Chapter 27: Commercial Purposes and Commercial Activity

Modern Australian charities are seeking innovative ways to fund their activities and are encouraged by governments to do so. The Committee considers that the definition of a charity should not inhibit these developments.

Competitive neutrality concerns generated by the taxation treatment of charities are issues for taxation policy, not the definition of a charity.

Current approach

As discussed in Chapter 11, charities are required to be not-for-profit, but that does not mean that they cannot make a profit. Charging for the provision of charitable services does not deprive a charity of its charitable status, even though it may generate a profit. The extent or size of the fees charged is not specifically limited but it cannot be such as to exclude the element of public benefit.

However, that does not require that no member of the public be excluded from the benefit. In Re Resch's Will Trusts, the Privy Council ruled that it would be wrong to conclude that `a trust for the provision of medical facilities would necessarily fail to be charitable merely because by reason of expense they could only be made use of by persons of some means'. <sup>1</sup> The court held that the public benefit was `strongly present' in this case because the need for the service was undisputed, even though some of the poor might be excluded from the service. Lord Wilberforce noted that:

To provide, in response to public need, medical treatment otherwise inaccessible but in its nature expensive, without any profit motive, might well be charitable; on the other hand to limit admission to a nursing home to the rich would not be so. The test is essentially one of public benefit, and indirect as well as direct benefit. In the present case, the element of public benefit is strongly present... The service is needed by all, not only by the well-to-do. So far as its nature permits it is open to all: the charges are not low, but the evidence shows that it cannot be said that the poor are excluded: such exclusion as there is, is of some of the poor...²

Operating a commercial enterprise to generate funds for a charitable purpose is not in itself considered a charitable purpose. In Re Smith the Supreme Court of South Australia held that while the motive for establishing a commercial activity was `no doubt religious and its profits were no doubt used exclusively in aid of the teachings, activities and purposes of a religious body', the commercial operation was found not to be within the spirit and intendment of the Statute of Elizabeth.<sup>3</sup> The judgment referred to the decision of the High Court of Australia in Roman Catholic Archbishop of Melbourne v Lawlor<sup>4</sup> in which a gift to establish a Catholic newspaper was held to be for a non-charitable purpose `notwithstanding that the newspaper and any resulting profits would be used for advancing the Roman Catholic faith'.⁵

The Australian Taxation Office (ATO) provided the following information to the Inquiry concerning its understanding of the law:

Business or commercial activities that are merely incidental to an entity's charitable purposes do not prevent it being a charity. Nor does the mere holding of passive investments. There will also be circumstances where charitable purposes may be carried out in a business-like way, and indeed, as appears from the cases, in some circumstances a charitable purpose might need to be carried on in a commercial way. However, a purpose of merely carrying on a business or commercial enterprise to raise revenue is not itself charitable.

Views on the current approach

Submissions supported the current approach of differentiating between profits distributed to charitable purposes and those distributed to shareholders or for personal gain.

The Catholic Church in Australia argued that seeking a contribution to the cost of a charitable service through some form of payment should not affect the status of the act as charitable. Two reasons were put forward: that asking for payment assists in preserving the dignity of the recipients by allowing them to make a contribution to the cost of the good or service, as opposed to being the recipient of a `hand-out'; and the charging of fees may allow a charitable organisation to cross-subsidise other charitable activities.

A number of submissions sought to maintain the distinction between the commercial provision of the charitable good or service and commercial operations run solely to generate funds for the purposes of the entity. For example, the National Heart Foundation argued that when it seeks sponsorship and funding from other sources it `has always required such arrangements to be directed towards achieving its mission to improve the health of Australians and not entered into any agreement solely as a fund-raising exercise'. JewishCare commented that `ostensibly commercial work' carried out by people with various disabilities provides focus and dignity for the person and value for the customer. `To judge such enterprises by commercial criteria (which does occur in some cases) because of the nature of the activity negates much of what is said about self-help and empowerment.' JewishCare argued that this type of `commercial activity' should be differentiated from commercial activities for fundraising only, with the latter subject to normal commercial regulation.

