Photo by Joel Muniz on Unsplash

One of the perennial debates in New Zealand charities law is whether businesses run by charities have a ‘competitive advantage’ over their for-profit counterparts. The usual complaint is that the income tax exemption for the business income of charities (section CW 42, Income Tax Act 2007) gives charities an ‘unfair’ cashflow advantage by removing the requirement to pay income tax, which in turn enables charities to ‘grow a business faster’ by being able to accumulate funds, and reinvest them back in the business, tax-free.

Reporting in February 2019, the Tax Working Group Te Awheawhe Tāke considered the competitive advantage argument something of a ‘red herring’, with the real question being whether the broader policy settings were encouraging appropriate levels of distribution: ‘if a charitable business is regularly distributing funds to its head charity, or providing services connected with its charitable purposes, it will not accumulate capital any faster than a taxpaying business’. In other words, the Group conceptualised the issue as whether there was ‘excess accumulation’ by charities running businesses, rather than competitive advantage per se.

Nevertheless, some argue the charitable business income tax exemption should be removed altogether: a charitable business could claim deductions for donations made to registered charities (section DB 41) like any other business, with profits retained in the business subject to tax. Such an approach, it is said, would ‘level the playing field’ between charitable businesses and their for-profit counterparts.

However, the Tax Working Group did not go this far; perhaps reflecting the fact that issues relating to charities had received little more than 1 hours’ deliberation during the Group’s tenure, matters relating to charities were identified as ‘requiring further work’, and ‘kicked for touch’ to the review of the Charities Act.

This blog suggests some issues that might be usefully considered as part of that further work (see also Barker 2020).

Tax expenditure analysis

One question is how tax privileges for charities should be viewed. The Tax Working Group described charities’ tax privileges as ‘concessions’, and recommended charities’ use of ‘what would otherwise be tax revenue’ be periodically reviewed to ‘verify that intended social outcomes are being achieved’.

These statements reflect a ‘tax expenditure analysis’, which conceptualises tax privileges for charities as a ‘subsidy’, and recasts the revenue said to be ‘foregone’ from such ‘subsidy’ as a direct tax expenditure by government. Such ‘tax expenditures’ can then be assessed against alternative policy options, such as an equivalent direct spending programme, in considering whether to progress them.

However, uncritical acceptance of a tax expenditure analysis ignores a significant debate: it assumes that taxing charities is a normal part of the ‘benchmark’ structure for tax calculation purposes, and that charities’ tax privileges are a departure from that benchmark and therefore a ‘concession’.

The alternative view is that charities’ tax privileges are merely a proper measure of the tax base. Tax systems are generally designed to tax individuals and businesses on their personal gain, resulting in a misfit for entities such as charities where personal gain is prohibited: although there is no universal agreement on the ideal tax ‘benchmark’ (which may be politically contestable), there is remarkable consistency around comparable jurisdictions in providing tax privileges for charities. On this view, charities are outside the normal tax base, and their tax privileges should not be considered a ‘concession’.

An example might illustrate. While for-profit companies are subject to tax on their business income, the tax system permits deduction of expenses in calculating the amount on which tax is imposed. While such deductions reduce the amount of tax payable, they are not conceptualised as ‘concessions’, and companies are not considered to be ‘using what would otherwise be tax revenue’: the deductions for company expenses are simply considered a proper measure of the tax base. Similar arguments apply to the income tax exemptions for charities.

Criteria for registration

Another factor often overlooked is the criteria a charity must meet in order to access the business income tax exemption: from 1 April 2020, the business entity must be independently registered under the Charities Act 2005 (section CW 42(1)(aa)). Registration criteria require the business entity to have a constituting document that articulates its ‘charitable purposes’, which purposes must, by definition, operate for the public benefit.

All New Zealand registered charities must file annual returns accompanied by financial statements prepared in accordance with financial reporting standards issued by the External Reporting Board, and make this information publicly available on the charities register. These standards include a requirement to prepare a ‘service performance report’, which must articulate in non-financial terms why the charity exists and what it has done during the year towards that goal.

