Third Dimension – New Rules for Income Tax Exempt NFPs

July, 2015

Summary of TR 2015/1

1. Overview

Division 50 of the Income Tax Assessment Act 1997 (ITAA 1997) exempts from income tax the total ordinary and statutory income of an entity that is covered by one of the various items in the tables listed in the Division. Many of the items in the tables require that certain special conditions be satisfied before the income of an entity can be exempt from income tax. These special conditions vary depending on the nature of the entity.

This tax ruling provides guidance on how the law is interpreted and applied regarding two of the special conditions that certain not-for-profit and other organisations must meet to be exempt from income tax.  These requirements were introduced in the Tax Laws (Measures No. 2) Act 2013, which require a not-for-profit organisation:

a.  to comply with all the substantive requirements in its governing rules (‘the governing rules condition’); and

b.  to apply its income and assets solely for the purpose for which the entity is established (‘the income and assets condition’).

1.1. Date of Effect of these Special Conditions

These two additional special conditions apply to an entity from the entity’s income year that commences on or after 1 July 2013.

1.2. Date of Effect of this Tax Ruling

The date of effect for the new tax ruling is 25 February 2015, but applies to income years prior to the current year.

2. Governing Rules Condition

The governing rules of an entity are those rules that authorise the policy, actions and affairs of the entity.  That is, governing rules of an entity consist of the rules that direct:

a.  what the entity is required and permitted to do; and

b.  what those, who control the entity, are required and permitted to do in respect of the entity.

An entity may have governing rules from more than one source.  However, the written documents under which an entity was formed will usually be the main source of its governing rules.  An entity must identify all of its governing rules in order to then consider what the ‘substantive’ requirements are in those rules. Some examples of ‘substantive’ requirements contrasted with ‘procedural’ requirements are as follows:

Substansive requirements Procedural requirements
  • objects/purposes;
  • non-profit status;
  • powers and duties of directors/officers;
  • audit and accounts; and
  • winding up.
  • membership;
  • meetings; and
  • votes of members.

Please therefore ensure that your constitution is always up to date. Otherwise this will cause you problems if:

a.  your organisation is required to comply with an out of date constitution in order to remain income tax exempt; or

b.  your organisation decides not to comply with your outdated constitution in order to comply with other laws, and this results in your organisation no longer being income tax exempt.

3. Income and Assets Condition

3.1. 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’.

Two questions must be considered to determine whether an entity satisfies the income and assets condition:

a.  what is the ‘purpose for which the entity is established’; and

b.  has the entity applied its income and assets solely for the purpose for which the entity is established?

3.2. 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:

a.  the objects in the entity’s constituent documents;

b.  the activities of the entity after its formation, up to the time at which the income and assets condition is applied;

c.  policies and plans;

d.  administration;

e.  finances;

f.  history;

g.  control; and

h.  any legislation governing the operation of the entity.

3.3. Incidental or Ancillary Purposes

The purpose for which the entity is established can include an incidental or ancillary purpose.  A purpose is incidental or ancillary to the purpose for which the entity is established if it tends to assist, or naturally goes with, the achievement of that purpose. It does not mean a purpose that is minor in quantitative terms.

3.4. Accumulation

The income of an entity may still be ‘applied’ for the purpose for which the entity is established if some of the entity’s income (whether it be gross income or net income) is accumulated, provided the accumulation is consistent with the purpose for which the entity is established.  An entity may use some of its income to acquire assets which, in future, will produce income for its purpose or purposes, and may accumulate some of its income for later distribution.

To satisfy the income and assets condition, an entity that accumulates most of its income over a number of years will need to show on a year by year basis that the accumulation is consistent with the purpose for which the entity is established.

Please note that excessive or indefinite accumulation is not permissible under the income and assets condition. An entity’s entitlement to income tax exemption is a year by year assessment.

The relevant factors to be considered include whether the entity has identified:

a.  when its income is to be applied to its purpose;

b.  how its income is to be applied to its purpose; and

c.  if accumulation is to continue for an extended period, the reasons for this.

3.5. Meaning of ‘Solely’

The income and assets condition requires an entity to apply its income and assets ‘solely’ for the purpose for which the entity is established.  This means that the entity must exclusively or only apply its income and assets for that purpose.

A strict standard of compliance is required under the ‘solely’ test. Nevertheless, the Commissioner accepts that misapplications of an entity’s income and assets of an insignificant nature will not result in a breach of the condition. Relevant considerations include the amount of the misapplication and how often the misapplication occurs.  The income and assets condition will still be satisfied where:

a.  the misapplication or misapplications are immaterial in amount; and

b.  there is a one-off misapplication or occasional, unrelated misapplications of part of the income or assets of an entity for a purpose other than the purpose for which the entity is established.

4. Relationship between the Governing Rules Condition and the Income and Assets Condition

The governing rules condition and the income and assets condition are independent special conditions that must be satisfied by an entity (in addition to other special conditions for some entities) in order for its ordinary and statutory income to be exempt from income tax under Division 50.

While an entity is in breach of either or both of the special conditions, its ordinary and statutory income will not be exempt from income tax.

5.  Corrective Action

In some circumstances, an entity may take subsequent action to correct:

a.  a breach of a substantive requirement in an entity’s governing rules; or

b.  the application of part of its income or assets to a purpose other than the purpose for which it is established (‘misapplication’).

For the purpose of the Commissioner’s administration of the governing rules condition and the income and assets condition, this is referred to as ‘corrective action’ having taken place in relation to the relevant breach or misapplication.

Corrective action has the overall effect of putting the entity back to the same position it was before the breach or misapplication occurred. Nevertheless, in such circumstances, a breach or misapplication is still taken to have occurred, although the effects of the breach have been reversed.

This article originally appeared in Third Dimension – Winter 2015

Contact Mills Oakley

For more information, please contact:

vera-visevic

Vera Visevic | Partner
T: +61 2 8289 5812
E: vvisevic@millsoakley.com.au

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