By Andrew Egri, Laywer
Directors of not-for-profit organisations are well aware that the organisation’s reserves play an important role in its financial stability. Reserves allow an organisation to meet its ongoing financial commitments and continue to provide services.
There are obvious issues that arise from an organisation not having sufficient reserves. However, for those income tax exempt entities that are fortunate to enjoy substantial reserves, they must act carefully to ensure that those reserves do not give rise to unintended problems.
Accumulating a high level of reserves without a clear explanation or justification may adversely affect the public’s perception an organisation, and risk its income tax exemption. An organisation can accumulate income and still be income tax exempt, however there are restrictions to the accumulation of income which occurs for no identified purpose.
There are a wide range of scenarios which might result in an organisation holding substantial reserves. For example, an organisation may have sold property or experienced unexpected levels of profitability over a number of years.
Section 50-50(2) of the Income Tax Assessment Act 1997 (Cth) imposes special conditions that income tax exempt entities must satisfy to remain income tax exempt:
The ATO clarified, in Taxation Ruling 2015/1, how an organisation may satisfy the income and assets condition:
A organisation can generally accumulate funds for either or both of the following:
The income and assets condition allows an income tax exempt organisation to accumulate funds for the purpose of specific future projects, programs, services, asset acquisitions etc., which are in fulfilment of the organisation’s objects. So long as it has recorded:
the accumulation of funds is permitted and will not jeopardise the organisation’s income tax exemption.
Once the organisation starts becoming vague about any of the above, the risk of not complying with the Taxation Ruling (and thereby losing its income tax exemption) increases.
It is good practice for any organisation, particularly a not-for-profit organisation, to set aside a reasonable quantum of funds in reserve as a Contingency Fund to protect it in the event of future unfavourable or unexpected circumstances.
The ATO has not prescribed what level is considered “safe” to accumulate for this purpose. Specifically, there is no set limit on how much money an income tax exempt organisation can place in reserve, and no rule setting out how long it is able to keep money in reserve.
While the ACNC recently released a fact sheet addressing the financial stability and sustainability of charities, it also did not prescribe an appropriate level of reserves. Rather, the ACNC holds the charity’s governing body as being responsible for ensuring that the charity maintains an appropriate level of reserves.
5.1 Project fund
As mentioned above, an organisation can accumulate funds for future projects, programs, services and asset acquisition as long as the arrangements are recorded.
If they have not already done so, we recommend that the members of the organisation’s governing body put their minds to documenting how the project fund is calculated. The composition of the project fund should be broken down into amounts to be applied for specific projects, programs, services or asset acquisition. For example, an organisation may decide to sponsor a new program, which will cost $300,000 per year for 5 years, and so the governing body determines to set aside $1,500,000 in the project fund to cover that cost.
5.2 Contingency fund
we recommend that the governing body determine for itself what is an appropriate amount to hold in respect of the organisation’s contingency fund.
The governing body should be prepared to explain in as much detail as possible, the grounds on which it determined the amount to be retained in the contingency fund. Specifically, any assumptions made by the governing body in determining the size of the contingency fund should be clearly set out. Some examples of factors which the governing body might consider in determining an appropriate amount are:
Some organisations choose to develop and approve a “reserves policy”. Such policy usually specifies the purpose of amassing and maintaining reserves and sets out the calculation of target amounts. For example, an organisation’s policy may provide that the level of reserves should cover at least three months and no more than six months of general operating expenditure.
5.3 Annual review
Irrespective of whether an organisation has approved a “reserves policy”, in order for it to maintain its income tax exemption, it will need to review its approach to the size and nature of its reserves at least once per year to comply with paragraph 32 of the Taxation Ruling.
We recommend that the governing body confirm the amounts to be retained and its rationale for determining those amounts by: