Comparing Institutional Reform of NPO in Japan and China

Date May 18, 2004
Speaker Leon E. IRISH(Visiting Professor, Catholic University of America / President, International Center for Civil Society Law)Karla W. SIMONProfessor and Co-Director, Center for International Social Development, Catholic University of America)
Commentator DEGUCHI Masayuki(Professor, National Museum of Ethnology)
Moderator HAMABE Tetsuya(Deputy Director of Administration, RIETI)


Irish: I am the President and Karla is the chair of the International Center for Civil Society Law, and we publish a free online journal describing the activity of law reform affecting not-for-profit organizations (NPOs) in countries all over the world. We are currently in Japan because of a large project for the Ministry of Civil Affairs and the Ministry of Finance in China.

Our draft report has three parts. The first part describes the current tax laws of China applying to their NPOs. Japan has nine different kinds of NPOs, China has three or four. China has over one million public service units, which cover a whole range of activities. They constitute one-third of the government pay roll and represent 5 to 10% of the gross domestic product, and China is considering moving most of them into the not-for-profit sector so it is important for China to get the tax rules right. This report describes the current rules in China and discusses the different kinds of taxes that can apply to NPOs and how they are applied in other countries around the world.

We then make 26 recommendations. We recommend providing full exemption from the enterprise income tax, full exemption from the business tax, special benefits under the value-added tax and the customs duties, and under real property tax, more generous benefits to donors to NPOs. We also recommend a system for determining which NPOs are for public benefit through an independent commission that will have representation from key government ministries, the not-for-profit sector and the public. So this commission would work with all these people to decide which of the not-for-profit organizations in China are public benefit organizations and thus be entitled to the highest level of tax benefits.

Simon: I was asked to talk a little bit about a book that we wrote called Guidelines for Laws Affecting Civic Organizations. We discuss the establishment of non-for-profit institutions in various countries across the world, and their tax rules. I have done research on Japan and have published a chapter dealing with the legal and fiscal framework for NPOs in Japan, which was current just before the Chukan Hojin Law came into effect in 2002. Japan is an example of a situation which is unsustainable, with its many different kinds of NPOs and rules. We are pleased to hear that the Japanese government has now undertaken the process of trying to change the system but in some ways it does not go far enough. The notion of taxing NPOs on certain kinds of incomes like donations and membership dues is something that we feel very strongly about.

Irish: Most not-for-profit organizations do not have profit. Even those with profits, it is essential that they are prohibited by law from distributing them. Is it then normal to impose corporate taxes on a NPO, which cannot and does not distribute the profits? The answer is no. There are a couple of exceptions. Some countries tax some investment income, and some countries tax profits that are unrelated to the not-for-profit purposes of the organization.

Can the government tax donations or member fees? Donations include several kinds of things: contributions from an individual to an NPO, grants from private foundations and grants or contract from the government to NPOs. A new worldwide rule is that none of these are subject to the corporate profits tax. The reason is because they are not regarded as income. Corporate profits tax is imposed to the extent that revenue that is constituted as taxable income exceeds the expenses related to the production of that income so donations, gifts or grants are not regarded as taxable income. For member fees, the new organizations may have member fees but almost all NPOs in Japan do not have real members and do not have membership fees. Membership fees are not treated as taxable income and not subject to the corporate profits tax.

Is there a kind of tax that can be applied to donations and members? Yes, it is the turnover tax, imposed on state-owned enterprises in socialist countries. They tax each state-owned enterprise on the gross turnover. In socialist countries with a huge turnover tax, it was regarded as a very bad tax. So countries have moved away from the turnover tax to the corporate profits tax.

Is it appropriate to make an NPO distribute its accumulated assets at dissolution? The answer is yes and no. If the organization has pursued a public benefit purpose or has been exempt from tax then they have received a substantial benefit from those tax exemptions. They also may have received donations from the public and it would be inappropriate to distribute the assets left from those public donations and public tax benefits to private members. But if it is a Chukan Hojin, a membership organization that has not received substantial tax benefits and has not received substantial donations from the public, then it would be permissible to distribute the assets.

