Deemed application provision causes uncertainties for donation aggregators

Charitable entities set up for different charitable causes such as education, yoga, relief of poor, medical relief, advancement of any general public utility etc., receive a tax-exempt status under Section 10(23C) and Section 11 of the Income-tax Act, 1961 (‘Act’). As per Section 11 of the Act, the trusts or charitable institutions are subject to following conditions to obtain tax exemption:

• During a financial year, charitable entities are expected to apply whole of the sums received by it towards charitable objects.
• However, these entities are permitted to accumulate sums towards charitable objects provided that the sums so accumulated do not exceed 15% of the income from property held for charitable objects.
• This application of income can be either towards themselves or by making donations to other charitable entities with similar objectives.
• If donated to other trusts or institutions, the donation should not be towards the corpus of other charitable entities[1].

A charitable entity was allowed to accumulate a maximum of 15% of its income received during a year for application towards charitable causes in subsequent years. However, this benevolent threshold of 15% was misused by various charitable entities by formation of multiple layers of chartable entities. It was seen that chains of charitable entities were formed to accumulate income to the extent of 15% at each stage. Retention of 15% at each stage essentially resulted in actual application of income towards charitable objects below 85% of the total receipts. The said practice was defeating the intent of legislature which aimed at ensuring maximum application of the income of charitable entities towards the end charitable causes.

Let us understand this with an example. Let us say there are 3 trusts- Trust A, Trust B and Trust C. Trust A receives INR 100. Trust A accumulates 15% with itself and donates the rest to Trust B. Similarly, Trust B accumulates 15% of the donations received from Trust A and donates the rest to Trust C. The workings come out to be as follows:

The receipts of Trust C in this case are INR 72.25. Assuming Trust C also accumulates 15% of its receipts, then the actual application towards the end charitable causes comes out to INR 61.84. Thus, by formation of chain of charitable entities, the actual application has come down to 61.84% as against the intended minimum application of 85%. Thus, charitable entities with more layers were able to enjoy exempt status by applying a relatively small portion of their receipts towards charitable causes.    

To plug this loophole, the Legislature has amended Section 11 of the Act vide Finance Act, 2023 with effect from 1 April 2024. An insertion has been made in Explanation 4 to Section 11(1) of the Act which restricts application of sums paid to other charitable entities to the extent of 85% of such payments. The bare text of the amendment reads as follows:

“(iii) any amount credited or paid, other than the amount referred to in Explanation 2, to any fund or trust or institution or any university or other educational institution or any hospital or other medical institution referred to in sub-clause (iv) or sub-clause (v) or sub-clause (vi) or sub-clause (via) of clause (23C) of section 10, as the case may be, or other trust or institution registered under section 12AB, as the case may be, shall be treated as application for charitable or religious purposes only to the extent of eighty-five per cent of such amount credited or paid.”

Though, the intent of this amendment was to discourage the practice of retention of more than 15% of the sums received through formation of multi-layers of charitable entities, however, it may seriously impact those charitable entities which are working on channelizing the donations (‘Aggregators’) by aggregating donations from multiple donors and applying almost whole (after retention of small amount towards admin expenses) of the donations by contributing to charitable entities engaged in actual application towards end causes.

Aggregators work as a single point of contact for a large number of donors and collect funds for application towards various charities. In order to enable the donors the claim deduction under Section 80G, the Aggregators may be registered under Section 80G of the Act. The Aggregators retain a small margin to meet their operating expenses and apply the remaining amounts towards other charitable entities. Clearly, in case of the Aggregator there is no accumulation of funds using layers of charitable entities. Rather, these Aggregators play a significant role in channelizing the donation by acting as a bridge between the end cause charities and the donors and ease out the compliance burden at the end of the end charities.

The amendment proposed to Explanation 4 to section 11 was not intended to be applied to charities applying 100% of the sums received by them to other charitable entities. However, on literal reading, it seems that there is incongruity between exemption criteria in Section 11 and the amendment made vide Finance Act, 2023. As per Section 11, a charitable entity is generally expected to apply the entire sums received by it towards a charitable object. However, the charitable entity is granted exemption even if it has accumulated 15% of the sums for charitable purpose. Thus, the benchmark for exemption under Section 11 for unapplied receipts is accumulation of income.

The amendment made vide Finance Act, 2023 deems that 85% of the sums paid/credited by a charitable entity to another charitable entity will be treated as application of income. In doing so, the amendment ensures that 85% of the sums will not be taxed in the hands of the Aggregator. However, as stated above, the qualifying condition for exemption of unapplied receipts under Section 11 is accumulation of not more than 15% of income for charitable object. Since, the Aggregator would have applied entire sums received by them, they would not be able to demonstrate any positive accumulation for charitable cause. The proposed amendment does not lend any support to the donor charitable entity for demonstrating that 15% of the remaining sums (in respect of which exemption has not been granted) have been accumulated for charitable purpose.

Thus, a charitable entity which has donated 100% of its receipts to another charitable entity could be subject to tax in respect of 15% of its receipts as it would fail to demonstrate that the 15% of the receipts have been accumulated for charitable purpose.

If the aforesaid interpretation is followed by the tax authorities, the Aggregators would be left worsen off from the charitable entity which have accumulated 15% of their receipts. This may be explained with the help of an example where Charity A receives INR 100 and donates INR 100 to Charity B vis-à-vis Charity X which receives INR 100, accumulates 15% and applies 85% towards charitable objects.

Thus, Charity A would be subject to tax at maximum marginal rate on INR 15 even after applying its entire receipts whereas Charity X does not suffer any tax even after accumulation of receipts. Further, there may be practically challenges to bear the tax cost on INR 15 in the absence of availability of any receipts in the hands of Charity A.

It is also possible that fearing tax demands, certain Aggregators may reduce the quantum of donations (to accumulate funds to meet tax demands). If such a practice is adopted by the Aggregators, the amendment may become counterproductive to its stated intent.

Visibly, the intent of legislature as is evident from Memorandum was not to scope in genuine Aggregators, however, the language of the amendment is wide enough to encapsulate them. Further, amendment uses the words ‘any sum paid or credited’ which signifies that not only donations, but also any other amount payable/paid (like service fees) by one charitable entity to another charitable entity will be subject to the rigors of the amendment. Further, in such a case there may be challenges as to computation of exemption amount of 85% of the sums paid or credited where the amount is credited in current year and the payment is spread across future years.

Conclusion

Truly, the language employed in Explanation 4 goes way beyond the intent of the legislation while introducing the said explanation. This has forced many Aggregators to reconsider their operational models. The Aggregators may consider approaching Central Board of Direct Taxes for necessary exclusions/relaxations in this regard. 

[The authors are Associate and Principal Associate, respectively, in Direct Tax practice team at Lakshmikumaran and Sridharan Attorneys, New Delhi]

[1] Explanation 2 to S. 11(1)