In reviewing and formulating appropriate fiscal legislation with respect to NPOs, a number of critical issues need to be addressed. These include the following.

5.1 The two distinct South African tax benefits

5.1.1 As in most countries which have devised fiscal regimes favourable to NPOs, South African law recognises two distinct benefits which are available, viz:

1. an exemption available to the NPO itself in respect of its liability for income tax, and other fiscal levies; and
2. a right available to donors to deduct from their taxable income, limited amounts representing philanthropic contributions for the benefit of eligible institutions.

5.2 Problem of defining eligibility criteria

5.2.1 A key problem which becomes evident in most countries surveyed, is the matter of defining eligibility criteria and identifying activities and organisations which qualify for beneficial tax treatment. A summary of the survey appears in Appendix 1.

5.2.2 Each country has sought to grapple with these problems and achieve a tax regime which is certain, equitable and administratively practical. Of particular interest is the United Kingdom which has devised a novel solution to the problem of donor tax deductibility by stipulating minimal amounts and requiring a written "covenant" for a period which may exceed three years. The mechanism for conferring such benefits is to afford the charity the right to reclaim from the fiscus, the amount of tax attributable to the donation in the hands of the donor. By contrast, South Africa permits the donor to deduct eligible donations from taxable income. The United Kingdom method is administratively- sophisticated in that it limits the need for fiscal oversight to the relatively small number of charitable institutions reclaiming tax, rather than requiring oversight over a multitude of tax-paying donors.

5.3.1 It is necessary to devise formulations which are clear, flexible, and have reference to objective criteria, which do not rely upon arbitrary or subjective discretions. Wording such as "activities which the Commissioner is satisfied are of a cultural nature" (s.10(1)(cB)i(dd)) need to be avoided. Moreover, section 18A - which itself contains three pages of definitions, including definitions within definitions - must be reduced to plain language. Philanthropic needs and methodology change over time. Accordingly, the legislation should have a degree of flexibility, both as to eligibility criteria and as to the quantum and nature of fiscal benefits conferred. The legislation should make provision for the Government to focus its own fiscal priorities on particular social issues which may change with the passage of time.

5.3.2 It is undesirable to vest sweeping discretions in the Commissioner. Ideally, the legislation should provide clear objective criteria which can be uniformly applied by reference to jurisdictional facts, thereby removing concerns about subjectivity, inconsistency and perceived discrimination.

5.4.1 Any system should recognise the severely limited resources available to the South African Revenue Service. The system should not place undue demands upon Revenue personnel to monitor and exercise oversight thereby preventing "tax leakage" and abuse. Accordingly, the provisions should, insofar as possible, be self-regulating and should be devised in a manner that limits the need for extensive audit.

5.5.1 As Salamon has pointed out, in granting tax exemptions and other fiscal privileges, the fiscus is passively co-opted into benefiting eligible organisations and donors to the extent of tax waived or deductions permitted. Democratic governments are rightly jealous of their prerogative to order and determine their own fiscal priorities, with due regard to changing social needs. Accordingly, a system that is overly liberal as to eligibility and uniform as to benefits granted, would not only represent an indeterminate fiscal cost, but also in effect deprive Government of its ability to make its own choices and direct its own social spending, as it deems appropriate.

5.5.2 In particular, a recommendation to expand the range and scope of deductions for donations to NPOs beyond the present dispensation provided for in terms of section 18A raises the issue of whether the tax system is the appropriate mechanism for supporting the commendable work of such organisations. Two fundamental problems need to be addressed, namely:

1. the potential for the tax base to be eroded by means of incentives, introduced all too often as a result of special pleading that does not amount to rational justification for the measure and, as a result of which, the Government's scope to reduce rates of tax to internationally-competitive levels is severely reduced; and
2. a system of special exemptions and deductions raises the possibility of abuse, particularly in the form of tax-based schemes.

5.5.3 The Commission has taken careful cognisance of these concerns by attempting to frame its proposals in terms of the approach adopted by the Commission in its Interim (First) Report, namely:

"The Commission's policy is that the range of incentives should be narrowed as far as possible and that those which exist should all be justified in terms of the objectives in the Reconstruction and Development Programme. If this approach is adopted it will assist in preventing tax leakage and in promoting the closure of the gap between effective and nominal rates of taxation."12

5.5.4 For the same reason, the Commission considers that the selection of categories of activities within the NPO sector that should be eligible to benefit from a beneficial dispensation should be decided upon by Government in terms of its own developmental priorities.

5.6.2 The Commission has taken note of various foreign tax regimes which have drawn a distinction between "related" and "unrelated" trading activities. The notion of "relatedness" refers to the nature of the trading activity as having some substantive relationship with the philanthropic purpose of the organisation. One concern has been to ensure that "trading" activity does not become the de facto raison-d'etre of a tax-exempt organisation, providing more private inurement than public benefit. Thus, overly generous remuneration packages, consultancy fees, rentals, administration charges and other devices can be used as the conduit for personal benefit.