Simon: This is a problem everywhere in the world. In the U.S., until 1950, we did not worry about competition between not-for-profit organizations and for-profit organizations. In 1950, the U.S. Congress imposed what is called the Unrelated Business Income Tax and from that time on, we have distinguished between related and unrelated business activities of NPOs. Before that, we did not tax any income from any business activities of U.S. NPOs. The first rule we listed in our book - do not tax any of the income from the business activities of NPOs - is called the Destination of Income Test. As long as an NPO carries on a business, earns money from that business and uses the money for its not-for-profit purposes or public-benefit purposes, then it is not subject to tax. Although the U.S. moved away from that rule in 1950, it can be found in many countries today. In most developing market economies, that is the rule and the reason is that in many countries, NPOs usually obtain funds to operate a business activity. Many of those countries have kept this notion but in other countries, including the U.S., it is considered too beneficial to the NPOs because they will compete with business if they can.

Many other countries, following the U.S. model, have imposed a Related/Unrelated Test, which is a difficult test to apply. It is very hard to figure out if an activity is related to the public benefit purposes of an NPO. We can use the example of a museum shop, which is making money for the museum because otherwise the fees for entering the museum would be much higher. But is its business activity related to the activity of the museum? There are various tests, but it is difficult in the U.S. to parse that.

The third test used to distinguish whether the activities of NPOs should be taxed is a test used in France. It looks at the commerciality of the way in which the organization operates its business activities. Does it act like a commercial organization? Does it distribute its profits? If it does, it is not a NPO. But the test is sliced very finely and they are really looking at the manner in which the NPO acts competitive to the for-profit institution. In that stance, most museum shops would not be taxable.

Irish: How should we judge the public interest of NPOs in Europe or the U.S.? We would like to know the standard and the institution of judging public interest. Many countries, like Japan, are reexamining the way in which they determine public interest. Is the organization one that is exclusively for public benefit? What that means is that it has to serve a public benefit purpose and a typical way of defining this is to list a range of purposes that will qualify. You have to make up your own list that fits your country.

But it is not enough simply to have one or more of those listed purposes. The organization also has to be pursuing that purpose in a lawful way, which will benefit all or some defined group of actual or possible beneficiaries. You might have the purpose of benefiting the orphans only in Tokyo. That is a defined group of people and would be a perfectly permissible class of beneficiaries. Third, the class of beneficiaries does not have to receive any benefit right now. If your organization has the purpose of doing medical research to cure cancer and has not yet obtained it, there is still a permitted purpose because when you do create a cure for cancer that will be a benefit.

The organization has to meet all of these tests: it has to have a public benefit purpose that can be tested by the purpose and not the activities. The luxury is that you can engage in any lawful activity that advances your charitable purpose and we are not going to tell you what activities you can or must engage in. One simple example is the magazine National Geographic, the principal activity of the National Geographic Society, whose purpose is to promote interest and knowledge about the world we live in. They do this principally by selling a magazine and selling television shows. It is all a business activity and they make hundreds of millions of dollars doing it. But all of their activities are directly in support of their purpose and their purpose is a public benefit purpose. So they are tax exempt in the U.S.

But there is more to it than purpose. The NPO itself must be organized and operated according to certain rules which require high standards of internal governance, transparency, accountability and a lack of conflicts of interests. Whatever your purpose and activities are, you still must be organized and operating in accordance to those standards. So it is a complex process and one that requires great skill to crack the law and great sensitivity in applying the law.

I think the best way to prevent unfair activities of NPOs is that citizens monitor NPOs through disclosure. Is that better than a single authority that has control over the NPO? My answer is that we do not have to choose and we should not choose. There should be a government agency responsible for receiving reports on the finances and activities of the organizations and making periodic checks to make sure the organization is being run properly. But the notion of citizen monitoring is also important and adopted more and more around the world. The best way to do that is to require each public benefit organization to make its reports public. Why is this important? First of all, it increases public confidence in the special public benefit organizations. Second, it also gives individuals the chance to look very closely at what is being done and often a citizen will catch something that the government missed and they can notify the government. So citizens can be very effective in monitoring.

Simon: One of the important monitors in most countries is the press. By making the information available to the public, it is available to the press. This has surprisingly taken root in China. Although the press is not free, the press does pick up on things that the people do not like. If there are scandals in the NPO sector in China, they are reported quite widely. So although the press is not free there, there is the sense that public disclosure and media involvement is tremendously important in the nonprofit sector.

