A guide to the new tax regime for. Recreational clubs

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2 Contents Many clubs now engage in business activities... 3 SARS believes that clubs have exploited their tax-exempt status... 3 A new tax dispensation for recreational clubs... 4 Trading or business income of a club, derived from providing amenities to its members... 5 The scope of the exemption... 6 The roll-over of capital gains... 6 The new tax dispensation is not a disaster... 6 The compliance burden imposed by the new tax rules... 7 The administrative and accounting compliance burden... 8 Will club subscriptions have to rise as a result of the new tax rules?... 9 Consequences of non-compliance... 9 The way forward This publication is provided by PricewaterhouseCoopers Inc. for information only, and does not constitute the provision of professional advice of any kind. The information provided herein should not be used as a substitute for consultation with professional advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all the pertinent facts relevant to your particular situation. No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author, copyright owner or publisher PricewaterhouseCoopers Inc. All rights reserved. PricewaterhouseCoopers refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. PricewaterhouseCoopers Inc is an authorised financial services provider. 2

3 A guide to the new tax regime for Recreational clubs Hitherto, section 10(1)(d)(iv)(aa) of the Income Tax Act 58 of 1962 has granted an exemption from tax to any company, society or association established to provide social and recreational amenities or facilities for the members. These words are wide enough to cover social, cultural and sporting clubs, irrespective of their legal structure, in other words, irrespective of whether they are incorporated as section 21 companies, trusts or unincorporated associations. For brevity, this guide will refer to all such clubs as recreational clubs, or simply clubs. Historically, the reason behind this exemption is that, in a sporting, recreational or similar club, the members provide money by way of membership fees or subscriptions which the club then uses to finance amenities (a club house, swimming pool, tennis courts, golf course, etc) which the members, collectively, can enjoy. In other words, no business is arguably carried on the members are essentially just sharing expenses. The membership fees were therefore not regarded as income in the hands of the club, and were therefore not liable to income tax. Many clubs now engage in business activities But times have changed, and many sporting and recreational clubs now engage in all kinds of business-like activities to boost their coffers. Many clubs have bars and restaurants and some have shops on the club premises ( pro-shops ) where sporting equipment, clothing and other goods are sold. Non-members also use these facilities at a fee. It is common for clubs to hire out their premises to non-members for weddings, parties, conferences and corporate events. Under the loose wording of section 10(1)(d)(iv)(aa) of the Income Tax Act, all the income of a recreational club has hitherto been completely exempt from tax even its investment income and the rent it derives from leasing out its premises to nonmembers. Moreover, whilst enjoying this exemption, the club did not need to apply for approval from the South African Revenue Service. If the club and its activities fell within the scope of section 10(1)(d)(iv)(aa) the club was automatically tax-exempt. SARS believes that clubs have exploited their tax-exempt status.. and hence a new tax regime has been introduced. 3

4 In view of the above, SARS has become concerned that recreational clubs have exploited the elastic boundaries of the tax exemption granted by the Income Tax Act to carry on activities which are far removed from their core functions. Extensive income-earning club activities have resulted in a loss of tax collections to SARS from what are, in reality, ordinary trading activities and have exposed tax-paying businesses to unfair competition from taxexempt clubs. SARS has also taken note of concerns that the exemption enjoyed by recreational clubs in terms of section 10(1)(d)(iv)(aa) has become anomalous, in that they are treated more leniently than public benefit organizations, such as churches and charities, which have recently been made subject to a system of partial taxation. A new tax dispensation for recreational clubs In order to tighten up the tax rules relating to recreational clubs and eliminate anomalies, the Revenue Laws Amendment Bill of 2006 foreshadows a new tax dispensation for such clubs which will come into effect for the club s tax year which commences on or after 1 April Under the new dispensation, recreational clubs will continue to be exempt from tax on income they derive in the form of membership fees or subscriptions paid by members, but members will have to take out annual or seasonal membership. (Under the new tax dispensation, a club s constitution will have to state that members must be annual or seasonal members.) in the form of payments by members for social or recreational facilities, amenities or services provided directly to members. (This exemption would cover, for example, green fees, any charges for the use of the club s tennis or squash courts, or fees for the use of amenities such as gymnasium equipment or saunas, provided that payment is made by a member. This exemption will probably also cover income from the hire of club premises by a member for a social occasion.) from any fund-raising activities of the club which are of an occasional nature and undertaken substantially with assistance by the members on a voluntary basis without compensation. (The key words here are occasional and without compensation. What is envisaged is that club members should help out at such events without payment. If a non-member were paid for substantially organizing or managing the fund-raising event, the money raised would not be exempt from tax.) from any other source, up to a maximum of R per annum or 5% of the total membership fees and subscriptions payable by the club s members during the particular tax year, whichever is the greater. (In other words, if the club engages in ordinary trading activities, such as investing its surplus funds or hiring out its premises to non-members, the club will 4

