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Chapter VIII - Tax Exemption and Tax Deductions

The Income Tax Act 1961 (amended by subsequent Finance Acts) governs tax exemption of nonprofit entities throughout India. The Act provides that organisations may qualify for tax exempt status if the following conditions are met:

  1. The organisation is established for religious or charitable purposes

  2. The organisation spends at least eighty-five per cent of its income in any financial year (April 1 to March 31). If it is unable to do so on account of late receipt of the income during the fiscal year, it may exercise the option to spend it in the following year by filing online Form No. 9A. Unspent income may also be accumulated for specific projects or a capital purpose for a period up to five years by filing online form No. 10

  3. The funds of the organisation must be deposited as specified in Section 11(5) of the Income Tax Act

  4. No part of the income or property of the organisation may be used or applied directly or indirectly for the benefit of the founder, trustee, relatives of the founder or trustee, or a person who has contributed more than Rs 50,000 to the organisation in a financial year

  5. Audit report in form 10B or 10BB as the case maybe, and return of income in ITR-7 must be filed annually

  6. The organisation's income must be applied or accumulated in India. However, income may be applied outside India with the prior permission of the Central Board of Direct Taxes (CBDT) to promote international causes in which India has an interest (such as disaster relief, or a cultural exchange), without being subject to income tax

  7. The organisation must keep a basic record (name, address, telephone number and PAN) of all donors

  8. According to Section 115BBC, introduced under the Finance Act (2006), all anonymous donations to charitable organisations are taxable. Finance Act No. 2 (2009), however, carves out the following exception: anonymous donations equaling up to five per cent of the total income of the organisation or a sum of Rs 100,000 (whichever is higher) will not be taxed. Religious organisations, including, temples, churches, and mosques, are exempt from the provisions of this section

  9. The organisation must maintain proper books of account

NPOs must also meet the Income Tax Act's scope of charitable purpose which includes poverty relief, education and yoga, medical relief, preservation of environment, preservation of monuments, places, or objects of artistic or historic interest, and the advancement of any other object of general public utility. An amendment to these provisions in 2015 placed new limits on the final category (i.e. the advancement of any other object of general public utility), primarily limiting the permissible scope of income generating activity an NPO may carry out without losing its tax-exempt status. The amendment provides that, if an organisation conducts even limited business activity, it will not be eligible for tax exemption unless:

  1. The business activity is undertaken in the course of advancing an object of general public utility; and

  2. The aggregate receipts from the business activity during the previous fiscal year do not exceed twenty percent of the organisation's total receipts for that year

Annual compliance

  1. Audit Report in Form 10B or 10BB (as the case may be) must be filed every year by 30th September

  2. File 10B if total income of the organisation is over Rs 5 Crore, or if the organisation receives foreign contribution, or if the organisation applies its income outside India. File Form 10BB if none of the above is applicable

  3. File the Return of Income in Form ITR - 7 every year by 31st October

  4. File statement of donations received in Form 10BD every year by 31st May and send Form 10BE to all donors

Inter-charity donations

Inter-charity donations (i.e. donation or grant from one tax exempt charitable organisation to another) is permissible, but with some restrictions:

  1. The objects of the donor NPO and recipient NPO must be similar

  2. The NPO cannot donate to another NPO out of its accumulated income (i.e. the income set aside for a period of five years by filing Form No. 10). Such accumulated income must be spent by the NPO on its own, and for the purpose for which such income was sought to be accumulated

  3. The NPO, even from its non-accumulated or current year's income, should not give towards the corpus of another NPO. As per Finance Act 2017, 'any amount credited or paid out of income of one charitable institution to any other charitable institution being voluntary contribution with specific direction that it shall form part of the corpus of the institution, shall not be treated as application of income to its objects.'

  4. As per Finance Act 2023 if one tax exempt NPO donates to another tax exempt NPO, only eighty-five per cent of such donation given will be considered as application of income for the donor NPO

Impact of Finance Act 2023 on grant-making

On 31st March, 2023, the Ministry of Law and Justice, Government of India notified the Finance Act 2023. Inter-charity donations (i.e. one tax exempt charitable trust or institution donating to another tax-exempt charitable trust or institution) continues to be allowed even from 1st April 2023, but with various restrictions.