On question seven, there are four different types of benefits for donors to NPOs around the world. Three include tax deductions, tax credits and the so-called 1% laws. A tax deduction is something that can be available both to businesses and to individuals who are self-employed. It is a little more difficult to allow an individual a tax deduction if he or she does not file a tax return. If I make a donation to an NPO, I subtract that from my income when I file my taxes. In a country which has a tax credit on the other hand, if I make a donation, I would be entitled to deduct from my tax rather than from my income a percentage of that. In a progressive income tax structure, the deduction is more beneficial to people in higher brackets because it reduces the taxable income, whereas the credit is exactly the same for everybody in every bracket. So when people debate whether to have credit or deduction, it is a question of equity and that is a tax policy decided on a country-by-country basis, but most countries use the deductions.

The most interesting development that has occurred in the past ten years is that of these tax designation schemes, the so-called 1% laws, which allows a taxpayer who does not file a tax return to designate that 1% of his or her tax be paid to an NPO. This system is based on rules with regards to the Church tax, where the tax is levied to support the Churches. Spain and Italy both moved away from the Church tax and adopted this system. Hungary was the first country that used a tax designation system for NPOs and it has impacted the not-for-profit sector tremendously. This scheme is sweeping through Central and Eastern Europe because, as in Japan, most people do not file tax returns and it is a way for the government to support NPOs by allowing citizens to designate the NPOs that get their support. There is some critical reaction that the government is now reducing its subsidies. This may be good or bad, but it should be considered in Japan. The Sasakawa Peace Foundation has also supported this effort in Central Europe.

Irish: One other comment on tax deductions: most countries do allow tax deductions and most countries except Australia put a limit on the extent to which you can claim a deduction. In our report to China, we are recommending that it have a limit of 10% for corporations and 50% for individuals and for any gifts above that, our recommendation is to allow the deduction to be carried forward into subsequent years.

Simon: On question eight: the New Zealand government has been working with the Organization of NPOs and they are holding public meetings all around the country and have a set of questions which are being published on the website. The New Zealand Organization of NPOs is getting academics, citizen activists and NPOs involved. The government is interested in getting a response from the nonprofit sector. It has been a cooperative and informed process and the best way to convince Japan that this is a good idea is to show them what the New Zealand government is doing now.

Deguchi: The topic of nonprofit law is worldwide. NPOs are sometimes referred to as nongovernmental organization beyond the national border. It is important to compare countries and you may believe that developed countries have better systems than developing countries, but no. Poland has just introduced the 1% tax law and it has spread to many countries. We need to share and exchange knowledge.

Questions and Answers

Q: When you see different tax systems around the world, there are different categories in different countries. Japan seems unique, but what kind of variety should there be in terms of NPOs?

Simon: What is most troubling is that what exists now is not strange. To have a variety of different rules, different levels of exemption to permit certain organizations to qualify for tax deductible gifts is normal. What would be abnormal would be a system in which all NPOs are taxed on donations and on membership fees. In the U.S., if a for-profit corporation receives a contribution to capital, or initial investors contribute capital to the corporation, it is not taxable to the corporation. If I make a gift or a foundation makes a grant to an NPO, it is not taxable. It makes no sense from the standpoint of defining income to say that that would be a flow of revenue which should be taxed. Whether it is in the for-profit field or the not-for-profit field, a contribution is not treated as a taxable event, which is troubling. For membership fees, if I give money to an organization of which I am a member, I expect something in return. How can that organization have income from my membership fee? It must return to me something equal to what I give it. So to tax for membership is inconsistent with tax theory.

Irish: The other aspect of Japan which is unusual is having nine different legal entities that can be not-for-profit. It is very confusing to citizens and regulators to have many kinds of legal entities and what countries around the world are doing is to simplify this and treat all NPOs the same. The only legal entities that you need are a membership organization and a nonmembership organization. In civil law, we call that an association and a foundation. In the membership organization, the highest governing organ is the assembly of all members. In nonmembership organizations, the highest governing body is the board of directors. Those are the two basic kinds of governance. Beyond that, will you treat any of these organizations as public benefit organizations? That should be a set of uniform rules that apply equally to all organizations.

Deguchi: In Japan, each Ministry gave privileges to each organization, so it is divided ministry by ministry. But it will be reformed.

Q: Does this issue of tax exemption or taxability have something to do with the political attitude of the NPO for or against the government? I would like to know about what is going on in China, as the government was known to be authoritarian.

