What do the Shotover jetboat operator, the maker of Weet-Bix breakfast cereal, St George’s Hospital in Christchurch, winemaker Mission Estate, and that group that plays the backing music on X-Factor have in common?

No, this is not a joke. All these companies are registered charities. Told you it was not a joke.

This fact came to light last week when The New Zealand Initiative published its latest report, Giving Charities a Helping Hand. The report looked into the decade’s worth of regulatory change and found that, despite an abundance of legislation, the rules governing the charitable sector need further balancing.

Of particular concern is a rule that has persisted in New Zealand for over 100 years allowing for-profit businesses owned by charities to register as limited liability companies. And because the earnings of these firms are supposed to be put towards charitable purposes, the profits produced by these firms are exempt from income tax.

To some extent this arrangement makes sense, particularly where the untaxed profits are distributed to their owners (the charities), and the use of these funds is monitored to ensure that it is being put to genuine charitable purposes.

But while it makes sense on paper, in practice it has led to a situation that is far from desirable.

For example, Ngai Tahu Charitable Trust’s status as a registered charity organisation has allowed the South Island tribe to classify 38 of its commercial businesses as charities. These businesses include Ngai Tahu Development Corporation, Ngai Tahu Property, and of course Shotover Jet Ltd, as mentioned earlier.

These commercial entities recorded a profit of $161 million in the 2014 financial year with no tax deduction. However, only 20% of this was distributed to the tribe, with no oversight into how these funds were spent. The remainder of these untaxed profits were retained within Ngai Tahu’s business units.

The South Island iwi is not alone in taking advantage of this regulatory arrangement.

Dunedin’s Mercy Hospital uses it, and Mission Estate’s profits remain untaxed because it is owned by a religious organisation. Similarly, breakfast giant Sanitarium also claims an income tax exemption because it is owned by the Seventh Day Adventists.

Independent charities researcher Michael Gousmett estimates that there are 700 limited liability companies on the Charities Register that generate $372 million in tax-exempt profits and hold $3.6 billion in assets, excluding Ngai Tahu. At a tax rate of 28%, the government has foregone an estimated $104 million in fiscal revenues annually by allowing this arrangement to exist.

But the problem with this legal arrangement extends beyond the government’s tax take. Companies that are exempt from income tax have a significant advantage over their private sector counterparts.

Parachute Music, a Christian charity, was accused of using its tax-free status to outbid other firms for the contract to supply backing music production services to the X-Factor television show.

Changes proposed but abandoned

It should be noted that to date no evidence has been produced to back the accusation against Parachute, or indeed show that other for-profit business owned by charities have behaved in an uncompetitive way. But the potential is there, and this avenue should be blocked before anyone uses it.

In highlighting this issue, the Initiative’s report is not breaking new ground. Roger Douglas, in his role as finance minister as part of the David Lange government, proposed making any profits produced by charity-owned businesses assessable for tax.

In 2001, the Helen Clark government again raised the issue in a discussion document, proposing the same solution as Douglas but added that any distributions to charities would have unlimited tax deductions.

Unfortunately, neither measure made it into law.

We favour this solution as a simple means of removing any unfair tax advantage that charity-owned businesses have over their private competitors. In addition, by taxing retained profits, it would incentivise these firms to distribute more of their pre-tax earnings to their relevant charities, thereby boosting the resources of the charitable sector.

Greater transparency into how these funds are used once they get distributed is also needed but the regulatory building blocks for this already exist, thanks to mandatory financial reporting rules which came into effect this year. These, in theory, should allow the regulator and the public to dig into the detail of how charities run their operations.

Damaging public trust

These reforms are urgently needed if we are to bolster public trust in the sector.

Charities perform a significant amount of good work in our society, much of it dependent on voluntary donations of money, goods and time. For example, charities reported an average of 1.1 million volunteer hours each week in 2010, equivalent to 27,500 fulltime staff, and at last count total sector revenue stood at $16 billion a year.

If we continue to pursue policies that damage the level of trust the public has in these institutions and the rules which govern them, it is entirely predictable that they will withdraw their support. This will leave a vacuum that the state will be called on to fill. This is a role it is poorly equipped to do because it does not have the deep connection that these groups have with their communities, and neither can it rely on a volunteer workforce in the same way that charities can.

This is why we need urgent reform of the charities legislation, and political leadership on the issue that can look through the inevitable deluge of bad headlines that will greet any meaningful attempt to tax for-profit firms owned by charities.

But the payoff could potentially be worth it for the politician bold enough to try it. New Zealand is a nation built on fairness, and you can almost count on a groundswell of support for the person who slams the door on a longstanding legal loophole, even if it is a rort of the government’s own making.