This distinction between a charitable purpose for which a fee is charged and commercial activities operated solely to generate funds for charitable purposes is followed in the UK. The Charity Commission for England and Wales states that:

...charity law does not permit charities to exercise a trade on a substantial or regular basis simply for the purpose of raising funds. This is because of the general expectation that contributions made to a charity will be applied for its purposes or invested prudently, rather than being risked in trading activities which are undertaken simply to raise money.⁶

Trading activities of this type can only be conducted through a separate non-charitable entity.

Similarly, in Canada a charitable organisation is considered to be devoting its resources to its charitable activities to the extent that it carries on a `related business'. A `related business' can include a business unrelated to the objects of the organisation if substantially all those employed in the business are volunteers.

In the United States, the distinction between two `types' of commercial activity is set out in the Internal Revenue Code. While a charity is tax exempt, it may be liable for tax on its unrelated business income (that is, a trade or business regularly carried on and not substantially related to achieving the exempt purpose of the organisation).

Contrary to overseas practice, the predominant position submitted to the Committee was that as long as the funds generated by the commercial operation were used within the organisation then it should be regarded as an appropriate activity of a charity. For example, the Bobby Goldsmith Foundation (BGF) noted that they `engage in surplus making or semi-commercial programs in order to apply that surplus to charitable and benevolent programs that run at a substantial cost (eg 100 per cent of direct financial assistance provided to BGF clients represents revenue from fundraising and `for profit' activities.)'

Accountability

Jobs Australia argued that charities and related organisations should be accountable to communities and governments for how they generate and utilise funds from `activities that do not appear, prima facie, to have a direct religious, charitable or community benefit purpose'. The Hellenic Community Benevolent Association also argued for transparency to show how commercial operations contributed to the charitable purpose.

Mission Australia drew attention to how an entity structures its activities and argued that where a charity sets up a separate proprietary limited company to run its commercial activities it should be regarded as a separate entity and should not receive the same treatment as the charity that set it up.

If the charity had set this up as a new business within its existing structure then the risk will have been borne by the entity and the creation of a new service would have no effect on the definition of the entity. Similarly if it had set up a separate company limited by guarantee and meeting all the other requirements of a charity it may be defined as charitable in its own right.

The Australian Conservation Foundation commented to the Committee that the members of the charity will ensure that its commercial activities do not go against the purpose of the organisation. For example, as an environmental organisation, they argued that if they invested funds in a company running a uranium mine then `our members would start leaving us in droves'.

Reasons for undertaking commercial activities

Many submissions argued that charities needed and were expected to engage in commercial activities. The arguments are summarised by ACROD which noted that pressure to engage in income-generating activities more generally came from:

• a climate of fiscal restraint and increasing cost pressures;

• demand for services exceeding the level which can be met by current levels of government funding;

• increasing competition for philanthropic funds;

• governments expecting non-government organisations to find alternative sources of funding to subsidise their service provision;

• governments becoming increasingly reliant on non-government service providers; and

• a growing trend towards social entrepreneurship.

Governments supported the proposition that charities are now `expected' to actively generate additional funding. The Queensland Government noted that `in many cases there is a clear expectation by governments that organisations will set fees and raise funds in other ways to supplement government funding, despite the fact that the activity is a core service delivered through that organisation...'

A number of submissions also argued that charities were increasingly expected to operate in a business-like way in order to compete for government funding.

Competitive neutrality

Allen Consulting, commissioned by a consortium of for-profit companies active in the Australian health care sector, and Access Economics, commissioned by Kellogg's Australia, argued that the principles of competitive neutrality should be applied to the commercial activities of charitable and religious organisations. The concept of competitive neutrality underlies the Competition Principles Agreement between the Commonwealth, State and Territory governments. It ensures that government business enterprises operating in direct competition with private businesses do not enjoy tax, interest cost or other regulatory advantages over private businesses. The two submissions sought to have this approach applied to the competition between not-for-profit and for-profit providers.

