Cheng & Cheng Taxation Services reveals the important tips of setting up a charity in Hong Kong

The HKSAR Government is committed to combating abuse of charity status (Section 88)

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HONG KONG, CHINA
- Media OutReach - 22 September 2020 - 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:-

 

Documents	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.

This article is by Henry Kwong, Tax Partner of Cheng & Cheng Taxation Services Limited. 

About Cheng & Cheng Taxation Services Limited

Cheng & Cheng is one of the
top 20 accounting firms in Hong Kong, with over 300 staff in Hong Kong and the
PRC. We are the principal auditor for 20 listed corporations in Hong Kong and
the tax advisor for over 50. We specialise in providing Hong Kong, PRC and international
tax advisory services, as well as transfer pricing services to international
clients. If you would
like to know more about tax exemption provisions for charitable organisations
in Hong Kong, or seek tax advice from our tax experts, please do not hesitate
to contact us by email (henry.kwong@chengtax.com.hk) or phone (3962 0114).