Restrictions on inter-charity donations have been in existence for two decades. Under an amendment brought in by Finance Act 2002, one charitable organisation could donate to another charitable organisation but not from its 'accumulated income'. What does this mean? One of the key conditions for tax exemption given to charitable organisations is applying or spending at least eighty-five per cent of the total income every financial year. The balance fifteen percent can be taken as unrestricted reserves. However, if the organisation is unable to spend this minimum amount (eight five per cent of the total income) it has the option to accumulate the same for up to five years by exercising option u/s 11(2) of Income tax Act and filing online Form No. 10. However, this accumulated amount must be spent by the organisation on its own activities and cannot be donated to another charitable organisation.

Later, the Finance Act 2017 disallowed charitable organisations from giving donation to another charitable organisation, whether from its accumulated or current year's income towards the corpus of another charitable organisation. Now under the amendment brought in by the Finance Act 2023, in addition to the earlier restrictions, if one tax exempt charitable organisation donates to another tax-exempt charitable organisation, only eighty-five per cent of such donations given will be considered as application of income for the donor charitable organisation. In other words, if trust A donates a sum of Rs 100,000/- to Trust B, in the books of account of Trust A while Rs 100,000 will reflect as given or spent, only Rs 85,000/- will qualify as 'application of income for charitable purpose'. This is a potential setback for purely grant-making organisations, unless of course they spend one hundred per cent of their total income every year and not avail the benefit of stashing away fifteen per cent towards reserve after applying eighty-five per cent of the income.

Minimal impact on implementing trusts and institutions

Tax exempt charitable trusts and institutions that carry out all activities on their own have nothing to worry. They can continue to apply at least eighty- five per cent of their total income (on overheads, programs, and activities) and stash aside fifteen per cent every year as unrestricted reserves.

Example:

Let us assume that ABC Trust/Society/Section 8 Company has total income of Rs 1 Crore. It spends Rs 10 lakhs on administration and overheads. It spends Rs 75 lakhs on programmes and activities on its own as per its objects. Since it has spent Rs 85 lakhs (i.e. at least eighty-five of its total income of Rs 1 crore it can carry Rs 15 lakhs (fifteen per cent of the total income) as unrestricted reserve to its balance sheet. Thus, this amendment under Finance Act 2023 will have minimal effect on implementing agencies that carry out charitable activities on their own. The only indirect effect may be that some grant-making foundations may decide to become implementing foundations and therefore funding received through grants from grant-making foundations could suffer.

Effect on grant-making foundations

Borrowing from the earlier example, let's assume that ABC Foundation which could be either a Trust, Society or Section 8 Company has a total income of Rs 1 crore. It spends Rs 10 lakhs on administration and overheads. It spends Rs 75 lakhs by giving grants to other charitable trusts, societies, and section 8 companies.

Now, under the recent amendment only eighty-five per cent of the Rs 75 lakhs (i.e. Rs 63.75 lakhs) given by way of grant to other organisations will be considered as application of income for ABC Foundation. Thus, Rs 10 lakhs plus Rs 63.75 lakhs totals Rs 73.75 lakhs, making it Rs 12.75 lakhs less than the mandatory eighty-five percent that needs to be spent.

What is the solution?

The Rs 15 lakhs that the foundation could have set aside as reserves must also be used. It has two options for the Rs 15 lakhs:

  1. Use on its own and still manage to take Rs 2.25 lakhs to its reserve fund

  2. Grant Rs 15 lakhs to other organisations and, once again, since only 85% of the Rs 15 lakhs, i.e. Rs 12.75 lakhs will be considered as application of income, it will still cover the shortfall in applying minimum 85% of its income during the fiscal year, but leaving nothing for reserves

Change in object clause

Application to the Commissioner of Income Tax (CIT) must be made within 30 days if there is any change in the object clause which does not conform to the conditions of registration.

Cash payments

As per Finance Act 2018 the following amount shall not be considered as application of income for the purpose of tax exemption u/s 11 or 10(23C) (iv), (v), (vi) & (via):

  1. If any payment above Rs 10,000 is made in a day other than by way of Account Payee Cheque or Account Payee Bank Draft or use of Electronic Clearing System (ECS) through a bank account or

  2. If any application of income is claimed and provided for as liability, and subsequently the liability over Rs 10,000 is paid other than by paying by way of Account Payee Cheque or Account Payee Bank Draft or use of ECS through a bank account

In other words, avoid cash payments exceeding Rs 10,000.