The Committee received a small number of submissions arguing that commercial operations run by charitable and religious organisations had an unfair advantage when competing with for-profit organisations. The competitive advantage was said to be the result of taxation concessions that apply to the income and inputs of charitable and religious organisations, including their commercial operations. Submissions argued that the taxation concessions available meant that charities and religious organisations could undercut the competition. For example, Allen Consulting estimated that not-for-profit hospitals enjoy a tax advantage over for-profit hospitals equivalent to at least five per cent of total costs.

Income tax exemption

The Industry Commission addressed the issue of competition between for-profit and community social welfare organisations (CSWOs). ⁷ It concluded that:

...the income tax exemption does not compromise competitive neutrality between organisations. All organisations which, regardless of their taxation status, aim to maximise their surplus (profit) are unaffected in their business decisions by their tax or tax-exempt status.⁸

Access Economics, in a supplementary submission to the Inquiry, argued that the Industry Commission's conclusion flowed from a `pure competition' model of the economy and that when the assumptions underlying that model were relaxed, the conclusion did not hold. The Industry Commission itself argued that unfair competition might be valid in cases of oligopoly and Access Economics argued that in Australia oligopoly had been `close to reality for extended periods of time'.

ACOSS argued that the unfair competition argument was weak with regard to the income tax exemption because charities and related organisations did not have `income' in the sense in which that term is used in the taxation laws. That is, they did not have profits to distribute to shareholders, beneficiaries or members because their funds were devoted to the provision of services. Allen Consulting said that it was misleading to argue that concessional tax treatment allows charitable organisations to generate funds for charitable purposes because a business entity that was subject to tax could still make tax deductible donations to the charity.

An argument was also submitted that the income tax exemption allowed charities and related organisations to retain more profits for reinvestment, allowing them to expand more rapidly than their for-profit competitors and to capture greater market share.

Against that, charities pointed to their inability to raise equity or debt in capital markets, so that generating a surplus from their commercial activities was the only way to build up reserves to undertake capital works or longer-term commitments. For example, the Queensland Hospitals Foundations submitted that they required reserves to commit to funding multi-year projects to attract good researchers.

The Industry Commission noted that the income tax concessions available to CSWOs provided them with some advantages over for-profit firms, such as cash flow. It also noted that for-profits had advantages over CSWOs, such as easier access to capital, and concluded that `the overall situation is unclear'.⁹

Input taxes

Charities and related organisations also have access to concessional treatment of fringe benefits tax (FBT) and goods and services tax (GST) concessions at the Commonwealth level and to concessional treatment of payroll tax, rates and land taxes at the state level. Allen Consulting estimated that the FBT exemption available to employees in public and not-for-profit hospitals implied a potential cost advantage of up to 7.5 per cent of total expenditure.

The Industry Commission argued that these exemptions provided a competitive advantage for the commercial activities of CSWOs compared with for-profits and that they could be distortionary because they provided an incentive for charities to favour the use of the inputs that attracted the concessional taxation treatment.

A number of submissions from charities argued that exemption from FBT was essential if they were to attract the high quality staff that they required, particularly given the pressure on them to increase efficiency and operate in a more business-like manner.

Allocation of public resources

Access Economics submitted that the current entity-based definitions applying to charities and related organisations adversely impacted on the effectiveness and efficiency of public sector assistance for the charitable and related sector because it allows such assistance to go to both charitable activities and non-charitable activities, such as commercial operations. As a result there was a potential source of non-transparent, non-accountable and therefore unfocused assistance with unintended costs to revenue. Given the `inevitable' budget constraint, some deserving causes might lose out.