5.6.3 Apart from the test of "relatedness", suggestions have been made that the fiscus needs first to determine the fiscal cost in terms of lost revenue or, alternatively, that some absolute ceiling or limitation be placed upon the amount of "trading" income that may be treated as tax-exempt.

5.6.4 It is the Commission's view that the present constraints on trading activities are unduly restrictive and tend to discourage NPOs from becoming financially independent. Accordingly, it is proposed that trading by NPOs should henceforth be permitted, albeit within a carefully structured fiscal regime which facilitates oversight by the Commissioner and limits the opportunity for abuse.

5.6.6 In considering comparative law, it is noteworthy that the United States’ federal tax law exempts profits derived from a business which is "substantially related" to a NPOs tax-exempt purposes. Where profits are derived from an activity that is carried on with profit-making as the dominant purpose, the mere fact that the organisation tends to apply the income derived to further its charitable purposes will not qualify it for exemption from income tax. Salamon states:

5.6.7 Similarly, in the United Kingdom trading income derived by charities from "trades which are a primary purpose of the charity" are tax-exempt and the exemption extends to include ancillary activities "exercised in the course of the actual carrying out of a primary purpose". This exemption has been clarified in a Revenue Practice booklet CS2 entitled "Trading by Charities" which cites as examples of qualifying ancillary trades:

1. the provision of accommodation to students by schools or colleges; and
2. the sale of food and drink in a cafeteria to visitors to an art gallery or museum or to visitors to a hospital.

5.6.8 Apparently, United Kingdom Revenue Practice is to accept ancillary trades provided they are "small in absolute terms and the turnover of that part of the trade is less than 10 per cent of the turnover of the whole trade". However, unrelated trading by charities on a tax-exempt basis can be achieved in the United Kingdom by the simple mechanism of locating these activities in a separate trading company, which enters into a covenant in favour of a registered charity, in terms of which it donates the amount of its net profits.

5.7.1 Section 10 of the Income Tax Act seeks to impose (for example, in relation to "funds" as envisaged by section 10(1)(fA)) a number of constraints which are really "piggy-backed" onto fiscal legislation in order to address a broad sweep of public policy objectives. Whilst this use of fiscal regulation to promote broader public goals is not unique to South Africa, it does seem anomalous that the Commissioner should be charged with monitoring and promoting such matters which have little or no bearing upon normal fiscal criteria - and which require some philosophical base or technical competency that may not be readily available to the Commissioner. Thus, for example the Commissioner is:

1. required to regulate "prudent investment" by NPOs to the extent that an NPO may wish to place investment funds otherwise than in "listed securities" (quoted on a licensed Stock Exchange) or with a "financial institution" (as defined in the Financial Institutions (Investment of Funds) Act, No. 39 of 1984);

2. charged with adjudicating the merits of reasons advanced for the retention of revenue by a tax-exempt organisation that wishes to expend in any particular year less than 75 per cent of its net revenue earned in the preceding fiscal year;

3. required to grant or refuse consent (without any indication as to criteria) for the carrying on by an NPO of any business; and

4. required to approve expenditures for philanthropic purposes where the beneficiary is outside the Republic.

5.8.1 Through the newly-enacted Non-Profit Organisations Act, No. 71 of 1997, an attempt is to be made to promote the value of "transparency", or public accountability, on the part of NPOs. To the extent that such organisations are encouraged to choose voluntarily to register, such registration renders them bound to disclose certain statutory information, which is then publicly accessible. As an incentive, registered organisations are promised eligibility for (as yet unspecified) benefits, which will no doubt include eligibility for beneficial tax status.

5.8.2 Once again, it is proposed to use fiscal legislation to promote other social values - i.e. in this instance, the merit of NPOs making public financial information and details of their constitution, management, office bearers and auditors.

5.8.3 However, voluntary registration is hardly an adequate "stand-alone" criterion to justify fiscal benefits without some further qualifying conditions. As the evidence placed before the Commission has indicated, the newly-fledged Directorate of Non-Profit Organisations has limited resources and person power.

5.9.1 There exists a common law obligation upon directors, trustees and other officers of NPOs to avoid "conflicts of interest" and the abuse of their fiduciary responsibility in self-benefiting ways, e.g. through excessive remuneration. This important fiduciary duty is not presently provided for in legislation and depends upon the somewhat diffuse and inaccessible common law. In the absence of any other available oversight body, the regulation of NPOs in this respect is also likely to become the responsibility of the Commissioner, notwithstanding that it is a problematic area.

