The HKSAR Government is committed to combating abuse of charity status (Section 88)
HONG KONG, CHINA- Media OutReach - 22 September 2020 - Setting up a charitable organisationis common in Hong Kong, as Hong Kong citizens have always been committed toserving the community. The HKSAR Government also offers generous tax allowancesto both individual and corporate donors to tax-exempt organisations (up to 35%of annual taxable income). Having said that, the Audit Commission recentlyreviewed the tax exemption approval process and noted that the Hong Kong InlandRevenue Department ("IRD") should be exercising closer monitoring on whetherthese charitable organisations continue to fulfil their tax exemptionrequirements after having been granted the status. As a result, in April 2020 --following hot on the heels of its late 2019 guidelines -- the IRD issued an updatedand clarified version of its guidelines for charitable institutions, illustratingits firm resolve to review the tax exemption status of charitableorganisations.
Requirements for tax exemption status,in brief
Not everynon-profit-making organisation is an approved charitable organisation. In orderto qualify for tax exemption status as a charity, the organisation has to beestablished exclusively for one of the following four purposes:-
- therelief or poverty;
- theadvancement of education;
- theadvancement of religion; or
- otherpurposes of a charitable nature which serve the community.
In the firstthree headings, the organisation can provide services for people across theglobe, while for the fourth heading, the organisation can only serve the communityin Hong Kong. Examples of acceptable purposes for the final heading include therelief of illness, or assisting the physically and mentally disabled, and the promotionof health.
Anotherpoint to note is that a charitable organisation should be geared toward servingthe public in general, or at least a significant proportion of the community.If an organisation is intended to serve only a small group of individuals, itshould instead apply for the tax exemption available to clubs and tradeassociations under Section 24 of the Hong Kong Inland Revenue Ordinance (IRO).
Though notspecifically required, an approved charitable organisation is usually set up inthe form of a company limited by guarantee. A written governing instrument -- inthis case, the Articles of Association (AA) -- should be in place as a means of governingthe activities of the organisation.
Written governing instrument
The latestIRD guidance points out that certain clauses should be in place in the writtengoverning instrument or AA of a charitable organisation. In this section, wewould like to highlight some of the common mistakes committed by charitable organisationsin violating their written governing instruments. Please note that suchviolation may trigger termination of the tax-exempt status.
a) Precise and clear objects of thecharity
The objectof a charity set out in the AA should fulfil one of the above four headingsrequired by the IRD, which should thereafter be strictly followed by theorganisation. Occasionally, after several years of operations, members of an organisationmay have slightly different thoughts on the object of the organisation. Whilethe IRD also accepts activities that contribute indirectly to the objects ofthe organisation, it is suggested that an organisation should thoroughly considerall possible objects of the organisation to include in the AA, as long as theseare within one of the four acceptable headings, if they wish to avoid being challengedby the IRD. In case an organisation wishes to change its objects, it shouldtake the initiative to revise its AA.
b) Limitations on application offunds towards the attainment of stated objects
Charitableorganisations should exercise stringent control of their fund applications. Inreality, the lack of internal control in some organisations could result in themlending their funds to related parties, without charging interest. This lendingis shown as "amount due from related parties" in the financial statements. Sucha practice should be avoided, unless the lending was directly related to theobjects of the organisation (e.g., engage another charitable organisation with thesame objects to provide the services). Otherwise, the IRD may challenge whetherthe funds were used to support the objects of the organisation.
On theother hand, for interest-bearing loans, if the loan was not directly related tothe objects of the organisation, the interest income may be subject to HongKong profits tax, even where tax exemption status has been granted. Only incomethat is directly related to the approved objects are exempted from tax.
c) Prohibitions against membersreceiving remuneration
While themajority of charitable organisations are aware that remuneration at the marketrate should not be given to its members, they would prefer to reimburse part ofthe outlays incurred by members while supporting the activities of theorganisation. These reimbursements should be made based on the exact amount ofexpenses incurred by the members with supporting documents (e.g., vouchers).Strictly speaking, travel allowance without supporting vouchers is notpermissible, despite it being a trivial amount.
What a charity should be aware ofin the monitoring process
There is acommon misconception that, once the tax exemption status is granted, all incomederived by the charity is exempt from Hong Kong profits tax. In fact, charitiesoften carry out activities that may not be directly related to their objects.Income arising from such activities may not be exempt from Hong Kong profits tax,even when the IRD has accepted the tax exemption status. We will now examinethe tax implications arising from i) investment in securities; ii) leasing ofpremises; and iii) sales of goods.
i) Investment in securities
It is customaryfor a charity to make investments when it has surplus cash. Some charities maywrongly consider that, as long as the investment returns are ultimately used tofurther their objects, the investment income would automatically be exempt fromHong Kong profits tax. However, based on our understanding of the latest IRDguidance, it would apply the "badges of trade" test and would seek to chargetax on gains on short-term speculation activities. Long-term investment capitalgains are not subject to tax in Hong Kong.
In order toenhance the chance of a non-taxable claim being accepted, it is recommendedthat before making each investment, a charity should set up a detailed concreteinvestment plan, including an investment horizon and expected investment return,and how the utilisation of investment returns will be used to meet theorganisation's specific charity projects in the future. This could helpdemonstrate that the intention of acquiring the investment is not forshort-term trading purposes.
On thecontrary, investments in high-risk volatile assets (e.g., derivatives), as wellas a high frequency of trading, are unlikely to be lodged as capital gainsclaims, as the IRD will consider that it is difficult for the charity topredict the investment returns to meet the funding needs for its charityprojects.
Lastly, acharity is discouraged from investing in companies that are associated with itsmembers, as the IRD may perceive this move as being for personal benefit ratherthan public benefit, and may therefore disallow tax exemption status of thewhole company.
ii) Leasing of premises
Rentalincome is exempt from Hong Kong profits tax only when it is derived in thecourse of charitable activities. In this regard, a charity which leasesproperty out at market rent, without focusing on any specific target group oftenants, is unlikely to be considered as being for charitable purposes. Assuch, in order to enhance the chance of obtaining tax exemption status,charities should consider setting different rates of rental charges and offeringdiscounts to its target group of beneficiaries.
iii) Salesof goods
Under thefollowing circumstances, profits from sales of goods are generally exempt fromHong Kong profits tax:-
- whendonated goods are sold without alternation; and
- whenselling activities and/or production of the goods are mainly carried out by thebeneficiaries of the charity.
Application procedure for tax exemptionstatus
Undernormal practice, a charity would seek tax exemption status approval from theIRD prior to the commencement of its activities. The following documents shouldbe submitted for the consideration of the IRD:-
Point to Note
Draft written government instrument (i.e., AA)
As the IRD generally offers comments before granting the status, a DRAFT version of the AA is preferred
A list of planned charity activities over the next 12 months
The IRD would expect the applicant to provide detailed information to prove their capabilities and intention to perform these activities, and may review related progress after the granting of tax exemption status.
Last piece of advice
Auditedfinancial statements enclosed in annual tax filings are generally the firstdocuments the IRD will refer to in a tax exemption review process. As such,charitable organisations should seek advice from an audit firm and a taxadvisor familiar with Section 88 of IRO, i) before making important decisions,and ii) in the preparation of audited financial statements.
This article is by Henry Kwong, Tax Partner of Cheng & Cheng Taxation Services Limited.
About Cheng & Cheng Taxation Services Limited
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