Irish: China is not the best example because there is hardly any independent political activity anywhere in China, so it is not special to NPOs. But it is an issue in many countries. In the U.S., there are certain kinds of NPOs that are given freedom in advocacy activities and to lobby the government for changes in the law. Those organizations are exempt on their own income, but if you make a contribution you get no deduction. For public charities, you get a deduction but they are not permitted to engage in lobbying activities or to oppose or support a candidate for office. A third kind of entity is taxable on its investment income but can engage in election areas. So we allow different kinds of entities to engage in political activities, but we measure the tax benefits differently. If you want the highest form of tax benefits, have no lobbying or electioneering.

Simon: With respect to China, there are many organizations that are critical of the government. Many NPOs, and citizens as well, are extremely critical in the environmental area. Certain things are OK as long as you do not establish another political party or something like that, and keep your criticism within certain bounds. The Chinese government actually seems to be welcoming it because it gives new ideas. There has been an enormous change in ten years. Chinese NPOs have been very vocal about the changes in the world affecting them and they actively talk with the government. So the Chinese government is not totally monolithic. They may not agree or do what the NPOs want and may even stonewall them, but they will listen. As long as it is within the system, things may change more quickly than we can imagine.

Simon: The level of political discussion is much greater now than it was ten years ago. The government says it will allow public discussion but not discussions that criticize the Communist Party, recommend changes in the constitution or oppose democracy. You are free to have public discussions on almost anything outside of those three subjects.

Q: With regards to relations between NPOs and the government, I understand that in Japan sometimes the central government organization is in charge and in some cases local governments or prefectural governments are in charge. In the U.S., which government plays the central role vis-a-vis not-for-profit organizations?

Irish: We try to stay away from the peculiarity that the U.S., Canada, Australia, India and Russia have. They are federal systems, or agglomerations of separate governments. Each state is said to be a sovereign separate entity in the U.S. So there is a central government and fifty state governments. It is complicated and you typically create your NPO under the laws of the particular state, which will be regulated by that state. But then you will seek your basic public benefit status from the national government. In our case, it is a branch of the Internal Revenue Service and I would not recommend that to any country that is starting out. Japan has the fortune of being a unitary nation. There are prefectural taxes and laws, which are part of the decentralization. This is desirable.

Simon: The most interesting thing for us is that the property tax is being levied to support local government. So you can have vast differences between localities in a state. The issue of property tax exemption for entities in the U.S. may be even more important than income tax because they may have no revenue subjected to the income tax but if they have property then whether or not they have to pay property tax, is a big issue. But on the other side are municipalities. The municipality of Cambridge, Massachusetts has very little land that is not owned by public benefit educational organizations. So they find it very difficult to pay for public services because their entire tax base is a not-for-profit tax base. So there is enormous push and pull in our system.

Q: My question is about a floor in the tax deduction system. Japanese students can deduct the portion exceeding ¥10,000 from taxable income when they make a contribution because of the floor. Do you think the floor is appropriate and which countries have a floor in their tax deduction systems?

Irish: I recommend a floor. Japan and Australia have a floor. One of the greatest challenges a tax authority has is to check your claim that you made a charitable contribution. If you made a very large contribution, it is easy to check. But if you claim to make a very little contribution, it is hardly worth the time of the government to check, but then there is a lot of cheating in little deductions. If you have a floor, you get rid of that cheating because you have to prove you gave up to that floor and above, and that is the amount that is worthwhile for the government to check.

Simon: The other thing that is important is that in most countries, poorer people give anyway without regard to whether there is a floor or whether it is deductible. So our feeling is that it is not going to deter people from giving to have a floor. It will discourage fraud, so why not have a floor if it makes it easier for the system to operate.

Q: I am interested in salary and compensation for NPO workers. Japanese people working for NPOs get very small salaries and compensation. To get more effective human resources, higher salaries and compensation would be required. However, higher salary and compensation would reduce the profit for public use. How can we determine the suitable level of salary and compensation?

Irish: This is an important problem in developed countries. In China, we are trying to recommend a system that would deal with this problem now before it gets out of hand. We are recommending that every public benefit organization has to choose either the model of a university or the government, and pay salaries that are no higher than those allowed on the government or university pay scale. In the U.S., it has gotten out of hand. The Internal Revenue Service (IRS) requires public charities to disclose the five highest paid individuals in an organization but many organizations do not fill it out and nobody bothers them. On the other hand, large foundations have been successful in persuading the IRS that they can judge appropriate compensation by looking at the for-profit sector and the nonprofit sector. The rule in the U.S. is you cannot be paid more than what somebody in a comparable job is paid. If we look at both for-profit companies and not-for-profit, there is no realistic limit.

*This summary was compiled by RIETI Editorial staff.