5.10.2 It is possible that, over time, resourceful NPOs may operate at a scale and with such zeal that might threaten the profitability and viability of competing tax-paying enterprises. In such circumstances, it is possible that some form of constraint or "ceiling" will be necessary upon the scale of trading activity by NPOs that would qualify for privileged tax treatment. A related concern is to ensure that NPOs do not invest a disproportionate amount of their human and financial resources in the generation of income at the expense of their core, altruistic, purposes.

5.10.3 Various mechanisms for controlling "unfair competition" have been considered, including:

1. a test directed to:

5.11 Prudent Investment

5.11.1 In some jurisdictions (e.g. the United Kingdom), specific legislation exists to prescribe prudent investments that are permitted by charities and tax-exempt endowment funds. In some measure, the South African Income Tax Act makes similar provision to the extent that organisations seeking exemption are precluded, in terms of section 10(1)(fA), from investing funds in any manner,

1. "with a financial institution as defined in section 1 of the Financial Institutions (Investment of Funds) Act, 1984 (Act 39 of 1984);
2. in securities listed on a licensed stock exchange as defined in section 1 of the Stock Exchanges Control Act, 1985     (Act 1 of 1985); or
3. in such other financial instruments as the Commissioner may approve."

5.11.2 A number of difficulties arise with reference to the application of these formulations, which must also be read in conjunction with related prohibitions on "the carrying on of any business" (save to the extent that the Commissioner may permit). It should be mentioned that the Commissioner has been in the practice of administratively imposing further conditions which frequently include restrictions on:

1. the granting of loans; and
2. the making of investments in private companies.

5.11.3 An exception is made in respect of "any asset or business undertaking acquired by such funds by way of donation, inheritance or bequest, [which] may be retained or continued as the case may be in the form so acquired".

5.11.4 There was evidence placed before the Commission that problems have arisen in recent years when NPOs have been precluded, as a result of these constraints, from benefiting from "empowerment" investment opportunities targeted to benefit the previously disadvantaged. In view of the existing statutory restrictions on permissible investments, NPOs have been prevented from taking up such investment opportunities. Thus far, the Commissioner has refused to sanction investment in unlisted equities within the rubric referred to in (C) above.

5.12 Community-based and Informal Organisations (CBOs)

5.12.1 A particular problem relates to the arbitrary disqualification of smaller, informal, community-based organisations which are prevented from benefiting from grants by funding institutions that are themselves exempt from income tax in terms of sub-section 10(1)(fA). The reason for their ineligibility relates to the fact that the present formulation of this Sub-section prohibits the granting of benefits by a tax-exempt fund to any beneficiary organisation, unless that beneficiary organisation is itself exempt from income tax in terms of section 10(1)(f), viz. a "religious, charitable or educational institution of a public character".

5.12.2 There are no reliable statistics available regarding the numbers of non-profit and public- benefit organisations presently operating in South Africa. Only a limited number of more formally structured organisations have brought themselves within the purview of official registers maintained respectively in respect of Trusts and section 21 Companies and an even more limited number within the purview of the Tax Authorities.

5.12.3 However, by far the largest percentage of NPOs and CBOs are in fact constituted as Voluntary Associations, for which there exists no public office of registry. The newly established Directorate of NPOs will, over time, build records on the basis of voluntary registration only, as presently envisaged. Accordingly there are no relevant records available. It is the experience of most large funding institutions that they are often frustrated in their wish to support commendable local initiatives because they lack the necessary legal and financial expertise to present successful application to the fiscus for tax exemption. In many instances they are in fact probably unaware of the requirements of the legislation.

5.12.4 Accordingly, it is the opinion of the Commission that tax-exempt funding institutions should be permitted to devote their funds to any eligible purpose without prescription in respect of eligible organisations. Further the beneficiary organisations should not be required first to secure formal tax exemption, as presently required. As a matter of public policy, it may well be that registration in terms of the new Non-Profit Organisations Act should become a prescribed requirement; particularly in the light of the intention that the Directorate is mandated to assist organisations and to provide resources, where necessary, to facilitate registration under the Act.

5.13.1 Representations were received with regard to a special genre of organisation, falling somewhere between a "philanthropy" and a "members' co-operative". Legislation makes provision for a number of special-type organisations (for example, Communal Property Organisations) which are to be constituted as vehicles to facilitate restitution and redistribution, and which envisage communal or group ownership, and the collective administration of compensation awards. These situations are characterised by the disadvantaged nature and indigence of the beneficiary community, and represent evidence of our society's commitment to assist "the poorest of the poor", to enable them to establish reasonable conditions of life, including security of tenure, rudimentary housing, employment opportunities, and access to basic amenities.

