Charitable funds: lasting legacy in new regime

The Australian Government has recognised the importance of people structuring their affairs to be able to gift funds to charities of their choice and has amended the law to provide an easier system of operation that is more robust.

Philanthropy is the planned and structured giving of money, time, information, goods and services, voice and influence to improve the wellbeing of humanity and the community.

From Bill Gates to the average investor, more people are taking an active role in philanthropic endeavours. Further, more people are looking at how they give back to the community and moving to effectively manage their involvement.

This article examines the recent Government changes to private charitable funds, their role in philanthropy and how the proposed guidelines help to manage and control this activity. It will also introduce a new term, private ancillary funds (PAFs). Funds were formerly referred to as prescribed private funds (PPFs) and the previous regime that governed charitable funds was prescribed by the Governor-General.

A PAF is a type of charitable fund that is established by an individual, group, family or business. Definitions may vary, but it generally means a trust established for charitable endeavours. The key benefit of structuring philanthropy in this manner is the measure of personal ownership and control it can give the donor in determining the ultimate beneficiary of the charitable funds.

Draft guidelines setting out the minimum standards for the governance and conduct of a PAF and its trustee have been issued and will be finalised prior to their commencement on October 1, 2009. These guidelines replace the complex rules of PPFs and will be under the authority of the Commissioner of Taxation. To allow the commissioner the necessary powers to protect charitable funds, all trustees of PAFs will need to be corporate entities. The Treasurer has the power to make guidelines binding, unlike the previous PPF regime, which was not binding.

One of the key areas of the guidelines is the introduction of a simpler minimum annual distribution rate of 5 per cent subject to a minimum of $11,000, or the remainder of the fund if that is less than $11,000, or 5 per cent if this is less than $11,000. The other key changes are the market valuation of fund assets on an annual basis, the valuation of land only every three years and the need for an investment strategy.

As of November 2007, there were 610 PPFs approved or awaiting formal approval. As at June 2006, the total value of funds in PPFs was $820 million, and this is likely to have recently exceeded $1 billion.

A PAF is a private arrangement for the receipt of charitable funds. It embodies a trust structure either established or maintained under a will or an instrument of trust.

The trustee must exercise the same degree of care, skill and diligence that a prudent person would exercise in managing the affairs of others.

At all times at least one of the directors of the corporate trustee — or in the case of PAFs established prior to October 1, 2009, one of the individual trustees — involved in the decision-making of the fund must be an individual with a degree of responsibility to the Australian community as a whole and cannot be a founder, major donor, or an associate of a founder or major donor. In this context, a ‘responsible person’ literally means a person who has a general responsibility to the community.

A PAF must be established and operated on a not-for-profit basis and the governing rules must reflect this basis of operation.

The fund must be established and operated only in Australia.

An appropriate investment strategy must be prepared and maintained by the trustee. The strategy needs to be reviewed regularly so that it is current and takes account of the risk involved in making, holding and realising fund investments, having regard to fund objectives and required cash flow requirements.

Additionally, a PAF must prepare and maintain a distribution strategy that reflects the quantity of donations expected, the expected recipients and the size of the distribution the fund is expected to make.

Funds established prior to October 1, 2009, will become PAFs from this date. All existing funds will be deemed to have agreed to comply with the new guidelines.

Funds established before October 1, 2009, with non-corporate trustees will not be required to replace trustees with corporate trustees.

If a fund was established as an accumulation plan under the PPF regime and has not chosen to change to the new distribution formula of PAFs, the fund must distribute 5 per cent of each gift in the next financial year and distribute the trust income within one year after receiving it. The exception to this is if an amount of the trust income is to be retained to maintain the capital in line with inflation.

How are PAFs used?

Final legislative rules and guidelines will specify how a PAF can be used by dealing with the role and purpose of a PAF, the class of entities that the fund may donate to, that the character of the trust is not-for-profit and the distribution requirements.

PAFs in practice

Below is an example of how a PAF will operate:

Ongoing Donations

Jim Frost is establishing the Jim Frost Foundation. It is proposed that the foundation will be established with a capital sum of $10 million. This capital amount is to be achieved over a 10 to 12-year accumulation period with annual donations of $1 million, subject to the donor’s financial capacity.

Of the amount donated each year, 5 per cent will be distributed in the following year. That is, if $1 million is donated in year one, $50,000 will be distributed in year two.

The donated funds will be invested in line with the investment strategy of the fund and the investments will be reviewed and valued annually.

All investment income will be reinvested each year, except for any amount that may be needed to meet minimum distribution requirements, unless under transitional distribution rules. Upon reaching the target of $10 million, the foundation will continue to distribute in line with its distribution strategy and all investment income will be reinvested, except if minimum distribution requirements have not been reached.

What are the tax implications of a PAF?

A PAF benefits from having the status of a deductible gift recipient (DGR). This simply means donations to the PAF will be tax deductible. Donations to a DGR may not create a loss. Provisions exist in the Income Tax Act 1997 to allow donations to be deductible over a period of up to five years. The person must make an election, prior to completing their return for the year of the donation, as to the percentage of the donation to be deductible in each year.

This declaration may be varied in future years, but not with respect to the amount claimed as a deduction in prior years. In the case of a PAF this would allow a large initial deduction to be deductible over a number of years, thus reducing or obviating the tax inefficiencies that would arise if the donation exceeded assessable income or fell into the lower tax bands.

What are the advantages?

The advantages of a PAF are very much as the name suggests. Apart from the taxation advantages of the deductibility of donations, a PAF allows an individual or family group to leave an indelible lasting legacy to those who will be deemed to benefit. It also provides individual control over the investments of the fund in order to provide the philanthropic gifts.

What are the disadvantages?

Once a donation is made to a PAF, it is irrevocable and cannot be withdrawn. This measure is to preserve the integrity of the arrangement to ensure the tax concessions granted are not abused. Breaches of the provisions may lead to administrative penalties being imposed on the trustees or the suspension or removal of trustees by the Tax Commissioner.