Committee's conclusions

Commercial purposes

The issue of charitable entities engaging in commercial enterprises has long been contentious. The debate following the second reading speech upon the introduction of the Income Tax Assessment Act 1936 included a number of exchanges about whether the commercial operations of religious organisations were able to compete unfairly with private operators.¹⁰

The Committee approaches its consideration of this issue by applying the principles it recommends as the basis for the definition of charity; that is, that an entity must be not-for-profit and have a dominant purpose that is charitable, altruistic and for the public benefit.

If the commercial enterprise is not conducted for the profit or gain of any particular person or group of persons, including on winding-up, then it meets the not-for-profit requirement. To satisfy the second requirement, an entity must have a dominant charitable purpose or purposes; that is, any other purposes must further, or be in aid of, the charitable purpose or purposes or be incidental or ancillary to the charitable purpose or purposes. The dominant purpose of the entity must be altruistic and provide a benefit to the public or a sufficient section of it.

The Committee's view is that commercial enterprises operated by charities to generate funds for the charity's charitable purposes do further the charitable purposes. The Committee heard from charities that the competition for donations and philanthropic funds, and changes to the way governments fund activities undertaken by charities on their behalf, compel them to find innovative ways to raise funds. The Committee also heard that governments expect and encourage charities to find alternative sources of funding to supplement government funding. One plank of the Commonwealth Government's social coalition is to foster partnerships between the community and the for-profit sectors. Conducting commercial enterprises as a fundraising operation can be an important, at times essential, element in enabling a charity to achieve its charitable purpose.

Recommendation 18

That commercial purposes should not deny charitable status where such purposes further, or are in aid of, the dominant charitable purposes or where they are incidental or ancillary to the dominant charitable purposes.

The Committee sees no reason to treat commercial activities differently from other activities undertaken by charities. That is, activities must further the charitable purposes and cannot be illegal, against public policy, or support political parties or candidates for political office. These conditions should apply equally to commercial activities.

Accountability

The Committee is aware that charities operating commercial enterprises have the potential to result in charities becoming involved in activities that have no obvious connection with their charitable purpose. There is also the potential for some charities to become involved in activities that concern their members or the public more generally. Charities behaving in an increasingly business-like way may also raise some concerns with the public.

The potential for such concerns to emerge is not an issue that is appropriately addressed by seeking to alter the definition of a charity. Prohibiting charities from engaging in commercial enterprises would be an unnecessarily heavy-handed way to address these concerns.

We note the view put to us by the Australian Conservation Foundation that the response of the membership is an effective control on charities overstepping the mark and engaging in activities that run counter to their charitable purposes. While that may be the case for those charities that have an active membership base, it is of concern to the Committee that the limited public disclosure required of charities makes it difficult for the wider public to inform itself of the conduct of charities.

The Committee's preferred way of addressing these potential concerns is to seek to have the public provided with the information necessary to make an informed decision about the effectiveness with which the charity is seeking to meet its objectives and how its funds are being used. This is addressed more fully in Chapter 32.

Competitive neutrality

As mentioned, an argument put to the Committee in a small number of submissions was that the taxation treatment available to charities and related entities provides them with an unfair competitive advantage when they undertake commercial activities in the same market as for-profit providers. The submissions sought to redress this advantage by denying such entities charitable status.

The Committee rejects this approach. The definition of a charity should not be used as a way to overcome perceived shortcomings or unintended consequences of other laws and practices. It would also be inappropriate for the definition of a charity to change because other sectors of society engage in activities previously undertaken only by charities. The entry of for-profit providers into areas previously the domain of charities should not deny the charities their status if they retain their characteristics of being not-for-profit and with a dominant purpose that is charitable, altruistic and for the public benefit. Similarly, if charities engage in the provision of services in a commercial manner at the behest of government it would be unfair to deprive them of their charitable status.

Allegations of unfair competitive advantage generated considerable interest during the Committee's consultations. In recognition of that, the Committee offers a short commentary on the various arguments put before it. However, whether any action is required to address these matters is for taxation policy. The Inquiry's terms of reference do not seek our views on taxation policy and we do not intend to provide any. In particular, the Committee's conclusion that competitive neutrality should not be a factor in defining a charity is not a comment on the appropriate taxation treatment of charities.

