Senate

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 3 - Charitable trusts

Overview

3.1 The provisions in Schedule 3 of the Bill make amendments to the Income Tax Assessment Act 1997 (the 1997 Act) to reflect the amendments made by Schedule 5 ofthe Taxation Laws Amendment Act (No.4) 1997 (the No.4 Act) to the Income Tax Assessment Act 1936 (the 1936 Act). The No.4 Act received Royal Assent on 21 November 1997.

3.2 There are also three consequential amendments to the 1936 Act because the relevant provisions have not yet been rewritten and incorporated in the 1997 Act.

Summary of the amendments

Purpose of the amendments

3.3 The amendments in Schedule 3 will ensure that the rewrite of the income tax laws continues to reflect recent changes to tax legislation.

Date of effect

3.4 Schedule 3 will apply to income derived on or after 1 July 1997.

Background to the legislation

3.5 Schedule 5 of the No.4 Act amended the 1936 Act to address avoidance arrangements which took advantage of the tax exempt status of charitable trusts and closed off the possibility of certain organisations which also enjoyed an income tax exemption from being used for tax avoidance purposes. Additionally, the amendments prevented, in particular circumstances, the transfer of revenue from Australia to a foreign country where Australia gave up its taxing right by providing an income tax exemption for the Australian source income of an offshore organisation but the organisation was not exempt from tax on this income in its home country.

3.6 The 1997 Act contains a rewrite of many parts of the income tax law including the exempt income provisions. As these rewritten exempt income provisions took effect from the commencement of the 1997-98 income year it is now necessary to amend the 1997 Act to "catch-up" the amendments made by the No.4 Actto the 1936 Act.

Explanation of the amendments

Part 1 - Amendment of the Income Tax Assessment Act 1997

3.7 Chapter 5 of the Explanatory Memorandum to the No.4 Act fully deals with the recent measures to address tax avoidance through the use of charitable trusts and certain other exempt bodies distributing funds offshore. Details of the measures, therefore, are not reiterated here. Rather, a brief description only is provided although the commentary on the "special conditions" and the "activity test" has largely been repeated and to some extent expanded. This is because the law concerning tax exempt entities now contains a number of special conditions that must be met in order for a tax exempt entity to retain its tax exempt status.

3.8 The provisions of the 1997 Act which are being amended to bring them into line with the 1936 Act are set out at paragraph 3.9 below.

Items 1 to15

Provisions being amended:

3.9 The following provisions which currently provide exemptions are to be amended to "catch-up" with the 1936 Act:

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section 50-5 charity, religion, education and science

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section 50-10 community service

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section 50-15 employers and employees

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section 50-20 finance

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section 50-30 health

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section 50-45 sports, culture and recreation.

3.10 Under the 1936 Act, to remain eligible for the exemption from income tax provided by the above mentioned provisions, it is necessary for an organisation or fund to meet an extended set of special conditions.

Item 14

Special conditions

3.11 The basic rule now provides that for an organisation to be exempt from income tax it must generally have a 'physical presence' in Australia or in some cases be 'located' in Australia. These terms are not defined in the legislation and therefore take their ordinary or everyday meaning.

3.12 In the case of 'physical presence' a broad interpretation has been adopted - all that is required is for an organisation to operate through a division, sub-division or the like in Australia. The structure of the organisation is immaterial as is whether it has its central management and control or principal place of residence in Australia. On the other hand, the term does not apply where an organisation merely operates through an agent based in Australia.

3.13 A much narrower meaning is intended in relation to the term 'located'. A mere physical presence is not sufficient to satisfy this requirement although it is not necessary for an organisation to be a resident for income tax purposes. A separate centre of operations such as a branch falls within the meaning of this term.

3.14 To be exempt from income tax, a charitable trust established on or after 1 July 1997 must pursue its charitable purposes ' solely' in Australia. This does not mean, however, that an incidental activity or pursuit outside Australia will prejudice the exempt status of a charitable trust. An institution, however, generally only has to pursue its objectives 'principally' in Australia. This term is also not defined in the legislation. The dictionary meaning of the word 'principally' is mainly or chiefly. Accordingly, it is not possible to specify a particular percentage but less than 50% would not be considered to meet the 'principally' requirement. Where there is some doubt whether this requirement is satisfied it will be necessary to examine each institution's individual circumstances.

The "Activity test" - gifts

3.15 Voluntary payments of money such as donations, tithes, plate money and the like or transfers of property from one person to another are generally not income in the hands of the recipient. Broadly speaking, these payments or transfers constitute a 'gift' where they are made without legal obligation, by way of benefaction and without any advantage of a material character being received in return. However, a payment or transfer of property may constitute income in the hands of the recipient notwithstanding that it is a gift.

