Acting outside your objects - Tax and other consequences
Some people believe that trading is prohibited for PBOs, and others that all income of PBOs is tax exempt. Neither of these is true, and the answer lies somewhere between the two extremes: Under Section 10(1)(cN) of the Income Tax Act, all non-trading income and some types and parts of trading income are exempt from tax if the organisation has PBO status.
Any organisation with PBO status potentially receives three categories of income:
- Non-trading tax exempt income;
- Non-taxable trading income; and
- (the rest) which is taxable trading income.
One way to understand this is that PBO status is granted to your organisation, but tax exemption only applies to certain parts of the organisation’s income stream.
Section 10(1)(cN)(ii)(aa) says that business or trading income which satisfies all of (A), (B) and (C) in that section will not be taxable. The three parts (summarised) are:
- The income is integral and directly related to the object of the PBO; and
- It is substantially a cost-recovery operation; and
- Taxable entities are not unfairly competed with.
A recent SARS Private Binding Rule (BPR 348) examined part (A) in relation to a particular PBO. (Although these BPRs are not of general legal application, they do give an indication of how SARS will approach and interpret this part of the law.)
In this case, the PBO was set up with the object of promoting entrepreneurship through education and training. It now wished, as part of its entrepreneur-training programme, to provide seed funding to young entrepreneurs. The proposed loans granted to the beneficiaries would not attract interest in the usual way, but beneficiaries would repay the loans by paying a small percentage of monthly revenue to the PBO. The income received by the PBO would be used to provide further funding or for other PBAs.
SARS was approached by the PBO for a BPR on whether the income earned by the PBO on the loans would be taxable trading income.
SARS ruled that it would consider the income as taxable trading income, as (in SARS’ view) the activity would not be ‘integral or directly related’ to the objects of the PBO. (SARS did confirm, however, that the PBO ‘basic exemption’ amount (5% of gross income under 10(1)(cN)(ii)(dd) would apply, so that an amount equivalent to 5% of the entire income (of all types) of the organisation, would be exempt from tax).
On the main ruling made by SARS we feel that there would be scope to argue that part of the training was on-the-job and required working experience and that the seed funding provided was an essential part of and thus integral and directly related to, the training provided. If this were a case which went to court, the PBO would be able to make this argument and it might prevail.
There is another way to fix the tax problem, and that is by the amending of the objects of the organisation to include provision of micro-loans. This option, though, is not without risk, as the relevant PBA for these micro-loans (1(p)) has traditionally been very narrowly interpreted by the Tax Exemption Unit, and SARS must be notified of any amending of the objects, and may pick up on this and, depending on the scale of the enterprises being supported, may not approve under 1(p).
In a way, it would be better for the non-profit sector as a whole if the organisation which applied for this ruling took SARS on and argued the ‘integral and directly related’ case. Winning this case would set a very useful precedent for the sector and guide for SARS in future.
Our main note to all organisations on this (even those with no trading income to be thinking about) is not chiefly about possible tax consequences.
It is very important to be aware that the objects clause in your founding document both enables and constrains the work the organisation may do. Putting aside the tax consequences, your organisation is simply not permitted to engage in activities which do not fall within the stated objects in the founding document.
There are two main legal drivers behind this:
- Any sort of non-profit organisation is set up for a purpose (and not for profit). Contractually, those who govern the organisation are bound by the expressed purpose in the founding document, and are not permitted to authorise activities and expenditure not falling under the recorded objects; and
- In terms of section 30(3)(b)(ii) of the Income Tax Act any PBO “ …is required to utilise its funds solely for the object for which it has been established.”
Things change, work shifts, new ways are found of doing things. At every twist in the road or new path taken, the Board needs first to review the objects clause of the organisation, and, if necessary, put in motion the process to amend it to permit any changes.