5 be exempt from tax on such income only up to the threshold amount. This category of non-exempt income comprises all income which does not fall within the categories of exempt income, as summarised in the bulleted points, above.) Trading or business income of a club, derived from providing amenities to its members Special criteria are laid down with regard to income derived by a club from any business or trading activity which is integral to its core function of providing amenities to members. Such income is tax-exempt only if it complies with the criteria laid down in the new section 10(1)(cO), as summarised in the points below. Income that a club derives from its bar or restaurant would fall into this category, for these are clearly business activities. In terms of the new statutory provisions, income which the club generates from any business or trading activity will be taxexempt only if such business or trading activity is integral and directly related to the provision of social and recreational amenities and facilities for the members ; is carried out on a basis substantially the whole of which is directed toward the recovery of cost ; and does not result in unfair competition in relation to taxable entities. Provided that the income falls within these parameters, all of it is completely exempt from tax. Each of these bulleted criteria presents problems of interpretation on which a club will have to seek expert advice in regard to how the rule applies in the circumstances of that particular club. For example, what kinds of business activities of the club are integral and directly related to the provision of social and recreational amenities and facilities for the members? If, for example, the club were to organize a package holiday for its members and took a slice of the profits, would those profits be derived from an undertaking that was integral and directly related etc? If a golf club were to organize a package holiday for its members in which they travelled around the country playing on different golf courses (and if the club took a slice of the profits from arranging the tour) would that profit be derived from an activity that is integral and directly related etc? 5

6 Secondly, what does it mean to carry on a business activity on a basis substantially the whole of which is directed toward the recovery of cost. Does this refer to the cost of running the club as a whole, or is each business activity of the club looked at in isolation? Could high profits from, say, the club bar, which far exceed the recovery of cost, fall foul of this rule even though it is cross subsidising the golf course at a loss? The answers to these questions are still unclear, and perhaps SARS will issue a practice note for the guidance of taxpayers. The scope of the exemption If the club s business income which falls outside the exempt categories, outlined above, exceeds the statutory threshold (namely, R or 5% of the total membership fees and subscriptions payable by the club s members during the particular tax year, whichever is the greater) is exceeded, the consequence is that the excess is not exempt, and must be added to any other of the club s income which fails to satisfy the exemption requirements laid down in s 10(1)(cO). The aggregate of the non-exempt income will constitute the club s gross income, as defined in the Income Tax Act, and the club s taxable income must then be determined in the ordinary way. In other words, the expenditure incurred by the club in the production of its non-exempt income must be deducted from its gross non-exempt income. The resultant figure is the club s taxable income on which it will pay tax at the corporate rate. SARS s Explanatory Memorandum says that expenditure incurred [by a club] in producing exempt income (viz levies, membership fees and subscriptions) cannot be offset against club income falling outside the [tax-exempt] categories. This is merely an application of the general principle laid down in section 23(f) of the Income Tax Act. Difficulties are likely to arise in apportioning the club s expenditure into that which produced exempt income, and that which produced non-exempt income. The roll-over of capital gains Capital gains on the disposal of club assets (for example, the sub-division and sale of part of the club fixed property) will qualify for roll-over relief. Thus, liability for capital gains tax will be deferred if the club uses the proceeds of the sale to purchase an asset for the club that will produce tax-exempt income, in other words, an asset that will be used for the core activities of the club. The new tax dispensation is not a disaster When SARS first published the new tax rules, some clubs were quoted in the press as saying that the system was so harsh that clubs would be forced to close. This was likely an over-reaction, based on inadequate information or a misinterpretation of the proposed legislation. 6

7 Under the new dispensation, clubs will remain completely exempt on income they receive in the form of membership fees and subscriptions from members, and also from certain of the club s business activities conducted with members which fall within statutory parameters, as outlined above. The new tax rules therefore impact only on payments made to the club by nonmembers (i.e. green fees, bar sales and renting of facilities); income from business and trading activities carried on by the club which are not integral and directly related to the provision of social and recreational amenities to its members; or which are not conducted, substantially on a costrecovery basis, or which result in unfair competition with taxable entities. fund-raising activities by the club which are not of an occasional nature, and are not undertaken substantially on a voluntary basis by members without compensation; the club s ordinary trading income, for example, income from investments or from the sale of goods by the club s pro-shop, if the aggregate exceeds the annual ceiling, outlined above, of R or 5% of the club s gross membership or subscription fee income, whichever is the greater. It is difficult to argue that there is anything unfair in principle about taxing the club s income falling into these categories, as the income is derived either from transactions with non-members or from activities which fall outside the core functions of the club. What could be questioned is whether the additional tax that SARS hopes to collect from clubs that operate on a traditional cost sharing basis, will warrant the cost of administering them and the additional cost of compliance now laid up on these organisations. The compliance burden imposed by the new tax rules Even where a club incurs little or no tax liability under the new rules, the new dispensation may have a significant financial impact as a result of the compliance burden imposed by the legislation. Firstly, the partial tax-exemption to be enjoyed by recreational clubs under the new dispensation is not automatic. The club will have to apply to SARS for approval as a club which complies with the new section 30A and is therefore partially tax-exempt in terms of the new section 10(1)(cO) of the Income Tax Act. Most clubs will instruct their attorneys or accountants to make application to SARS on 7

