New provisions in India affecting charitable institutions

17 August 2009

By Noshir H. Dadrawala

Direct Tax Code, 2009
Finance Act, 2009
Repercussions of Finance Act 2008

New Direct Tax Code 2009

A new Direct Tax Code has been proposed by the government of India, for which a draft and a discussion paper were recently released by the Union Finance Minister, Mr. Pranab Mukherjee.

The Direct Tax Code will replace the existing Income Tax Act that was enacted in 1961, which had replaced an earlier legislation of 1922 enacted prior to the country’s independence. The government intends to present the relevant bill during the winter session of parliament, after considering and incorporating, if seen fit, the opinions on its provisions from the public. The government hopes it will become law in 2011. 

The new code will completely overhaul and simplify the existing tax proposals for not only individual tax payers, but also corporate houses and foreign residents. The idea is to keep the provisions simple so that even an average taxpayer can understand the language, than having to go to chartered accountants and income tax practitioners. It will also introduce the concept of tax calculators. 

The new code proposes to cut tax rates to bring in more people and companies under the tax net, phase out profit-linked exemptions for companies and replace them with investment-linked incentives. Business losses will be allowed to be carried forward indefinitely, while rules for capital gains and mergers and acquisitions will be rationalized, according to the draft plan. 

The new code will also recast the powers of the Central Board of Direct Taxes, induce more transparency in decision-making and tune it to tax boards of countries like the USA, Canada and Britain. 

Effect of the Proposed Direct Tax Code on Charities In India

The Code replaces the phrase "charitable purpose" by the phrase "permitted welfare activities". Permitted welfare activities has been defined to mean any activity involving relief of the poor, advancement of education, provision of medical relief, preservation of environment, preservation of monuments or places or objects of artistic or historic interest and the advancement of any other object of general public utility.

Advancement of any other object of general public utility will not include any activity in the nature of trade, commerce or business, or any activity of rendering any service in relation to any trade, commerce or business, for a fee or for any other consideration, irrespective of the nature of use, application or retention of the income from such activity.

Trusts and institutions established for charitable purposes have generally enjoyed tax exemptions. However, the following shortcomings have been observed in the exemption regime:

  • a) The exemption regime is complex, overlapping and dissimilar since it varies across institutions based on their activities.
  • b) The provisions fail to meet the test of efficiency in as much as they provide different conditions for institutions carrying on similar activities.
  • c) The provisions also do not meet the test of equity in as much as the compliance cost for an institution varies depending upon the provision of law under which the exemption is granted.
  • d) The concept of income of such an institution has been the subject matter of litigation. Should gross receipts of the institution or the net income of the institution be reckoned as the income? This question has been the subject matter of extensive debate.
  • e) A vexed issue is whether the institution should be allowed to accumulate income not applied or utilized for charitable purposes and how the accumulation should be treated.
  • f) There is unending dispute whether a business is incidental to attainment of the objectives of the institution or not, since the income from incidental business is exempt from tax.

With a view to removing the aforesaid shortcomings, the Code proposes a new tax regime for all trusts and institutions carrying on charitable activities. The salient features of the new regime are as under:

a) The regime will uniformly apply to all non-profit organizations irrespective of the nature of their activities. b) An organization shall be treated as a non-profit organization if: (i) It is established for the benefit of the general public;
(ii) It is established for carrying on permitted welfare activities;
(iii) It is not established for the benefit of any particular caste;
(iv) It is not established for the benefit of any of its members;
(v) It actually carries on the permitted welfare activities during the financial year and the beneficiaries of the activities are the general public;
(vi) It does not intend to apply its surplus or other income or use its assets or incur expenditure, directly or indirectly, for the benefit of any interested person;
(vii) Any expenditure by the organization does not enure, directly or indirectly, for the benefit of any interested person;
(viii) The funds or assets of the organization are not used or applied, or deemed to have been used or applied, directly or indirectly, for the benefit of any interested person;
(ix) The surplus, if any, accruing from its permitted activities does not enure, directly or indirectly, for the benefit of any interested person;
(x) The funds or the assets of the non-profit organization are not invested or held in any associate concern or in any prescribed form or mode;
(xi) It maintains such books of account and in such manner, as may be prescribed;
(xii) It obtains a report of audit in the prescribed form from an accountant before the due date of filing of the return in respect of:

(A) The accounts of the business, if any, carried on by it; and

(B) The accounts relating to the permitted welfare activities; and

(xiii) It is registered with the Income-tax Department under the Code.

(c) The "permitted welfare activities" have been defined as discussed earlier;

(d) The tax liability of a non-profit organization shall be 15 percent of the aggregate of the following:

(i) The amount of surplus generated from the permitted welfare activities; and

(ii) The amount of capital gains arising on transfer of an investment asset, being a financial asset;

(e) The amount of surplus generated from the permitted welfare activities shall be the "gross receipts" as reduced by the "outgoings".