Charitable businesses in Aotearoa New Zealand are subject to significantly more stringent transparency and accountability rules than their for-profit counterparts (particularly those that are not publicly-listed): New Zealand arguably has the most comprehensive set of transparency and accountability disclosure requirements for charities in the world.

In addition, charities are subject to a “non-distribution constraint”: they are prohibited from distributing surplus income to any individual. A corollary of this is the “destination of funds test”, which provides that, in principle and subject to the general law, all funds of a charity must be ultimately destined for charitable purposes (even on winding up). Similarly, the prohibition on private pecuniary profit precludes a charity from applying any of its funds to the private pecuniary profit of any individual. These three principles are broadly all different ways of saying the same thing: although fair value may be paid for goods and services actually rendered, charities are not able to pay a return to private individuals like a for-profit business can. These principles are buttressed by section HR 12 which, broadly, requires a deregistered charity to divest itself of all its assets to charitable purposes or pay tax on the balance.

For-profit businesses can access the charitable business income tax exemption by restructuring as charities themselves; however, in doing so, they must forever forfeit access to personal gain from the business.

The above principles have a significant impact on charities’ ability to access capital, both equity and debt. Options to access debt capital are particularly limited, as charities often fail conventional lending criteria. In addition, government funding may not be available for capital development where priorities have shifted towards delivery of services, and the use of philanthropic capital on a loan basis to charities is also not widespread. Accessing equity capital is similarly limited, as the non-distribution constraint means that charities are unable to pay returns to private investors. In the absence of an income tax exemption, charities may be acutely unable to access sufficient capital to expand to an optimal size.

Rather than levelling the playing field, removing the business exemption for charities would only exacerbate a playing field already weighted in for-profit businesses’ favour.

Social enterprise

The analysis to date appears to proceed from an underlying assumption that by accumulating funds a charity is not ‘using’ them for charitable purposes; yet, there are many reasons why governors of a charitable business might legitimately decide to accumulate rather than distribute in furtherance of their stated charitable purposes. For example, as acutely highlighted by the COVID-19 pandemic, it is important to maintain at least 6 months of operational reserves.

In addition, the analysis appears to overlook that charities running businesses are, by definition, social enterprises: the fact that meeting investor needs is not their main priority, and that they aim to reinvest profits in the social mission of the enterprise, is a feature to be valued, not discouraged. In these COVID-affected times, the policy settings should be encouraging charities to diversify their income streams and strive for self-sustainability, rather than forcing them to rely on donations and government funding by placing arbitrary barriers in their way of running businesses.


Rather than removing the business income tax exemption for charities, a better solution would be to use the information the charities register now makes available to enable ‘questions from the monitoring authority’, and the ‘scrutiny of 1000 eyes’, to ensure that individual decisions regarding accumulation or distribution are in fact being made in the best interests of a charity’s charitable purposes: in other words, any concerns about individual charities ‘hoarding funds’ should be dealt with by a ‘focus on purpose’, using rules already in place. Such an approach would respect the inherent independence and autonomy of charities: just as the tax authority does not tell taxpayers how to run their businesses, the policy settings should similarly not interfere unduly with the day-to-day operational decisions of charities.

If there is indeed a problem with charities running businesses (an evidential basis for which has not yet been made out), the issue of how to address any such problem requires wider analysis and discussion than has been brought to bear to date.

This article has 2 comments

  1. Dr Michael Gousmett

    A well argued case from an expert in the charity sector. However, I disgree entirely. Tax expenditures are not a NZ invention (Sue does not claim that) but date from the USA in the 1960s. NZ has consistently published TE statements at Budget time since 2010. There is a simple solution to this issue. Companies can claim deductions for donations to charities to the extent of their taxable income. What is charitable about a jet boat ride? This should be enforced regarding unrelated commercial activities. Then we might have tax equity in this country.

  2. Thanks, Michael – I would turn it around and ask what’s wrong with a charity raising funds for its charitable purposes? But I guess we’ll just have to agree to disagree on this one!

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