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Taxation of Charitable Trusts

Given the large need for services in social development and social welfare areas, which the state is unable to meet in sufficient measure, and the need to encourage and support non-profit organisations promoting cultural activities as well those 'civil society' organisations defending civil liberties, promoting the welfare of women and children, etc, the state should spare from tax income that does not accrue to any individuals or juridical persons for private benefit. The acceptance of the recommendations of the Advisory Group on Tax Policy and Tax Administration for the Tenth Plan on tax treatment of charitable organisations would do grave damage to the work of the voluntary agencies which form one of the heart-warming and bright aspects of our society.

It has recently been reported in the press that a committee has been set up by the CBDT in the department of revenue, government of India, to review the income tax provisions regarding the tax treatment of charitable trusts and institutions as well as some other related provisions. This review is said to have been undertaken in pursuance of the relevant recommendations made by the Advisory Group on Tax Policy and Tax Administration for the Tenth Plan in its report submitted to the Planning Commission.1 In this note, I propose to examine and evaluate the recommendations of the advisory group on the tax treatment of the charitable institutions now covered under Sections 11 and 10 (23C) of the Income-Tax Act.

Section 11 of the Income-Tax Act deals with the tax treatment of income from property held in trust and income of institutions engaged in philanthropic activities, where the income is not distributed to any one who controls the trust, a trustee or a board member. The various subsections of Section 10 (23C) relate to the tax treatment of income of educational institutions, hospitals and other medical treatment institutions existing solely for philanthropic purposes and not for purposes of profit. (There is some overlap between the institutions covered under these two sections.)

The advisory group has made recommendations calling for some drastic changes in the above-mentioned sections. If these recommendations are accepted, as also the recommendations on the tax concessions at present extended to donations to approved institutions, the activities of charitable institutions including non-profit educational institutions and philanthropic medical institutions would be very adversely affected. Hence these recommendations need to be very carefully examined to see if there is sufficient merit in them as against the harm which their implementation would cause to charitable and philanthropic activities in the country.

It is of course desirable that the base of the income tax should be broadened as much as possible subject to the fulfilment of basic criteria, and that unwarranted exemptions should be removed. However, the removal of exemptions should not be governed only by the consideration of increasing revenue.

The principle of horizontal equity requires that all accretions to the ability to pay of individuals should be included in their respective taxable incomes, with suitable adjustments, where necessary. Such accretions to juridical persons (organisations) which reflect accretions to individuals, because they are the ultimate beneficiaries, should also be part of the tax base. One of the basic reasons why the income of charitable trusts or non-profits organisations (NPOs) should not be taxed is that such income does not accrue to an individual or benefit those who control or run the NPOs. If the income of an NPO is exempted from tax, it is usually stipulated that no part of its income should be distributed to the members, directors or trustees. Even where an exemption provision does not mention such a constraint explicitly, as in the case of subsections under Section 10 (23C), the condition of non-distribution is implicit, because these provisions apply only to institutions that should be “solely for philanthropic purposes and not for purposes of profit”.2 Another important reason for granting tax exemption to NPOs is that they are providing important services that augment social welfare and that they are providing these services free or below cost or at the most very near cost. (The NPOs are not allowed to run large surpluses.) Third, to a significant extent, the services provided by NPOs in many fields supplement the social sector and social welfare services provided by the government, by increasing the range and volume of services, by filling in gaps and in some cases by improving quality. Government expenditure in the concerned fields could be lower than it otherwise would have to be.

Most of the charitable trusts and institutions are largely dependent for their finances on donations and on income from investment of the corpus, built up out of the capital donations. These two sources are supplemented by fees charged for services (to cover part of the cost) closely related to the objectives of the trust. Thus a non-profit educational or research institution might undertake research work on behalf of government or other organisations and receive fees or payment for that work. Such income from activities which are related to, and further, the objectives of the trusts are exempt from tax and should remain exempt. According to the existing law, the income or profits of a trust derived from activities not related the trust’s basic objectives have to bear tax.

There are a number of NPOs that receive financial aid from government, e g, aided colleges, universities and philanthropic medical institutions. Their non-aid income is now exempt under Section 10 (23C) (iii ab) and (iii ac). For a given scale and quality of services, to the extent that these institutions derive or raise some income additional to government aid..., the latter can be lower.

The advisory group has taken an extreme position and recommended that income tax exemption should be provided “only to donative NPOs”. It has also recommended that a donative NPO should be defined “as one where 90 per cent of the annual receipts is through donations including lump sum aid...” (p 114). If this most unreasonable recommendation that only donative NPOs, as defined by the advisory group, is accepted most charitable institutions and universities and colleges will become subject to tax at a rate applicable to ‘Association of Persons’. That would have a highly deleterious effect on the operations of NPOs. As pointed out earlier, a majority of NPOs depend for their finances on income from investments (in approved securities), on donations and some service fees. They cannot be expected to survive mainly on annual donations. The main source in the case of most charitable trusts is the income from the investment of corpus, generally speaking. Large private donations can come only occasionally. If NPOs which depend mainly on investment income are denied tax exemption, it would be tantamount to abolition of the exemption provision.

In this connection it is to be presumed that the advisory group would include aid/grant from government in ‘donations’. In that case, a government aided institution would remain exempt from tax only if the government aid it receives and other current donations account for at least 90 per cent of its income in a year. This means that universities and colleges will become taxable if the fees they charge exceed 10 per cent of their respective incomes! This follows from the fact that the advisory group has recommended the deletion of Section (23C) (iii ab) (iii ac) and (iii ad) which at present grant exemption to philanthropic educational institutions and universities. What the advisory group has recommended will do grave damage to higher education as the government does not have enough resources to finance the universities on an adequate scale and certainly there should be no disincentive for charging more than 10 per cent of current expenditure as student fees. Universities, other educational institutions and scientific research institutions should also be allowed to undertake research work in return for fees on behalf of government departments and industry groups, etc, without the risk of losing their tax exempt status.

