The ATO’s draft Taxation Ruling TR2014/D5 considers in detail the questions which an entity must ask in deciding whether it satisfies two particular legislative tests.

Governing Rules condition

The following three questions are used to determine whether an entity satisfies the Governing Rules condition:

  1. What are the 'governing rules' of the entity? 
  2. What are the 'substantive requirements' in the entity's governing rules? 
  3. Has the entity complied with all of the substantive requirements in its governing rules? 

An entity’s governing rules typically relate to the establishment, operation and winding-up of the entity and are usually to be found in its foundation documents (for instance, it’s constitution, trust deed or memorandum of association, as applicable).  The substantive requirements in an entity’s governing rules are those which define the rights and obligations of the entity and include those requirements which give effect to the purpose or objective of the entity, relate to its non-profit status or require financial records to be kept.
To meet this test, an entity must satisfy the Governing Rules condition at all times during the applicable income year.
On the surface this part of the draft ruling does not seem to give rise to significant concerns, however, as noted in relation to the Income and Assets condition below, the Governing Rules condition may become critical in considering the impact of accumulating income.

Income and Assets condition

The draft ruling highlights the following two key questions which must be considered by an entity in deciding whether it satisfies this condition:

  1. What is the 'purpose (or purposes) for which the entity is established'? 
  2. Has the entity applied its income and assets solely for the purpose(s) for which the entity is established?

Broadly, the purposes for which an entity is established encompass its main purpose or objective, together with any incidental or ancillary purposes.  This component of the test:

  • requires the entity to consider not only the purpose for which it was established at the time of formation but also the purpose for which it is currently conducted, ascertained by both an examination of the entity’s constituent documents and the nature of its day-to-day activities; and
  • needs to be considered on a continuous basis, so that where there has been a change in purpose the entity should meet the current purpose at all times

The Income and Assets condition requires an entity to apply all of its income and assets only for the purpose for which the entity is established and not for any other purpose. The draft ruling does confirm that insignificant, one-off misapplications may be ignored in determining compliance with this condition. 

However, most importantly, the ATO specifies that an entity that accumulates most of its profits over a number of years will need to be able to show that this accumulation is consistent with its purpose.

The draft ruling contains various examples considering the impact on an entity’s tax exempt status of situations such as private benefits being derived by its office holders, profits from commercial activities being generated, a change in the entity’s purpose throughout an income year and where an insignificant misapplication of assets or income occurs.

In an example relating to the accumulation of income, a scientific organisation with a five-year plan to accumulate funds to upgrade research facilities and employ a research scientist, retains approximately one third of its funds in a year. This accumulation of funds is regarded by the ATO as being consistent with the entity’s objects and does not trigger a breach of the Income and Assets condition. 

Therefore, in practical terms it might be necessary for entities to document formal plans in relation to any accumulation of funds to be in a position to demonstrate that the Income and Assets condition is being satisfied.  

The draft ruling serves as a timely reminder that Constitutions can become neglected over time and as the organisation evolves, the application of assets and the activities of the Not for Profit can become disconnected from the original purpose described in the Constitution. This can create taxation and other risks for the organisation.

In order to ensure compliance, Not for Profits will need to ensure that they undertake regular reviews of their Constitution in the context of their current plans and operations. 

An addendum to the draft ruling also provides guidance on the likely approach by the ATO where an entity takes corrective action in relation to a breach of either of the above-mentioned (tax exemption) conditions.