As noted above, the Industry Commission's assessment of the issue in 1995 was that the income tax exemption did not provide a competitive advantage. They considered that charities, like for-profit operators, at times will seek to maximise their profit when engaging in commercial activity. The charity will then act in the same way as a for-profit entity that was liable for tax. At other times, charities will not seek to maximise their profit because the commercial activity is being pursued as part of their charitable purpose. As the Industry Commission noted, in this latter case it is the behaviour of the charities themselves, not their taxation treatment, which may represent `unfair competition'.¹¹

The Committee further notes that if a charity were to conduct its commercial activities through a separate entity that was subject to tax, it would still be possible for that separate commercial entity to eliminate any tax liability on profits that are distributed to the charity. If the profits of the commercial entity were distributed as a gift to a charity that is also a deductible gift recipient, a taxation deduction equal to the value of the gift is available. For those charities that are not deductible gift recipients, the recent introduction of dividend imputation credits for charities allows them to receive a rebate equal to any tax paid on dividends distributed to them from a taxable entity.

The Industry Commission did find that input tax exemptions available to charities lower the costs they face and give them an advantage over for-profit competitors. At the level of the Commonwealth Government, the taxes discussed were the exemption from sales tax and exemptions from FBT provided to public benevolent institutions (PBIs) and public hospitals.

The Committee notes that the advantages offered by these taxation concessions have been considerably reduced since the Industry Commission reported. Wholesale sales tax has been abolished and the GST introduced. The GST treatment of charities provides for exemptions only for those supplies that are not provided commercially. Charities and for-profit entities are treated equivalently in respect of commercial supplies. Caps have also been introduced on the concessionally treated fringe benefits provided to employees of PBIs and public hospitals. From 1 April 2001 the FBT exemption for PBIs has been limited to $30,000 of grossed up taxable value per employee. For public hospitals a cap of $17,000 has been in place since 1 April 2000.

It was submitted to the Committee that the current income tax exemption available to charities provides an unfair advantage by allowing charities to retain pre-tax profits for further investment. The charities counter that they do not have access to the capital markets and so retained earnings are their only way to generate reserves. Charities' lack of access to the capital markets operates as a check on their ability to become significant players in the market place. The Committee notes that there are currently no guidelines on the distribution of funds generated by charities constituted as incorporated or unincorporated entities. The ATO does provide some guidance on the distribution of funds from public charitable funds.¹² This sets out a case-by-case approach as necessary, but requires that a substantial part of the income of the trust be distributed while allowing some funds to be used to acquire assets which will produce more income for charitable purposes and the accumulation of some income for later distributions.

1 [1969] 1 AC 514.

2 [1969] 1 AC 514 at 544.

3 Re Florence Smith, dec; Executor Trustee and Agency Co. of South Australia v Australasian Conference Association Ltd [1954] SASR 151 at 159.

4 [1934] 51 CLR 1.

5 [1954] SASR 151 at 159 to 160.

6 Charity Commission for England and Wales April 2000, CC35 - Charities and Trading.

7 Industry Commission 1995, Charitable Organisations in Australia, Report No. 45, AGPS, Melbourne. The Industry Commission adopted the name community social welfare organisations (CSWOs) to describe that part of the sector that was the subject of its Report. While the Industry Commission noted that this included services `not popularly thought of as charities', it excluded significant parts of the sector which are the subject of this Report, notably education, health and religious organisations. However, the difference in scope does not affect the applicability of the Industry Commission's analysis of the issues discussed here.

8 Industry Commission, p K5.

9 Industry Commission, p K6.

10 Australia, Senate 1936, Debates, pp 1893 - 1898.

11 Industry Commission, p K3.

12 Australian Taxation Office, 23 June 1982, Taxation Ruling No. IT 340, Accumulation of Income by Charitable Funds.