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ECONOMIC ACTIVITIES OF NOT-FOR-PROFIT ORGANIZATIONS
Prepared by the International Center for Not-for-Profit Law
Regulating Civil Society Conference
Budapest, Hungary — May, 1996
I. Introduction
As the countries of Central and Eastern Europe (CEE) and the Newly
Independent States of the fo rmer Soviet Union (NIS) develop laws governing the
not-for-profit sector, each must address “economic”/”commercial” activities of
not-for-profit organizations (NPOs)
1. This issue is intric ately linked with broader
questions concerning the definitions and boundaries of the three sectors of
society–governmental/state, commerci al, and not-for-profit. There are also
implications for macro-economic and mi cro-economic policy, governmental and
legal structures, and even the relationship between individua ls and the state.
Despite the breadth of their implications, legal issues relating to the “economic”
or “commercial” activities of NPOs in the CEE and NIS countries lend themselves
to fruitful categorization and analysis. In th is process, it is useful to consider
practices in the United States and West ern Europe, as well as developing
experiences in the CEE and NIS. This helps illuminate the policy trade-offs
inherent in choosing one approach over another.
To place the analysis in context, Pa rt II discusses the defining legal
characteristics of NPOs. Part III examin es various definitions of “economic” and
“commercial” activities. Pa rt IV analyzes the extent to which “economic” and
“commercial” activities are consistent with not-for-profit status, regardless of
whether such activities are taxed. Pa rt V outlines general approaches to the
income tax treatment of such activities , focusing on advantages and limitations of
three models: (A) taxation of all or subs tantially all NPO economic or commercial
activities; (B) the “destination of income” approach and variations thereupon; and
(C) differentiation based upon the relati onship or “relatedness” to the NPOs
public benefit purposes. 2 Part VI summarizes the analysis.
II. Assumptions Concerning the Defining Legal Characteristics of NPOs
Before attempting the task of defining and analyzing “economic” and
“commercial” activities of NPOs, it is necessary to identify and describe defining
legal characteristics of NPOs. These attributes are generally described below.
For a comprehensive review of this and other issues, please see the Open

Society Institute Handbook on Laws for Civic Organizations (prepared by ICNL,
1996).

The first assumption is that the legal entities under consideration are all
organized and operated primarily for some purpose other than private gain. The
emphasis here is not on avoiding the generation of profit (in the sense of an
excess of revenues from all sources over expenses of all types), but rather on
the existence of a substantial public benefit purpose .
3 This is often referred to as
the “principal purpose” test. 4 The different interpretations given to the “principal
purpose” test are discussed further in Pa rt III below, in the context of the
definition of “commercial” activities.
A second characteristic of NPOs is that they are prohibited from distributing net
revenues to private parties who might be in a position to control them f
or
personal gain, such as founders, mem bers, officers, directors, agents,
employees, and other natural and legal persons closely related to these parties.
5
This prohibition does not generally extend to distributions, even to private parties,
which are designed to further public benefit purposes (such as charitable
donations to the poor). However, this assumption removes from the scope
of this
discussion many mutual benefit organizations which make distributions to their
members and do not grant simila r benefits to the general public.
A third assumption is that these characteristics are not pr imarily dependent on
the legal form of the organization. In other words, the activities and purposes of
the organization, rather than the characteri zation of its legal personality, are most
significant. Accordingly, this paper addr esses what are varyingly known as
associations, foundations, trusts, non-sto ck or charitable corporations, public
benefit companies, and even unregist ered and unincorporated organizations
under certain legal systems, as long as t hey serve a public benefit and uphold
the principle of non-distribution.
III. Definitions of “Economic” and “Commercial”
The task of defining “economic” and “commercial” activities of NPOs is b
est
begun by identifying the fiscal transactions which are generally considered not to
fit into these categories. Transactions generally deemed not to be “economic” or
“commercial” include: the receipt of purely gratuitous gifts, grants,
6 donations,
and contributions; 7 the receipt of net revenues from passive investments; 8 and
the use of any funds from these sources to advance the public benefit purposes
of the NPO. A variety of other activities may be excluded under specific tax
systems.
The broadest definition that might reasonably be assigned to “economic”
activities is the active sale of goods or services–often referred to as “trade or
business” activities. However, exclusions from this expansive definition exist in
most of the CEE and NIS countries, as well as in Western Europe and the United
States.

