Setting up a charitable organisation is common in Hong Kong, as Hong Kong citizens have always been committed to serving the community. The HKSAR Government also offers generous tax allowances to both individual and corporate donors to tax-exempt organisations (up to 35% of annual taxable income). Having said that, the Audit Commission recently reviewed the tax exemption approval process and noted that the Hong Kong Inland Revenue Department ("IRD") should be exercising closer monitoring on whether these charitable organisations continue to fulfil their tax exemption requirements 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 updated and clarified version of its guidelines for charitable institutions, illustrating its firm resolve to review the tax exemption status of charitable organisations.
Requirements for tax exemption status, in brief
Not every non-profit-making organisation is an approved charitable organisation. In order to qualify for tax exemption status as a charity, the organisation has to be established exclusively for one of the following four purposes:-
- the relief or poverty;
- the advancement of education;
- the advancement of religion; or
- other purposes of a charitable nature which serve the community.
In the first three headings, the organisation can provide services for people across the globe, while for the fourth heading, the organisation can only serve the community in Hong Kong. Examples of acceptable purposes for the final heading include the relief of illness, or assisting the physically and mentally disabled, and the promotion of health.
Another point to note is that a charitable organisation should be geared toward serving the 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, it should instead apply for the tax exemption available to clubs and trade associations under Section 24 of the Hong Kong Inland Revenue Ordinance (IRO).
Though not specifically required, an approved charitable organisation is usually set up in the form of a company limited by guarantee. A written governing instrument -- in this case, the Articles of Association (AA) -- should be in place as a means of governing the activities of the organisation.
Written governing instrument
The latest IRD guidance points out that certain clauses should be in place in the written governing instrument or AA of a charitable organisation. In this section, we would like to highlight some of the common mistakes committed by charitable organisations in violating their written governing instruments. Please note that such violation may trigger termination of the tax-exempt status.
a) Precise and clear objects of the charity
The object of a charity set out in the AA should fulfil one of the above four headings required by the IRD, which should thereafter be strictly followed by the organisation. Occasionally, after several years of operations, members of an organisation may have slightly different thoughts on the object of the organisation. While the IRD also accepts activities that contribute indirectly to the objects of the organisation, it is suggested that an organisation should thoroughly consider all possible objects of the organisation to include in the AA, as long as these are within one of the four acceptable headings, if they wish to avoid being challenged by the IRD. In case an organisation wishes to change its objects, it should take the initiative to revise its AA.
b) Limitations on application of funds towards the attainment of stated objects
Charitable organisations should exercise stringent control of their fund applications. In reality, the lack of internal control in some organisations could result in them lending their funds to related parties, without charging interest. This lending is shown as "amount due from related parties" in the financial statements. Such a practice should be avoided, unless the lending was directly related to the objects of the organisation (e.g., engage another charitable organisation with the same objects to provide the services). Otherwise, the IRD may challenge whether the funds were used to support the objects of the organisation.
On the other hand, for interest-bearing loans, if the loan was not directly related to the objects of the organisation, the interest income may be subject to Hong Kong profits tax, even where tax exemption status has been granted. Only income that is directly related to the approved objects are exempted from tax.
c) Prohibitions against members receiving remuneration
While the majority of charitable organisations are aware that remuneration at the market rate should not be given to its members, they would prefer to reimburse part of the outlays incurred by members while supporting the activities of the organisation. These reimbursements should be made based on the exact amount of expenses incurred by the members with supporting documents (e.g., vouchers). Strictly speaking, travel allowance without supporting vouchers is not permissible, despite it being a trivial amount.
What a charity should be aware of in the monitoring process
There is a common misconception that, once the tax exemption status is granted, all income derived by the charity is exempt from Hong Kong profits tax. In fact, charities often 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 examine the tax implications arising from i) investment in securities; ii) leasing of premises; and iii) sales of goods.
i) Investment in securities
It is customary for a charity to make investments when it has surplus cash. Some charities may wrongly consider that, as long as the investment returns are ultimately used to further their objects, the investment income would automatically be exempt from Hong Kong profits tax. However, based on our understanding of the latest IRD guidance, it would apply the "badges of trade" test and would seek to charge tax on gains on short-term speculation activities. Long-term investment capital gains are not subject to tax in Hong Kong.
In order to enhance the chance of a non-taxable claim being accepted, it is recommended that before making each investment, a charity should set up a detailed concrete investment plan, including an investment horizon and expected investment return, and how the utilisation of investment returns will be used to meet the organisation's specific charity projects in the future. This could help demonstrate that the intention of acquiring the investment is not for short-term trading purposes.
On the contrary, investments in high-risk volatile assets (e.g., derivatives), as well as a high frequency of trading, are unlikely to be lodged as capital gains claims, as the IRD will consider that it is difficult for the charity to predict the investment returns to meet the funding needs for its charity projects.
Lastly, a charity is discouraged from investing in companies that are associated with its members, as the IRD may perceive this move as being for personal benefit rather than public benefit, and may therefore disallow tax exemption status of the whole company.
ii) Leasing of premises
Rental income is exempt from Hong Kong profits tax only when it is derived in the course of charitable activities. In this regard, a charity which leases property out at market rent, without focusing on any specific target group of tenants, is unlikely to be considered as being for charitable purposes. As such, in order to enhance the chance of obtaining tax exemption status, charities should consider setting different rates of rental charges and offering discounts to its target group of beneficiaries.
iii) Sales of goods
Under the following circumstances, profits from sales of goods are generally exempt from Hong Kong profits tax:-
when donated goods are sold without alternation; and
when selling activities and/or production of the goods are mainly carried out by the beneficiaries of the charity.
Application procedure for tax exemption status
Under normal practice, a charity would seek tax exemption status approval from the IRD prior to the commencement of its activities. The following documents should be 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
Audited financial statements enclosed in annual tax filings are generally the first documents the IRD will refer to in a tax exemption review process. As such, charitable organisations should seek advice from an audit firm and a tax advisor familiar with Section 88 of IRO, i) before making important decisions, and ii) in the preparation of audited financial statements.