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Financial reserves: too much, too little or just right?

By Andrew Egri, Lawyer; Mills Oakley

 

Directors of not-for-profit organisations are well aware that the organisation’s reserves play an important role in its financial stability. Reserves allow an organisation to meet its ongoing financial commitments and continue to provide services. There are obvious issues that arise from an organisation not having sufficient reserves. However, for those income tax exempt entities that are fortunate to enjoy substantial reserves, they must act carefully to ensure that those reserves do not give rise to unintended problems.
Too much of a good thing?
1. Accumulating a high level of reserves without a clear explanation or justification may adversely affect the public’s perception of an organisation, and risk its income tax exemption. An organisation can accumulate income and still be income tax exempt, however there are restrictions to the accumulation of income which occurs for no identified purpose.

There are a wide range of scenarios which might result in an organisation holding substantial reserves. For example, an organisation may have sold property or experienced unexpected levels of profitability over a number of years. Section 50-50(2) of the Income Tax Assessment Act 1997 (Cth) imposes special conditions that income tax exempt entities must satisfy to remain income tax exempt:
• the entity must comply with all the substantive requirements of its governing rules (governing rules condition); and
• the entity must apply its income and assets solely for the purpose for which the entity is established (income and assets condition).

2. Income and assets condition
The ATO clarified, in Taxation Ruling 2015/1, how an organisation may satisfy the income and assets condition:
31. The income of an entity may still be ‘applied’ for the purpose for which the entity is established if some of the entity’s income (whether it be gross income or net income) is accumulated, provided the accumulation is consistent with the purpose for which the entity is established. An entity may use some of its income to acquire assets which, in future, will produce income for its purpose or purposes, and may accumulate some of its income for later distribution.
32. To satisfy the income and assets condition, an entity that accumulates most of its income over a number of years will need to show on a year by year basis that the accumulation is consistent with the purpose for which the entity is established. A organisation can generally accumulate funds for either or both of the following:
• future projects, programs, services or asset acquisition (Project Fund); or
• as a reserve in the event of future unfavourable or unexpected circumstances (Contingency Fund).

3. Project Fund
The income and assets condition allows an income tax exempt organisation to accumulate funds for the purpose of specific future projects, programs, services, asset acquisitions etc., which are in fulfilment of the organisation’s objects. So long as it has recorded:

• the nature of the future project, program, service, asset acquisition etc.;
• the estimated cost of the future project, service, program, asset acquisition etc.; and
• how the accumulation of funds over future periods of time will allow it to fund the estimated cost; the accumulation of funds is permitted and will not jeopardise the organisation’s income tax exemption. Once the organisation starts becoming vague about any of the above, the risk of not complying with the Taxation Ruling (and thereby losing its income tax exemption) increases.

4. Contingency Fund
It is good practice for any organisation, particularly a notfor-profit organisation, to set aside a reasonable quantum of funds in reserve as a Contingency Fund to protect it in the event of future unfavourable or unexpected circumstances.

The ATO has not prescribed what level is considered “safe” to accumulate for this purpose. Specifically, there is no set limit on how much money an income tax exempt organisation can place in reserve, and no rule setting out how long it is able to keep money in reserve.

While the ACNC recently released a fact sheet addressing the financial stability and sustainability of charities, it also did not prescribe an appropriate level of reserves. Rather, the ACNC holds the charity’s governing body as being responsible for ensuring that the charity maintains an appropriate level of reserves.

5. Recommendations for Boards
5.1 Project fund
As mentioned above, an organisation can accumulate funds for future projects, programs, services and asset acquisition as long as the arrangements are recorded.

If they have not already done so, we recommend that the members of the organisation’s governing body put their minds to documenting how the project fund is calculated. The composition of the project fund should be broken down into amounts to be applied for specific projects, programs, services or asset acquisition. For example, an organisation may decide to sponsor a new program, which will cost $300,000 per year for 5 years, and so the governing body determines to set aside $1,500,000 in the project fund to cover that cost.

5.2 Contingency fund
Given that:
• ATO and the ACNC have not specified what is an appropriately sized Contingency Fund; and
• each not-for-profit organisation is different, with different sources of income, and each facing different contingency events, meaning that what will be an appropriate amount retained in a Contingency Fund will vary from organisation to organisation; we recommend that the governing body determine for itself what is an appropriate amount to hold in respect of the organisation’s contingency fund.

The governing body should be prepared to explain in as much detail as possible, the grounds on which it determined the amount to be retained in the contingency fund. Specifically, any assumptions made by the governing body in determining the size of the contingency fund should be clearly set out. Some examples of factors which the governing body might consider in determining an appropriate amount are:
• the organisation is nearing the end of a substantial funding agreement and needs to set aside funds in the event that the agreement is not renewed;
• the organisation has been experiencing a steady decline in membership over a number of years and the Board has determined that funds will be needed to cover future expenses should the decline continue;
• the organisation is holding an event and the governing body has determined that funds will be needed to cover related expenses should registration numbers be lower than expected.

Some organisations choose to develop and approve a “reserves policy”. Such policy usually specifies the purpose of amassing and maintaining reserves and sets out the calculation of target amounts. For example, an organisation’s policy may provide that the level of reserves should cover at least three months and no more than six months of general operating expenditure.

5.3 Annual review
Irrespective of whether an organisation has approved a “reserves policy”, in order for it to maintain its income tax exemption, it will need to review its approach to the size and nature of its reserves at least once per year to comply with paragraph 32 of the Taxation Ruling. We recommend that the governing body confirm the amounts to be retained and its rationale for determining those amounts by:
• passing a resolution that confirms the amount to be retained by the organisation in reserve, as well as the basis on which the governing body considers that amount to be reasonable; and
• ensuring the financial reports of the organisation note the basis on which the amounts retained in both funds were determined by the governing body.