The first commonly recognized category of exclusion relates to isolated, irregular,
or occasional activities, which do involve the sale of goods or services, but which
are not pursued with the frequency or continuity characteristic of comparable
practices in the commercial sector. Examples include raffles, occasional fund
raising dinners, and charity auctions. These activities are principally
a form of
fundraising (subject to appropriate rules on fundraising), but are not generally
treated as economic activities because they are not regularly carried on for
commercial purposes.
A second group of NPO activities often recognized as non-economic in nature
(although they involve the sale of goods and services) are those activities
primarily or exclusively carried out with volunteer labor and/or donated materials.
The fact that charitable donations and volu nteer work generally serve the public
benefit justifies this category of exclusion. An example of this is a thrift or second-
hand store operated by an NPO to generate profits which are devoted to its
public benefit purpose.
A third broad category of exclusion rec ognized by many legal systems, which
may overlap with the second category above, is derived from historical practices
or traditions. This category includes activities which are considered to be
intrinsically connected to the public benefit purposes of certain NPOs. Depending
upon the legal system, examples may include admission fees for museums,
tuition payments for instruction at educati onal institutions, or even fees from
patients at not-for-profit hospitals. Fees of this sort are so well-established that
they are often excluded from the definition of economic activities. It may also be
that they are not thought as separate trades or businesses because the fee is so
integral to the principle ac tivity of the organization — e. g., culture, education or
health care. Because these exclusions are based on traditional or historical
conceptions of the public benefit, ex amples are often country-specific.
Accordingly, “economic” activities of NP Os may be generally defined as regularly
pursued trade or business activities involv ing the sale of goods or services and
not involving activities excluded under some distinct tradition. The next issue is
whether all “economic” activities are necessarily “commercial” in nature.
United States law illustrates the concept ual confusion surrounding the distinction
between “economic” and “commercial” activities. Although the Internal Revenue
Code and Treasury Regulations (the primary sources of federal law governing
NPOs in the United States) barely use (and never define) the term “commercial,”
various American courts and commentat ors have created a loose doctrine of
“commerciality.” Most commonly, the iss ue is whether an NPOs activity has a
direct “counterpart” in the commercial sector. The following factors have also
been suggested to indicate inappropria te “commerciality”: profitable operation
and the accumulation of profit s, competition with for-profit firms, extensive and
successful expansion, and the use of paid workers.
9

Dutch law also incorporates an element of “commerciality”: NPOs are permitted
to engage in economic activities so long as they do not substantially compete
with private sector enterprises. (This rule is modified to allow NPOs to operate in
certain targeted areas such as health ca re.) Current Romanian law contains a
similar principle, denoted “economic charac ter.” Only activities with economic
character are taxed. Economic characte r is defined by example, and includes
sales, the performance of services or professions, and income from events.
10
The receipt of donations and membership dues is deemed not to have any
economic character. However, there is disagreement regarding whether this
doctrine is in actuality a test of comme rcial manner, or whether it subjects all
“economic” activities to taxation, regardl ess of the manner in which they are
conducted.
11
Approaches based on “commerciality” seek to address several concerns: a
blurring of the line between the not-for -profit and commercial sectors; the
potential for abuse of NPOs for private gai n; and the threat of unfair competition
between economically active NPOs and t he commercial sector. Implementation
of this conceptual design is difficult, however, because there is a lack
of
consensus on what constitutes a comme rcial “counterpart” or “substantial
competition.” Moreover, these approaches require government officials (or
judges) to undertake exceptionally co mplex microeconomic analyses of
industries and NPO activities to det ermine whether the conditions of the
particular test are met.
Arguably, no precise conclusion em erges from the preceding discussion
distinguishing between t he definitions of “commercial” and “economic” when
used to describe NPO activities. The use of the term “commercial,” however,
does add an additional factor to this anal ysis, by focusing attention on whether
the manner in which the NPO carries out the ac tivity is clearly distinguishable
from the manner in which traditional for-profi t organizations carry out similar
activities. Accordingly, it may be appropr iate to speak of “economic” activities
when an NPO regularly engages in active tr ade or business activities involving
the sale of goods or services, unless the activities fall under some traditionally
excluded area. We can then define “commerc ial” activities as a subset of
“economic” activities consisting of those activities for which t here is a for-profit
“counterpart.”
IV. Are NPOs Permitted to Engage in Economic or Commercial Activities?
A threshold issue is the extent to wh ich NPOs should be permitted to engage in
economic or commercial activities and retain their not-for-profit status. At this
stage of the analysis, the question is not whether such activities should be tax-
exempt, but whether there should be a limit to the amount of
economic/commercial activities undertaken by an NPO.