3.16 The test as to whether a gift is income in the ordinary sense of the word is whether it is made in relation to some activity or occupation of the donee of an income producing character. Therefore, the character of the receipt in the hands of the recipient becomes the determinative issue in each particular case in deciding whether the 'gift' constitutes income.

3.17 Accordingly, gifts received by either Australian or offshore entities which are not made in relation to some activity of the entity of an income producing character will not constitute income in the hands of the entity for the purposes of the activity test.

3.18 In addition, for the purposes of the activity test, receipts from fund raising by means of raffles, dinners, auctions, jumble sales and the like by non-commercial or non-business organisations will be treated as amounts "in the nature of gifts". However, where a donor is likely to obtain a tax deduction (eg, for advertising) the material advantage obtained would disqualify the donation as a gift in the hands of the recipient.

3.19 All of these "gifts" will be disregarded when determining whether an organisation incurs its expenditure and pursues its objectives principally in Australia or whether a charitable trust pursues its charitable purposes solely in Australia and, therefore, can be applied overseas without affecting an entity's income tax exempt status. Government grants may also be applied offshore without affecting the tax exempt status of entities.

Alternative exemption conditions for organisations

3.20 An organisation covered by items 1.1 (charitable institutions), 1.2 (religious institutions), 1.3 (scientific institutions), 1.4 (public educational institutions), 1.6 (scientific research funds), 1.7 (science associations), 2.1 (community service bodies), 4.1(friendly societies), 9.1 (sports, culture and recreation bodies) or 9.2 (musical bodies) will also be exempt from income tax if it has tax deductibility status -broadly, if it is referred to in a table in Subdivision 30-B of the 1997 Act.

3.21 If an organisation is located offshore it can also be exempt from tax on a case by case basis if:

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it is exempt from income tax in its country of residence; and

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has been prescribed by the Income Tax Regulations to be an exempt organisation.

3.22 In the case of charitable or religious institution covered by either items1.1 or 1.2, an exemption may also be granted by regulation, on a case by case basis, even if the organisation has a physical presence in Australia but does not incur its expenditure and pursue its objectives onshore. This exemption by regulation process will also be available for members of peak or representative bodies as well as individual organisations, thus permitting a system of self regulation whereby the peak organisation would have the responsibility to monitor its membership and expel any members who did not meet the necessary regulatory requirements.

Alternative exemption conditions for charitable trusts

3.23 A charitable trust that falls within item 1.5B (established on or after 1 July 1997) will also be exempt from income tax if it has tax deductibility status (broadly, if it is referred to in a table in Subdivision 30-B) or if it distributes its funds to a charity that has tax deductibility status.

3.24 Alternatively, if it distributes its funds to another charity that operates solely in Australia it will be exempt. As it would be unreasonable to expect the trustee of a charitable trust to be aware whether the organisation to which it distributes funds was undertaking its work solely in Australia the requirement in the legislation is simply, "to the best of the trustee's knowledge, is located in Australia and pursues its charitable purposes solely in Australia".

3.25 Accordingly, the trustee does not need to undertake a detailed examination of the charity to whom the distribution is to be made. The trustee cannot, however, ignore the fact that a charity is known not to pursue its charitable purposes solely in Australia.

Notional trusts

3.26 In order to prevent testamentary trusts from being used as conduits in tax avoidance arrangements, settlements (for example trust distributions, funds or shares) received on or after 1 July 1997 will be subject to the new measures. This is achieved by the legislation providing for a "new trust" and an "old trust" and is fully discussed in the explanatory memorandum for the No.4 Act.

3.27 Because it would be possible for assets in the new trust to be sold or otherwise disposed of and the proceeds then used to purchase other assets which would otherwise be subject to the old rules, thus circumventing the new measures, subsection 50-80 (2) provides that the sale or substitution is to be ignored and the new assets treated as if they were old assets. Of course, the reverse situation is possible and if assets in the old trust are sold or otherwise disposed of, the assets which take their place will still be part of the old trust and thus subject to the old rules.

Part 2 - Amendment of the Income Tax Assessment Act 1936

Items 17 to19

3.28 These amendments will simply replace references to old provisions in the 1936 Act (concerning exemption from withholding tax for tax exempt bodies and record keeping requirements) to the relevant new provisions in the 1997 Act.

Application

3.29 The amendments to both the 1997 Act and the 1936 Act apply to income derived on or after 1 July 1997 [Items 16 and 20] .