I would urge the government to reject totally the recommendation of the advisory group given on p 114 of its report that “the law should be amended to provide the tax exemption only to donative NPOs” which according to the group are those who receive 90 per cent of their annual receipts through donations. The existing provisions are quite reasonable and should be continued.

An argument is sometimes put forward that tax exempt NPOs are enabled to compete on an unfair basis with firms run for private profit, making more or less the same commodities or providing similar services. Now, the Memorandum of Association of a charitable trust clearly specifies the major objectives of the trust and the major activities it would undertake. They are such as to increase social welfare. It is on that basis they are granted registration. It is in the public interest to make it possible for the charitable institutions to provide essential services at a lower cost to the poorer sections. In any case, the existing law stipulates that income of an NPO derived from activities not closely related to its basic objectives will be taxable. If found necessary, this provision could be tightened.

 

Tax Treatment of Donations

The advisory group has recommended in its report amendments also to the income tax provisions relating to concessions in tax granted to taxpayers making donations to approved charitable institutions such as Sections 80-G and 35 (1)3. These provisions grant a deduction from taxable income based on the amount of the donation. For example, under Section 80-G, the donor is entitled to a deduction equal to 50 per cent of the donation and under Section 35(1)3, 100 per cent of the donation. Another way of granting a concession by way of incentive is to give a rebate for the amount of donation at a specified rate against tax liability. The former method gives gain (in terms of tax saved) to taxpayers at different income levels at their respective marginal rates, whereas the latter gives it at the same rate. So under the income deduction method, all taxpayers other than those subject to the lowest marginal rate get greater incentive to donate.

Insofar as the larger part of donations is likely to come from the upper income taxpayers, the income deduction method would be more effective in inducing donations. But some hold the view – this is the view of the advisory group too – that the tax rebate method is more equitable, because under that method all taxpayers would get the same tax saving for a given amount of donation. Assuming that this is a valid argument, one has to choose between a more effective and more equitable method. Obviously, income deduction method is the more effective one. But the equity argument itself is not very strong. It does not seem equitable to tell a taxpayer that if you add a certain amount of income to the existing level, we will tax that additional amount at the marginal rate, but that if having earned that amount you give it away as donation to a charity, we will reduce your tax liability only at a lower standard rate. The point to keep in mind is that tax liability is to be linked to ability to pay which is reflected by income. If part of the income earned is given away to approved donees, there is reduction in the ability to pay and it seems proper to reduce the tax liability accordingly. Of course, the government could rightly set a limit on total deductible donations in a year.

The advisory group has totally opted for the tax rebate method in all cases of tax concessions whether they are for directing savings into particular channels or making donations or making pension contributions.3 The group apparently gave little weight to giving a fairly strong incentive to make charitable donations, but was largely concerned with maximising gross revenue. The group has not only recommended that only a tax rebate should be given in respect of approved donations, but also that the rebate should be granted only at the lowest marginal rate. The equity argument that the advisory group has used against the income deduction method only suggests that the tax rebate method is preferable. That is, the gain should be the same proportion of donation for all taxpayers. The group seems to argue that since the lowest marginal rate is 10 per cent now, the rebate should be granted at 10 per cent only. The lowest marginal rate has nothing to do with the equity argument. The group’s recommendation can only be justified on the ground that it is most important to minimise the loss of revenue.

I think that the present provisions governing donations under 80-G, etc, are quite sound, being based on the balance of relevance considerations and that therefore the recommendation of the advisory group in this regard should be rejected.

The advisory group made a rough estimate of the loss of revenue from exempting the income of charitable institutions and extending tax concession to charitable donations to be of the order of Rs 3,000 crore as of 1996-97. This seems to be an overestimate, because it has been made on the assumption that the entire GDP from health, education and religious activities represents income exempt under Sections 11 or 10(23C). This is wrong because all government-owned institutions in these areas are part of government sector and will in any case be non-taxable. Besides, not the entire income, but only that part which is in excess of revenue expenditure will be taxable. Even assuming that the estimate made by the group of a possible loss of Rs 3,000 crore to be correct, the net loss to the exchequer would still be negative because of the saving of government expenditure that would have to be incurred to replace the expenditure by charitable institutions in crucial areas. Since in the case of these institutions, income excluding contributions to the corpus would be more or less equal to expenditure, taking one year with another, the loss to revenue would only be a fraction of the expenditure stimulated.

Given the large need for services in social development and social welfare areas, which the state is unable to meet in ample measure, and the need to encourage and support non-profit organisations promoting cultural activities as well those ‘civil society’ organisations defending civil liberties, promoting the welfare of women and children, etc, the state should spare from tax income that does not accrue to any individuals or juridical persons for private benefit. The acceptance of the recommendations of the advisory group would do grave damage to the work of the voluntary agencies which form one of the heart-warming and bright aspects of our society.

 

 

Notes

Report of The Advisory Group on Tax Policy and Tax Administration for the Tenth Plan (constituted by the Planning Commission, government of India) 2001.
2 It found legally recarry, the constraint of non-distribution can be introduced in the provisions under Section 10(23C).
3 In this case, the income deduction method would be more appropriate, because when the pension is received the marginal rates will apply.

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