The “principal purpose” test discussed above provides one model. This test
seeks to ensure that the organization is established and operated primarily for
public benefit purposes, and not private gain. Accordingly, an NPO that
consistently spent more than fifty perc ent of its funds or resources would be
required to reregister as a for-profit ent ity. This helps ensure a clear distinction
between the two sectors.
A second approach is the so-called “destinat ion of income” test. Contrary to the
“principal purpose” test, the “destination of income” test, in its pure form, entirely
ignores the economic or commercial nature of the activity in question, a
nd
instead focuses exclusively upon the purposes for which profits are used. Under
this test, an organization must devote all of its income to public benefit purposes
in order to qualify as an NPO. Accordingl y, a purely commercial enterprise which
is organized using a not-for-profit legal fo rm and which devotes all of its profits to
public benefit purposes might enjoy the same legal treatment as an NPO
accomplishing similar goals with donated f unds. Unfortunately, this may lead the
public to view NPOs as a means of av oiding taxation. This image, once created
by even a limited number of NPOs damages t he reputation of the entire sector. In
Bulgaria, for example, the la ck of effective regulation of economic activity led to a
governmental backlash against the sector, which has severely impeded
legislative initiatives in the country.
The distinct focus of the “destination of income” test highlights an additional
point. Under this test, it is completely irrelevant whether the profit-generating
activity is carried out directly by the NPO that will utilize the income, or by
another organization (such as a subsidiary or affiliate). In certain instances, the
“principal purpose” test is applied in the same fashion. However, some
jurisdictions require that a distinct entity with separate financia l records carry out
the profit-generating activity (particularl y activities unrelated to the public benefit
purposes of the organization).
12 Proponents argue this approach limits NPO
liability in the event that the activity loses money and minimizes public perception
that NPOs are merely for-p rofit entities in disguise.
13
Under either rule, an NPO is permitted to engage in economic activities that
further the public benefit pur poses for which it is organized. There are two
principal justifications for permitting NP Os to engage in such activities. First,
income from economic activities is a primary source of funds for NPOs
(particularly in countries in a transiti onal phase where there is an absence of
private capital and philanthropic traditions ), thereby reducing their reliance upon
both government and private sources of funding. Second, certain economic and
commercial activities directly accomplish public benefit purposes. For example,
although sales of a book on teaching tech niques by an educational organization
is an economic activity, the distribution of the book directly serves the public
benefit purpose of promoti ng education. Preventing NPOs from using such
commercial and economic means to attain their goals would directly impair their
ability to serve public benefit purposes.

