By Mark Lyons, Professor of Social Economy, UTS

A nonprofit organisation whose constitution prohibits the distribution of surplus assets to members on winding-up cannot be considered a mutual and is ineligible to the tax exemption provided to member-generated income, according to a judgement by Mr Justice Hill in the Federal Court of Australia.

The judgement was delivered in February in the case of Coleambally Irrigation Mutual Cooperative Ltd v Commissioner of Taxation. The case arose when the cooperative challenged a ruling by the Commissioner that as a non-trading cooperative with such a non-distribution on winding-up clause in its constitution, the coop was not eligible to claim that income from a levy imposed on members was exempt from taxation by the mutuality principle. The levy was to build a sinking fund to be used for rebuilding and expansion of its irrigation system at some time in the future.

The case is on appeal to the full federal court, set down for hearing in August. Meanwhile the Commissioner has indicated that the Australian Taxation Office will continue to apply its long held practice of allowing nonprofits that could not claim full exemption as charities or under other provisions of the Tax Act, to exempt income derived from their members, irrespective of whether they included a clause prohibiting distribution of net assets to members on winding up or not. If the full court upholds the original judgement this will change and many nonprofits will face tax bills that could be quiet substantial.

This is because many nonprofits have in their constitution two prohibitions on the distribution to members of any surplus: a prohibition on the distribution of any annual surplus plus a prohibition on distribution of any surplus assets if the organisation is wound up. For many years, nonprofits included only the former, but the ATO began insisting on both clauses as a prerequisite for income tax exemption, and even if a nonprofit (including a non-profit or non-trading cooperative) was not eligible for full tax exemption, many added the second clause. A number of state and territory acts of incorporation or registration require both clauses.

The court judgement exposes many of these organisations to income tax, as most nonprofits that were not eligible for full income tax exemption have been eligible for the exemption of member-generated income from their estimates of taxable income.

Those registered clubs for example, that are not fully tax exempt by virtue of being a sporting body, are nonetheless permitted to exempt from their taxable income any surplus derived from the use of club facilities by members. The Registered Clubs Act in NSW requires all clubs to have both non-distribution clauses in their constitution.

Many recreation or hobby clubs, advocacy groups and certain business and professional associations will likewise be affected. This is because in those states where cooperatives legislation permits the formation of non-trading cooperatives, that legislation requires them to include a clause in their constitution prohibiting distribution of assets to members on winding up. So too do associations acts in several states (eg NSW, South Australia and West Australia).

In essence what the judge has done is to determine that a social economy or third sector organisation can be a public serving nonprofit (ie by meeting the double nonprofit distribution test) or a member-benefit organisation, but it cannot be both. This has interesting implications for both the directors and managers of social economy organisations, and for nonprofit/third sector/social economy theory.

At a practical level, people setting up a third sector organisation and their advisors will face a dilemma when they seek tax exemption. If they believe they are tax exempt by virtue of being a charity they must have both non-distribution clauses in their constitution. This is scrutinised by the ATO before the relevant (ITEC) status is granted. If they believe they are exempt from income tax under some other part of the Tax Act, they can operate as if they are, but need to ensure they have the relevant clauses in their constitution in case they are audited. But if there is any doubt, and they wish at least to claim exemption from member-derived income under the mutuality principle, they cannot have the second clause prohibiting distribution of assets to members on winding up. This creates an element of jeopardy, especially for non-ITEC organisations.

A second implication is that member owned entities that have relied on that non-distribution clause to grant them some protection from demutualisation will now become more exposed. This has particular implications for some large registered clubs. There are good public policy reasons for hoping that the full bench will overturn Hill J's decision. Alternatively, another way of protecting important community assets against demutualisation must be found and urgently implemented.

At a theoretical level, the judgement raises several interesting issues about the definition and the behaviour of nonprofit organisations. At its most basic, a nonprofit organisation is one that does not distribute any annual surplus or profit to members who are the controllers and owners of the organisation. Instead, it applies the surplus to the operation of the organisation. This is as true for a public-serving charity as it is for a member-serving club. It is also true of mutual insurance societies and credit unions, though their constitution may not mention the practice. (By contrast, a trading cooperative can issue dividends from its annual surplus, though the amount is based on use rather than funds invested.) It is sometimes argued that these mutual entities distribute a surplus by subsidising services as an alternative to making an annual distribution of profit. Nonetheless, their behaviour is different to for-profit firms and members benefit from subsidies to the extent that they use the services of the club, rather than to the extent to which they have funds invested, as would be the case with a conventional investor-owned firm. For this reason all entities with the basic non-distribution of annual profit in their constitution are included in surveys of nonprofit sectors, such as the ABS Nonprofit Institutions Satellite Account. Nonprofit institutions that don't have the additional clause, such as credit unions, are excluded.

The issue also has important implications for the conflict in the literature between the US and (continental) European approaches to identifying the distinguishing characteristic that determines that the behaviour of third sector organisations is different to that of for-profit firms. The US literature generally relies on claiming that nonprofit organisations behave differently to for-profits because they are prevented from distributing not only an annual surplus but also net assets to members on winding up. By contrast, the European social economy approach emphasises democratic governance as being the key behavioural characteristic that distinguishes mutuals and even trading cooperatives from for-profit entities. The problem organisations then are those that have no, or only one or two, members.

If Hill J's decision survives appeal, the definition of nonprofit might be taken to apply to a somewhat smaller set of nonprofits than it has previously, mainly charities, but some others with purposes that the government wishes to encourage. In other words, it makes the whim of government the determining feature of organisational behaviour. This does not seem particularly satisfactory. It strengthens the case for using the European social economy approach together with the stronger US nonprofit criterion.