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Clarifying the tax consequences for deregistered charities

Chapter 5 - Tax consequences of deregistration

5.1 In general, the tax consequences that arise when a charity is deregistered depend on the reasons for deregistration. As mentioned earlier, a charity can be deregistered for a variety of reasons. Consequently, it is important to take account of the specific circumstances of each deregistration in order to determine the likely tax consequences.

5.2 The possible consequences for income tax, fringe benefit tax (FBT) and donee organisation status are set out below.

Income tax consequences

5.3 Once deregistration has occurred we need to determine what income tax provisions apply to deregistered charities and when they apply.

What tax provisions apply?

5.4 In general, the tax treatment of an entity follows its legal form, and the activities that it undertakes. In the absence of another tax exemption applying to the entity, corporate entities will be subject to the company rules and trustees of a trust will be subject to the trust rules. An entity can also elect to become a Māori authority if it meets the relevant criteria.

5.5 There are also transitional income tax consequences when a tax-exempt entity becomes a tax-paying entity. These include determining the opening value of any depreciable property and consideration for any financial arrangements.

5.6 The Income Tax Act 2007 provides transitional tax rules in certain circumstances. These are:

  • When a “charitable trust” is no longer eligible for income tax exemption on charitable grounds – A charitable trust is a trust whose income has been or is exempt from income tax under sections CW 41(1) or CW 42(1). Section HC 31 specifically provides that income derived on or from the date on which the charitable trust loses its charitable status will be subject to tax. The provision also requires a calculation to be made in order to establish the cost price of property and to determine any consideration for financial arrangements. The calculation is required to be undertaken on the date on which the charitable trust “lost” its charitable status. (Determining when a charitable trust has “lost” its charitable status is discussed below.)
  • When a trust or company elects to become a Māori authority. Section HF 9 provides for the consequences of a change in entity status for the purposes of the Māori authority rules. In general, any retained earnings, accumulated profits and capital reserves held by the trust or company on the date of change will not be subject to tax when it is subsequently distributed.

5.7 The current tax rules in the Income Tax Act 2007 do not adequately provide for the full range of transitional scenarios for deregistered charities. In particular:

  • Section HC 31 is limited in that it does not apply to charitable trusts that never had a charitable purpose.
  • There is no equivalent section HC 31 provision for incorporated entities and so it is unclear how incorporated bodies should transition to the general tax rules.
  • Section HF 9 has the effect of exempting from income tax the accumulated “charitable income” of a deregistered entity but we question whether this is the appropriate policy outcome in all cases involving deregistered charities. (See discussion later in this chapter on the accumulation of charitable income.)

When do the taxing provisions apply?

5.8 In most cases, the taxing provisions will apply from the effective date of deregistration – that is, the date the entity is removed from the Charities Register.

5.9 However, it may sometimes be necessary to apply the taxing provisions from an earlier date. This will arise when the underlying reason for deregistration is because the entity was found never to have had a “charitable purpose”. In these circumstances, the taxing provisions can be applied from the date on which the entity was established.

5.10 In deciding whether to apply the taxing provisions from the date on which the entity was found never to have had a charitable purpose, Inland Revenue will take into account the specific circumstances surrounding the entity’s charitable status before the “tax charity” rules (which included the registration requirement) were introduced from 1 July 2008. This would include, for example, did the entity receive confirmation from Inland Revenue that it was entitled to the charities-related income tax exemption before 1 July 2008. Inland Revenue will also look at voluntary deregistrations when there is concern that the deregistered charity may never have had a charitable purpose or may have ceased to be qualified for registration at some point in the past.

5.11 We consider that clearer guidance is required to allow deregistered charities to determine when the taxing provisions should apply.

Fringe benefit tax exemption consequences

5.12 The FBT consequences for a deregistered charity depend on the reasons for deregistration. It is possible that the FBT exemption could continue to apply to the deregistered charity without interruption.