V. Income Tax Aspects of Economic Activities
A. Introduction and Country Survey
Once it is decided to rule out polar extremes–a complete prohibition against
economic activities and allowing economic acti vities to be the principal activity of
the organization–the issue becomes the tax treatment of such activities. Three
general approaches exist, as indicated by the country survey below. The first
approach is to tax income from all economic activities, regardless of the source
or destination of the income. The second approach is to apply a “destination of
income” rule, exempting income from econo mic activities which is used for public
benefit purposes. The third approach focuses on the source of the income,
granting an exemption only w hen it results from activities which are “related” to
the public benefit purposes of the organizati on. A survey of countries utilizing the
three general approaches follows.
1. The practice of taxing the economic activities of NPOs
broadly defined:
• In Ukraine, NPOs face 28 different kinds of tax on economic
activity. There are no general ex emptions available to NPOs,
although some historically favored groups have received
exemptions (such as veterans groups).
• Until recently, Estonia imposed taxes on all “economic”
activities of NPOs, which are broadly defined to include
income from charitable events as well as business activities.
Lithuania also taxes income fo r NPOs, but at a significantly
reduced level of five percent.
• The Kyrgyz Republic taxes all economic activities of public
associations, but provides lowe r rates for certain traditional
public benefit purposes, such as education and medical
training.
2. The practice of making taxation contingent upon the
destination of income:
• Poland considers income earned by foundations to be tax
exempt if it is devoted to public benefit goals which are
specified in the tax law.
14
• The United Kingdom exempts income earned by for-profit
entities established by charit ies if the income is used
exclusively for charitable purposes.
• The Czech Republic taxe s profits on economic and
commercial activities related to the public benefit purposes
of NPOs, but 30% of the tax base or 3 million CZK (about
US$100,000) of t he profit, whichever is less, is exempt from

tax if used to further public benefit purposes. 15 Income from
unrelated activities is fully taxed.
3. The practice of making taxation depend upon the related
nature of the activity:
• The United States grants a ta x exemption for income from
economic activities which are related to the public benefit
purposes of NPOs, but taxes all income resulting from
economic activities which are not so related.
• Germany requires 1) that economic activity be directed
towards the accomplishment of the organizations public
benefit purposes, and 2) that the economic activity be
necessary to achieve these purposes. Otherwise, no tax
exemption is permitted.
• Hungary takes yet another approac h, providing a list of
activities (with a “catch-all” provision) which are exempt from
taxation. Income from other acti vities is taxed unless it is
less than 100,000 HUF or 10% of the organizations gross
income.
Of course, it is also possible to create a hybrid approach, based on
two or more of these approaches. For example, it is possible to
allow net income from economic ac tivity to be tax exempt under a
specified threshold and to apply a “relatedness” test to determine
whether net income over that threshold should be taxed.
As a general proposition, there is no consensus concerning which
system best serves the intere sts of NPOs and governments.
Divergent approaches reflect dive rse socio-economic conditions,
legal traditions, and legislative/ad ministrative developments. Some
commentators also suggest that this indeterminate state of affairs
reveals underlying disagreement c oncerning the proper function of
NPOs, and distinct psychological and institutional approaches to
standards of equity and justice in particular countries.
16
Perhaps there is somewhat gr eater consensus surrounding the
policy framework for analyzing t hese different approaches. This
paper identifies and applies five cr iteria for this analysis: the
simplicity or complexity of administration; the effects on revenue
collection; the effects on the comm ercial sector; the effects on the
development of the NPO sector ; and practical concerns about
implementation. Other criteria ar e certainly relevant, but this
framework sheds analytic al light on the practical implications
resulting from each approach.