(f) The "gross receipts" shall be the aggregate of the following:

(i) The amount of voluntary contributions received during the financial year;

(ii) Any rent received in respect of a property consisting of any buildings or lands appurtenant thereto;

(iii) The amount of any income derived from a business which is incidental to any of the permitted welfare activities;

(iv) Full value of the consideration received from the transfer of any investment asset, not being a financial asset;

(v) Full value of the consideration received from the transfer of any business capital asset of a business incidental to its permitted welfare activities;

(vi) The amount of any income received from any investment of its funds or assets; and

(vii) All other incomings, realizations, proceeds, donations or subscriptions received from any source.

(g) The amount of outgoings shall be the aggregate of:

(i) Voluntary contributions received during the financial year by the nonprofit organization made with a specific direction that they shall form part of the corpus of the non-profit organization;

(ii) The amount actually paid during the financial year for any expenditure, excluding capital expenditure, incurred wholly and exclusively for earning or obtaining any "gross receipts";

(iii) The amount actually paid during the financial year for any expenditure, excluding capital expenditure, on the permitted welfare activities;

(iv) The amount of capital expenditure actually paid during the financial year in relation to: 

(a) Any business capital asset of a business incidental to any of the permitted welfare activities; or

(b) Any investment asset, not being a financial asset.

(v) Any amount actually paid during the financial year to any other nonprofit organization engaged in a similar permitted welfare activity;

(vi) Any amount applied outside India during the financial year if the amount is applied for an activity which tends to promote international welfare in which India is interested and the non-profit organization is notified by the Central Government in this behalf.

(h) The surplus generated from permitted welfare activities will be determined on the basis of cash system of accounting. Capital gains arising on the transfer of an investment asset, being a financial asset, will be computed in accordance with the provisions under the head "Capital gains".

(i) A non-profit organization will be prohibited from investing any of its funds or holding any of its assets in any associate concern or in any prescribed form or mode.

(j) It will be mandatory for every non-profit organization to register with the Income-tax Department by making an application to the Chief Commissioner or Commissioner concerned. The Chief Commissioner or Commissioner will be required to pass an order within three months from the end of the month in which the application is received. If the order is not passed within three months or registration is refused, the applicant shall have the right to appeal before the Income Tax Appellate Tribunal.

The finance ministry has uploaded on its website (www.finmin.nic.in) the draft direct tax code, a discussion paper, a comment on the code, and what rating people would like to give to it.

Finance (No.2) Act, 2009

The Finance (No.2) Act, 2009 which is applicable with retrospective effect from April, 1 2009 will have the following effect on charitable institutions in India.

Definition of ‘Charitable Purpose’

The scope of Section 2 (15) of the Income Tax Act has been broadened. Prior to this amendment, “Charitable purpose” included: “relief of the poor, education, medical relief and the advancement of any other object of general public utility”. 

Finance (No.2) Act 2009 has now added: “preservation of environment (including watersheds, forests and wildlife) and preservation of monuments or places or objects of artistic or historic interest”.

Anonymous Donations

Section 115BBC was introduced for the first time by the Finance Act 2006 to tax anonymous donations to charitable organizations at the maximum marginal rate of 30%. 

A degree of relief has been provided under the present amendment such that anonymous donations aggregating up to 5% of the total income of the organization or a sum of rupees hundred thousand, whichever is higher, will not be taxed.

Repercussions Of Finance Act 2008 W.E.F. April 1, 2009

The Finance Act 2008 which has come into effect from April 1, 2009 has far reaching effect on charitable organizations which have been established for a purpose other than relief of the poor, education and medical relief.

The Finance Act, 2008 has excluded any trade, commerce or business related activity by any trust or NGO having as its charitable purpose “the advancement of any other object of general public utility”. 

Charitable organizations exclusively engaged in the field of education, medical relief and relief of poor are NOT affected by this amendment.

With effect from 1st April 2009, income from trade, commerce or business of those NGOs which fall under the fourth category of 'charitable purpose' (i.e. “the advancement of any other object of general public utility”), shall not be treated as charitable activity and the entire exemption of such Trust will be lost. 

Consequently such organizations will not be eligible for any exemption under section 11 or other provisions which provide exemptions towards charitable purpose. Even if the business activity of such an organization is incidental, it will lose its charitable status.

There seems to be a belief among some accountants that only the business income of the organization will become taxable at the rate of 30%. The fact is, if the organization is hit by this provision it will loose its charitable status and the entire income will become taxable.

It is pertinent to note that this amendment prohibits “business activity” and NOT “profit making”.In other words generating profit through charity shows, rent from property or conferences facilities, etc. is permissible and valid. 

However, the CBDT’s circular categorically denies incidental business or commercial activities such as marketing products of the beneficiaries or greeting cards etc, on a regular basis.

Many experts are of the view that Consultancy income should not be considered as part of business or commercial activity. ‘Consultancy’ is a professional exercise based on intellectual capital and expertise.

Going by the statute and various case laws, the following activities by charitable organizations established for “the advancement of any other object of general public utility” would not be considered as business income:

  • Income from Consultancy;
  • Income from rent (from immovable properties);
  • Income from conference halls and other such facilities;
  • Income from one time activities such as charity shows, etc;
  • Income from professional service related with expertise incidental to charitable work, etc.