Exit tax

As per Finance Act, 2016 'accreted income' of a trust or institution registered under Section 12AA would be taxed under prescribed circumstances. For the purposes of the Act, 'accreted income' is the difference between the fair market value of the assets and the liabilities of the trust or institution. Accordingly, trusts and institutions will be subject to the tax on accreted income under the following circumstances:

  1. If the trust or institution gets converted into any form which is not eligible for exemption under Section 12AA (e.g., the non-profit is converted into a for-profit firm)

  2. If the trust or institution is merged with any entity ineligible under Section 12AA (e.g., the non-profit merges with a for-profit company)

  3. If the trust or institution, in the case of dissolution, fails to transfer its assets to exempt entities under Section 12AA and Section 10(23C) (iv), (v), (vi), and (via) (e.g., the residuary funds are given to a for- profit entity after dissolution)

The tax on accreted income is to be paid in addition to the income tax on the total income of the trust or institution.

The Finance (No. 2) Act, 2019 amended Section 12AA of the Income Tax Act, 1961 to allow the Principal Commissioner or Commissioner of Income Tax to deregister a charitable trust or institution under certain circumstances; once deregistered, the organisation would be taxed at the maximum marginal rate of thirty percent on the trust's income from the assessment year and on accreted income.

Tax deduction for donors

The Income Tax Act permits donors to deduct contributions made to trusts, societies and Section 8 companies. Section 80G of the Act lists some of these institutions, many of which are government-related. Donors are entitled to a one hundred per cent deduction for donations to some of these government funds. The following are examples of governmental charities listed in Section 80G, contributions to which entitle the donor to a one hundred per cent deduction: the Prime Minister's National Relief Fund, the Prime Minister's Armenia Earthquake Relief Fund, the Africa (Public Contributions - India) Fund; and the National Foundation for Communal Harmony.

As to those entities not specifically enumerated in Section 80G above, donors may deduct fifty per cent of their contributions to such organisations, provided the following conditions are met:

  1. The institution or fund was created for charitable purposes in India

  2. The institution or fund has registered as tax exempt under Income Tax Act

  3. The institution's governing documents do not permit the use of income or assets for any purpose other than a charitable purpose

  4. The institution or fund is not designed to be for the benefit of any religious community or caste, and

  5. The institution or fund maintains regular accounts of its receipts and expenditures

In addition, total deductions claimed may not exceed ten percent of the donor's total gross income. Further, to qualify for a tax deduction, any donation more than Rs 2,000 cannot be made in cash. Vide Finance Act 2017, Section 80G(5D) was amended such that no deduction will be allowed for donation in cash over the sum of Rs 2,000.

As per Section 269ST of Income tax Act 1961: No person shall receive a sum of Rs 2 lakhs or more, otherwise than by way of an account payee cheque or account payee bank draft or use of electronic clearing system through a bank account:

  1. In aggregate from a person in a day

  2. In respect of a single transaction, or

  3. In respect of transactions relating to one event or occasion from a person

Thus, cash donations over Rs 2,000 and up to Rs 2 lakhs from a single donor in a day would not be illegal. However, tax deduction would be allowed for the donor only up to a sum of Rs 2,000.

Companies may also claim the standard fifty per cent deduction for charitable donations made to qualifying NPOs, for instance through their corporate social responsibility (CSR) programmes.

Exceptions

Donations to institutions or funds 'for the benefit of any particular religious community or caste' are not tax deductible. A non-profit organisation created exclusively for the benefit of a particular religious community or caste may, however, create a separate fund for the benefit of 'scheduled castes, backward classes, scheduled tribes or women and children'. Donations to these funds may qualify for a deduction under Section 80G, even though the organisation may be for the exclusive benefit of a particular religious community or caste. The organisation must maintain a separate account of the monies received and disbursed through such a fund.

In-kind donations (e.g. computers, medicines, relief material, etc.) are not tax deductible under Section 80G.

A donor may also donate any sum of money as a corpus donation to the NPO. However, it is essential that the donor specifies in writing that either a part of the donation or the entire donation be treated as a donation towards the corpus of the NPO.

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