5.13 If a deregistered charity is found not to have a charitable purpose either by Charities Services or the Courts, Inland Revenue’s current practice is to accept that the charity does not have a charitable purpose for tax purposes. This means the deregistered charity must meet the other requirements implicit in the definition of “charitable organisation” for FBT purposes. If the deregistered charity has a benevolent, cultural or philanthropic purpose, or meets the requirements to be added to schedule 32, it will likely continue to be eligible for the FBT exemption.

5.14 If the deregistered charity was deregistered because it has persistently failed to file an annual return (in the absence of specific investigation into its activities) it may continue to be eligible for the FBT exemption, as registration per se is not a requirement of the FBT exemption.

5.15 The continued application of the FBT exemption when a deregistered entity has engaged in “serious wrong-doing”, as described in Chapter 4, has been raised as a concern. Even so, we consider that the current requirements of the FBT exemption (that there is no private pecuniary gain) and the penalties regime in the Tax Administration Act 1994 should allow Inland Revenue to revoke the FBT exemption and to effectively deal with deregistered charities that continue to engage in “serious wrong-doing”. We also note that the number of cases that have involved serious wrong-doing is small.

Donee organisation consequences

5.16 Similarly, there is always a possibility that a deregistered charity can continue to qualify for donee organisation status even after deregistration. The donee organisation consequences for a deregistered charity depend on the reasons for deregistration.

5.17 If a deregistered charity is found not to have a charitable purpose either by Charities Services or the Courts, the entity may still be a donee organisation if it meets the other donee organisation requirements. This includes, for example, if it has benevolent, cultural or philanthropic purpose, or meets the requirements of being added to schedule 32.

5.18 The concern raised above about the FBT exemption being applicable even in cases of serious wrong-doing is equally applicable here.

5.19 There may be flow-on consequences for donors who have made cash donations to a deregistered charity. If the entity does not meet or has never met the donee organisation requirements then these donors should not have been eligible for any donation tax relief that had been claimed. Under current tax law, Inland Revenue can reverse previous donation tax relief claims. In practice, this requires Inland Revenue to approach each donor for evidence of the amount and circumstances of their gift, which can be onerous.

5.20 In deciding whether to reverse donation tax claims, Inland Revenue may consider the circumstances around the charity’s deregistration and the donor’s knowledge of those circumstances, as well as a variety of other factors. These could include the amounts involved, the capacity of Inland Revenue’s audit and collections staff, and the implications for current and future compliance, and integrity of the tax system for all taxpayers.

5.21 We consider it appropriate that Inland Revenue should continue to have the discretion to make decisions on whether to reverse donation tax relief claims in deregistration situations. Even so, we are interested in your views on the specific circumstances in which it would be appropriate to reverse donation tax claims.

Periods of non-registration

5.22 There have been cases when an entity has been deregistered and then subsequently re-registers with Charities Services, giving rise to periods of registration and non-registration. Under current tax law the deregistered charity is required to file tax returns for any periods of non-registration.

5.23 This gives rise to both complexity and costs for deregistered charities and Inland Revenue.

Consequences of deregistration – accumulation of income

5.24 We have also identified a problem where the assets of a deregistered charity can be applied towards non-charitable purposes without giving rise to a taxable event. This problem arises because the current tax law (legislation and case law) supports the ability of charities to accumulate their income for future use, and there is no symmetry required between the income tax exemption and the payments to charitable purposes, either in amount or timing.

5.25 Although there is a requirement for a deregistered charity that “winds-up” to distribute its assets and income to charitable purposes, there is no such requirement when a deregistered charity continues its operations. In part this question obviously revolves around what use the assets are put to after deregistration.

5.26 Other countries specifically addressed this problem by requiring deregistered charities to apply any accumulated “charitable income” (and assets) to charitable purposes or risk being subject to tax. In Canada, when a charity is deregistered, it must transfer all its remaining property to a donee organisation within one year or be subject to a revocation tax. In Australia, all charitable income amounts must be transferred to another donee organisation.

5.27 This issue raises the question of the appropriate treatment to apply to a deregistered charity. There is a range of possibilities for addressing this issue and we welcome submissions on this specific point.