent reporting would be required. However, if the definition cannot be modernised without affecting entities which the government considers should be supported, increased monitoring might be required, so that both the government and the public can see that their money is being spent to best effect.

Defining "charitable purpose" - two options 1. Use the same definition but with safeguards The first option is to leave the current definition unchanged, subject only to any liberalisation of the public benefit test, and the safeguards discussed below. 2. Replace the existing definition with a new, general definition assisted by detailed guidelines on how it should be applied, with specific approval required. This approach is a modernisation of the current law. It would encompass all of the traditional charitable purposes (relief of poverty, etc.) outlined in chapter 3, but expressed in terminology more fitting to 21st century society. Specific approval would be required before charitable status would be granted. Given that this is a broad definition, it would need to be accompanied by a set of guidelines that could be used in applying the definition. Safeguards Both of these options would be subject to some reporting requirements. They would also be subject to the public benefit test, and could be subject to a discretion or override by the government (on the recommendation of the Minister of Finance) in order to allow it to better target its support. The provisions of section CB 4 of the Income Tax Act 1994 would be amended to require an entity not only to be established for charitable purposes, but to continue to carry out those charitable purposes in order to remain eligible for the tax exemption. All charities would have to register with the government before the tax exemption was available, in accordance with a specified procedure to be developed.

Reporting requirements Registration The charitable tax exemption would be available only to those charities that have registered as such. This could also involve a specific approval process. Supply of information Charities would file annual accounts (audited when appropriate) and, possibly, tax returns. The annual accounts should be publicly available. Regular monitoring The government envisages that the activities of charities would be regularly monitored (by either the Inland Revenue Department, another government department or an independent body) to ensure that the charitable objects for which their tax exemption was granted were, in fact, being pursued.

Specific tax issues Trading operations Trading operations of charities would be subject to income tax but with an unlimited deduction for distributions made to the charity that owns the trading operation. Charitable purposes outside New Zealand The criteria for donee status (section KC 5(1)) for overseas charitable purposes (see paragraph 10.3) would be standardised by applying those same criteria to the income tax exemption (section CB 4(1)(c) and (e)). Rebates and deductions for donations to charities Rebates for donations by individuals would be increased in line with inflation since 1990, and the company deduction rules in the Income Tax Act 1994 would be simplified by removing the limit for each donation made, and allowing deductions for close companies that are listed on a recognised exchange. Fringe benefit tax The exemption from fringe benefit tax for fringe benefits provided to employees of charities would be removed. Superannuation schemes for the benefit of employees of charities The issue of whether superannuation schemes for the benefit of employees of charities should have charitable status is raised for discussion. GST To remove existing uncertainties, GST input tax credits would be allowed to GST registered charities and other non-profit bodies in relation to all their activities, other than the making of exempt supplies.

Outcome of consultation process

2.17 Any legislation resulting from this review is proposed to be included in a taxation bill later this year. We envisage the changes taking effect from the beginning of the income year following enactment.

Communicating your views

2.18 The government invites you to provide your views on the proposals in this discussion document. Although the document identifies specific issues for consultation, the government is interested in your views on any of the issues raised. Submissions should be made by 31 July 2001 and can be provided either in written form or electronically.

2.19 Written submissions should be addressed to:

The General Manager
Policy Advice Division
Inland Revenue Department
PO Box 2198
WELLINGTON

The electronic address is policy.webmaster@ird.govt.nz.

2.20 Please note submissions may be the subject of a request under the Official Information Act 1982. The withholding of particular submissions on the grounds of privacy, or for any other reason, will be determined in accordance with that Act. If you feel there is any part of your submission which you consider could be properly withheld under that Act (for example, for reasons of privacy), please indicate this clearly in your submission.

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