8 their behalf, and the professional fees could be substantial. For a club to qualify for approval by SARS, the club s constitution will have to comply with the provisions of the new section 30A of the Income Tax Act. This section prescribes a number of provisions which must be contained in the club s constitution. Most clubs will have to take legal advice as to whether their constitution in its present form complies with section 30A and, if not, what amendments are required. If amendments to the constitution are required, the club will have to go through whatever process is laid down in its constitution to make the required amendments. This will usually require a general meeting to be called in order to approve the proposed amendments. Section 30A(3) does however provide for a simpler mechanism, namely for a person in a fiduciary position in the club to give a written undertaking that the club will be administered in accordance with the new tax rules. It is likely that, where a club uses this simpler mechanism, SARS will grant approval, subject to the condition that the club formally amends its constitution within a stipulated period. The new legislation gives clubs until 31 March 2009 to apply for approval by SARS, and such approval can then be given retrospectively. Clubs therefore have a considerable breathing space to apply for approval, but the new tax rules become effective as from the commencement of a club s tax year which commences after 1 April As from that tax year, clubs will be taxable in the ordinary way on all their income if they have not received SARS s approval, although such tax liability could be reversed if the club applies for approval before 31 March 2009 and SARS retrospectively grants such approval. Clubs would be well advised not to delay in amending their constitutions and, if they cannot do so before the start of their tax year which commences on or after 1 April 2007, they should arrange for someone in a fiduciary position in the club to give the necessary undertaking to SARS, as a temporary measure, to secure the requisite approval from SARS. This will tide the club over until its constitution can be formally amended to bring it into compliance with the new section 30A. The administrative and accounting compliance burden Under the new tax dispensation, a club s tax exemption will not extend to income it receives from non-members unless such income falls under the statutory threshold. Clubs will have therefore have to ensure that their accounting system keeps track of amounts paid by non-members, and of all other income they receive which does not fall into one of the tax-exempt categories, and the club s income tax return will have to identify such non-exempt income. Keeping track of non-exempt income may be reasonably easy where, for example, the club rents out its premises to a non-member for a 8

9 wedding, and an easily identifiable lump sum is paid into the coffers of the club. Keeping track of non-exempt income may however be tricky where, for example, a nonmember buys a drink at the club bar or has a meal at the club restaurant. The amount paid by the non-member will not be tax-exempt in the hands of the club. The practicalities of keeping track of all these small amounts of non-exempt income are likely to present difficulties. One solution may be for the club to have a rule that only members are allowed to purchase drinks or pay for a meal. Or perhaps, that everything has to be paid for by pre-purchased vouchers, and records can then be kept of the value of vouchers purchased by non-members. Will club subscriptions have to rise as a result of the new tax rules? The cost to the club of taking professional advice (on legal, accounting, and computerrelated issues) in respect of the impact of the new tax rules, and then implementing the changes necessary to ensure compliance with the rules may necessitate a raising of club subscriptions, unless the club has sufficient reserves, or unless the club imposes a one-off special levy on its members. Consequences of noncompliance If a club applies for and is granted approval by SARS, it will have to ensure that it thereafter remains compliant with the new tax rules. Violation of those rules can result in the club s forfeiting its tax-exempt status, but SARS must first give the club notice of any violation and an opportunity to put its affairs in order within a stipulated period and cannot summarily deprive it of its approved status. Once the Commissioner has withdrawn approval of a recreational club, it must within six months transfer its remaining assets to another approved recreational club or to an approved, tax-exempt public benefit organisation, which must not be a connected person (as defined in the Income Tax Act) vis-à-vis the club whose approval has been withdrawn. If the club fails so to transfer its assets, or take reasonable steps to do so, then a drastic consequence ensues the market value of the assets not transferred, less the bona fide liabilities of the club will be deemed to be taxable income which accrued to the club in the tax year in which the Commissioner withdrew approval. 9

10 The way forward All recreational clubs need to take the new tax regime seriously, and should ensure that they comply with those rules and remain compliant. Few clubs are likely to throw up their hands in despair and resign themselves to being ordinary, non-exempt taxpayers. For a club that wishes to qualify for partial tax-exemption under the new regime, the first step is to get expert professional advice on the legal and accounting implications of the new regime for that particular club and its activities. Once a club has made the changes to its constitution which is an essential prerequisite to an application for partial taxexemption, it will need to make important policy decisions. In particular, the club will need to decide whether, and if so to what extent, it is going to make its amenities available to non-members. A club may decide that the tax complexities of doing so would outweigh the financial benefits. method will have to be devised as to how the club is going to keep track of the (nonexempt) income that is derived from nonmembers. A club will also have to take professional advice on whether its current business activities and their modus operandi for example, the operation and profit margins of the club bar and restaurant, and the leasing of its premises to non-members for weddings and parties fall foul of the tax-exemption criteria laid down in the Act, and if so, whether and how such activities should be changed or curtailed. Future fund-raising activities are going to have to be planned with an eye on the tax aspects, to ensure that the money that they generate qualifies as exempt income under the Income Tax Act. If the club decides to make certain of its amenities open to non-members, then a Contact: Mark Badenhorst mark.badenhorst@za.pwc.com (011) Erle Koomets erle.koomets@za.pwc.com (011)