Introduction

Setting up a charitable organisation is common in Hong Kong, a city where people are generally benevolent and substantial tax allowances (up to 35% of annual taxable income) are available for both individual and corporate on donations to tax-exempt organisations.

Nevertheless, upon review of the Hong Kong Inland Revenue Department (“IRD”)’s tax exemption approval process in 2017, the Audit Commission recommended that the IRD should exercise closer monitoring on whether charitable organisations continue to fulfil their tax exemption requirements after obtaining the tax exemption status. As a result, following hot on the heels of its late 2019 guidelines, the IRD issued an updated and clarified version of its guidelines for charitable institutions in April 2020, illustrating its firm resolve to ensure compliance by charitable organisations with the tax exemption requirements. In June 2023, the IRD updated its guidelines, which remain in effect to this present day.

Requirements for tax exemption status

Not every non-profit-making organisation is an approved charitable organisation. In order to qualify for tax exemption status as a charity, an organisation must be established exclusively for one or more of the following purposes:

1.      the relief of poverty;

2.      the advancement of education;

3.      the advancement of religion; or

4.      other purposes of a charitable nature which serve the community.

For the first three purposes, the services provided by the organisation may be targeted at people across the globe; whereas for the fourth purpose, the community served by the organisation must be a community in Hong Kong. Examples of acceptable purposes for the last category include the relief of illness, assisting the physically and mentally disabled, and the promotion of health.

Another point to note is that a charitable organisation should be geared towards 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 legally required, an approved charitable organisation is usually set up in the form of a company limited by guarantee. A written governing instrument, namely, the articles of association (the “Articles”), should be in place to govern the activities of the organisation.

Common pitfalls of non-compliance

Below are some common pitfalls of non-compliance with tax exemption requirements by charitable organisations which may result in part of their income being ineligible for tax exemption or, in the worst case, termination of their tax-exempt status.

1.    Deviation from the approved objects

According to the IRD guidance, a charitable organisation should include in its Articles at least one of the four aforesaid purposes and strictly adhere thereto. Occasionally, after some years of operation, members of the organisation may have slightly different thoughts on the objects. While the IRD accepts activities that contribute indirectly to the objects of an organisation, it is suggested that organisations should consider all potentially applicable objects within the four acceptable categories and include them in their Articles to avoid being challenged by the IRD. If an organisation wishes to vary its objects, it should take the initiative to amend its Articles.

2.    Income from activities unrelated to the approved objects

It is a common misconception that once the tax exemption status is granted, all income derived by the charitable organisation is exempt from Hong Kong profits tax. In fact, charitable organisations often carry out activities not directly related to their objects. Income arising from such activities may not be exempt from Hong Kong profits tax even if tax exemption status has been granted. As such, charitable organisations should apply their funds prudently and avoid using them for activities unrelated to their objects. Tax implications in respect of lending of funds, making investments, leasing of premises and sales of goods by charitable organisations will be examined below.

Lending of funds: Lending of funds to related parties free of interest and stating them as “amount due from related parties” in the financial statements should be avoided unless the lending is directly related to the objects of the charitable organisation (e.g., engage another charitable organisation having the same or similar objects to provide services). Otherwise, the IRD may challenge whether the funds were used to support the objects of the charitable organisation.

On the other hand, for interest-bearing loans not directly related to the objects of the charitable organisation, the interest income may be subject to Hong Kong profits tax even if tax exemption status has been granted. Only income that is directly related to the approved objects are exempted from tax.

Making investments: It is customary for charitable organisations to make investments with their surplus cash. Some charitable organisations may mistakenly believe that as long as the investment returns are ultimately used in furtherance of their objects, the investment income would be automatically exempt from Hong Kong profits tax. However, based on our understanding of the IRD guidance, the IRD would apply the “badges of trade” test to determine the nature of income. Long-term investment capital gains are not taxable in Hong Kong, while gains on short-term speculation activities are subject to tax.

In order to enhance the likelihood of a non-taxable claim being accepted, charitable organisations are recommended to set out a detailed plan before making investments. Such plan should include an investment horizon, expected investment return and the intended use of investment returns to meet the organisation’s specific charity projects in the future. This would show that the investment is not intended for short-term trading purposes.

On the contrary, investments in high-risk volatile assets (e.g., derivatives) or with frequent trading are unlikely to be accepted as capital gains claims, as the IRD will consider that it is difficult for the charitable organisation to predict the investment returns to meet the funding needs for its charity projects.

It is also inadvisable for a charitable organisation to invest in companies associated with their members, as such investments may be perceived by the IRD as for personal gain rather than for public benefit and may therefore result in the revocation of the organisation’s tax exemption status.

Leasing of premises: Rental income is exempt from Hong Kong profits tax only if it is derived in the course of charitable activities. Lease of a property at market rent by a charitable organisation to a tenant not being any specific target group of beneficiaries is unlikely to be considered as a lease for charitable purposes. As such, in order to enhance the chance of obtaining tax exemption, charitable organisations should consider setting different rents and offering discounts to its target group of beneficiaries.

Sales of goods: Profits from sales of goods by charitable organisations are subject to Hong Kong profits tax, except where:

·           donated goods are sold without alternation; or

·           the sale and/or production of the goods are mainly carried out by the beneficiaries of the charity.

3.    Remuneration to members

While most charitable organisations are aware that remuneration to members at market rate is prohibited, it should also be noted that reimbursements of outlays incurred by members in carrying organisational activities should be made in the exact amount of such expenses with supporting documents (e.g., vouchers). Strictly speaking, transportation expenses without supporting vouchers are not permissible despite the trivial amount.

Application for tax exemption status

Normally, an organisation should seek approval of tax exemption status from the IRD prior to the commencement of its charitable activities. The following documents should be submitted to the IRD for its consideration:

Documents	Point to note
Draft of written governing instrument (i.e., the Articles)	As the IRD generally gives comments before granting the tax exemption status, a draft version of the Articles is preferred.
A list of charity activities planned over the next 12 months	Applicants are expected to provide detailed information to prove their capabilities and intention to perform these activities. The IRD may review the progress of such activities after the granting of tax exemption status.

Conclusion

The audited financial statements enclosed in annual tax filings are generally the first documents reviewed by the IRD in a tax exemption application. As such, charitable organisations should seek advice from an audit firm and a tax advisor familiar with section 88 of IRO both before making important decisions and in the preparation of audited financial statements.

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Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors.

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