5.13.2 It has been argued that such institutions should be accorded limited tax relief as part of a "package" of social assistance for which they are eligible, notwithstanding that they are characteristically constituted with broad objects and intended to benefit community members - who also serve on their Boards of Trustees. The Commission is persuaded that some form of tax relief could be considered in such cases, which would, for example, render these institutions exempt from transfer duty on the acquisition of land and would enable them to function without the incidence of income tax for an initial "entry period" of, perhaps, five to ten years. Thereafter, the continued eligibility of such organisations for tax-exempt status might be subject to review and would depend on their level of need and deprivation. Obviously it would not be desirable to create a "tax haven" extending beyond the ambit of assistance to the poor and which might create the spectre of an affluent community enjoying a favoured tax shelter indefinitely.

5.13.3 A related problem concerns organisations which devote their efforts to creating small-scale business opportunities and encouraging entrepreneurial activity as a strategy for alleviating poverty, unemployment, and crime. Frequently such organisations directly, or in partnership with others, engage in some measure of "trading" or in establishing small enterprises as a strategy to facilitate "the escape from poverty and unemployment". Once again, it is the Commission's view that such organisations should be accorded tax relief, notwithstanding that their activities may be technically entrepreneurial in character. A fiscal precedent exists in the United Kingdom in respect of the so-called "beneficiary worker exemption" which exempts charity trading income from tax, provided it derives from trades whose work is carried out by beneficiaries of the charity.

5.14.2 Notwithstanding these practical constraints, the Commission has attempted to define a dispensation which would serve to promote a culture of philanthropy and would be administratively feasible and cost-efficient.

5.14.3 A number of theoretical options were considered and rejected, including:

1. leaving section 18A unchanged;
2. repealing section 18A to eliminate donor deductibility in its entirety; or
3. expanding section 18A to permit each and every tax-exempt organisation to enjoy the same benefits.

5.14.4 It would have been the Commission's first preference to suggest a system analogous to that currently operating in the United Kingdom, where tax-exempt organisations are entitled to claim back from the fiscus the tax paid by donors in respect of eligible and "covenanted" donations. The administrative burden which such a system imposes, dictates otherwise.

5.14.5 Accordingly, the Commission proposes, as an interim measure, a broadening of the provisions of the existing section 18A to permit a broader category of eligible organisations that would be entitled to grant-donor benefits similar to those presently reserved for educational institutions and funds.

5.14.6 However, if the necessary resources could be made available to SARS, consideration could be given to a system devised on the following lines:

1. in each budget, the State might appropriate a fixed amount available for appropriation amongst tax-exempt organisations, in respect of the tax attributed to tax-paying donors.

2. any tax-exempt organisation would then be entitled to apply for a pro rata allocation of the budgeted amount, on condition that its claim, duly vouched, was filed with the fiscus by no later than a stated date.

5.14.7 The pro rata amount attributable in respect of any given donation would be calculated as follows:

5.14.8 Such a system could incorporate a degree of "politico-fiscal" flexibility in that it might allow for certain high priority activities to be accorded a greater share or proportion of the budgeted amount.

5.14.9 The system would be relatively simple and cheap to administer because of the relatively small number of organisations to be audited and assessed, as compared with a system that necessitated oversight being exercised in respect of large numbers of individual taxpayers. Moreover, as in the United Kingdom, consideration might be given to excluding minor claims, and excluding claims not represented by a multi-year "covenant".

5.14.10 A disadvantage of the proposed system is that it would involve retrospective determination of each individual organisation’s share (X/Y) of the fixed amount (Z), because no organisation would be in a position to estimate Y (the aggregate of donations) in advance with any degree of accuracy. An alternative suggestion, involving a departure from the current practice of allowing full deductibility of any donation that qualified under section 18A, would be to move to a system of partial deductibility.

5.14.11 Under partial deductibility a figure would be proposed in each year’s budget indicating the percentage of any donation that would qualify for deduction from taxable income in the ensuing year, provided of course that it met all the other requirements of the amended section 18A. If, for example, the figure were to be set at 80 per cent, a donation of R1 000 would entitle the donor to a deduction of R800 from income subject to tax.

5.14.12 Partial deductibility would provide a welcome measure of flexibility in countering revenue loss as the scope of section 18A was gradually broadened to accommodate a wider range of institutions. The sensitive use of this measure on an incremental basis requires on-going information on the actual revenue losses being incurred, but that is a pre-requisite for any reform of the NPO tax regime.

5.14.13 Two "caps", one for individuals and another for companies, are currently in place to limit revenue loss. They restrict the extent to which section 18A donations may be deducted by any taxpayer to a maximum of 2 per cent of taxable income for an individual and 5 per cent for a company. The Commission can find no justification for this form of differentiation and for this reason recommends that "one cap" be introduced for all taxpayers.

5.14.14 The introduction of partial deductibility would enable the two "caps" to be lifted. The lifting of the caps is a separate issue from their standardisation to eliminate discrimination between individuals and companies but would not, in the opinion of the Commission, pose any significant risk of revenue loss if a system of partial deductibility were in place.