B. Taxation of All or Substantially All Economic and Commercial Activities
The first general approach is to tax all income from economic and commercial
activities, regardless of the source or destination. Ukraine follows this approach.
Until recently, Estonia followed this approach, and Lithuania is moving in this
direction.
1. Theoretical Explanation and Rationale
Proponents of this approach believe t hat providing tax preferences
to NPOs results in “unfair com petition,” which harms for-profit
organizations. The argument is th at tax exemptions reduce the
marginal cost of capital, t hereby lowering production costs for
NPOs. Many commentators believe that tax-exempt profits give
NPOs higher post-tax rates of return on their business activities
than for-profit organizations. Tax-free profits may also enable NPOs
to maintain lower profit margins on their economic activities. This
advantage could be used to reduce prices on goods and services
below levels which are competitive, or even sustainable on the part
of for-profit organizations. New participants often enter markets in
this way, and in competitive markets entry itself can harm existing
economic actors. Once an NPO begins operations and gains
market share, for-profit organizati ons may be driven out as a result
of competition for the diminished market which remains. Also, tax
exemptions may provide NPOs wit h a larger capital base, which
can be utilized to finance expansion and outbid for-profit
organizations for land and facilities.
17 In summary, proponents of
this approach argue that with the possible exception of certain
traditional public benefit activities , it is necessary to tax all
economic activities to place NPOs and for-profit organizations on
equal footing in the marketplace.
18
2. Analytical Criteria
(a) Simplicity or Complexity of Administration : A principal
advantage of this approach is its adm inistrative simplicity. While
traditional/historic exceptions or application of the doctrine of
“commerciality” would reduce the level of simplicity, the concept
that NPOs should be treated as any other organization for tax
purposes is not difficult to apply. Additionally, creation of a broad
tax base can minimize the potential for abuse.
(b) Effects on Revenue Collection : The tax base depends on the
number of taxpayers and their associated income. Taxing all
economic activities would likely decrease the number of NPOs
engaging in such activities. Thus — perhaps contrary to intuition —

this approach potentially reduces the tax base. Therefore, without
empirical analysis, it is difficult to determine the effect of this
approach on revenue collection.
(c) Effects on Commercial Sector : This approach creates the fewest
concerns over unfair competition between NPOs and for-profit
organizations. Since both are tax ed on economic activities, they
have virtually equal status.
(d) Effects on the Development of the NPO Sector : This approach
depresses the development of t he not-for-profit sector. NPOs
operating under this legal regi me must pay tax on economic
activities even when they are related to public benefit purposes.
Thus, they are limited in their ability to financially sustain their
operations. This approach also fails to provide incentives for NPOs
to engage in public benefit activi ties involving an economic or
commercial component (such as an a ssociation for the blind selling
walking canes), since these activities would be fully subject to tax.
(e) Practical Implementation Issues : From an accounting
standpoint, it is often difficult to determine NPO income and
expenses attributable to a specific project. Moreover, this approach
still requires a determination of wh ich activities fall within the
definition of “economic” or “commercial” activities.
C. “Destination of Income” Rule
The second approach is the “destination of income” rule. Countries applying
some form of this approach include Poland, the United Kingdom, Czech
Republic, Croatia, Denmark, and Ireland. T he source of the income (whether or
not the profitable activities are related to the public benefit purposes of the NPO)
is irrelevant. Instead, tax treatment depends entirely upon the use of the income.
Any income which is devoted to publ ic benefit purposes is not taxed.
19
Some countries place an upper limit on t he amount of income that is exempt
under this approach. In Croatia, for exam ple, the tax exemption is limited to
50,000 kunas (approximately US$10,000).
20 In the Czech Republic, income up
to approximately US$100,000 is exempt from tax if used to support public benefit
activities.
21
1. Theoretical Explanation and Rationale
This approach is based upon the premise that tax exemptions
should help to subsidize activities which benefit the public.
Therefore, only income actually spent in a legitimate effort to further
public benefit purposes should be exempt. Proponents of this rule

assert that tax preferences are appropriate for activities which
would or could be properly under taken by the government to
improve the situation of the citizenry.
Many countries applying the “destination of income” rule place a
limit on the level of the exemption, either in absolute terms or based
upon a percentage of the income or tax base. While establishing a
numerical limit is a simple means of limiting revenue losses for the
government, any particular choice is, in the final analysis,
somewhat arbitrary.
2. Analytical Criteria
(a) Simplicity or Complexity of Administration : This approach avoids
the necessity of conducting an in- depth analysis of the source of
income to determine whether it is related to the NPOs public benefit
goals (or whether the activity has commercial counterpart).
Nonetheless, it is necessary to ascertain whether the income is
spent on public benefit goals, which is often difficult to determine.
(b) Effects on Revenue Collection : Of the three approaches, this
rule in its purest form would likel y generate the lowest level of tax
revenue. As long as income is devoted to public benefit purposes,
there is no tax liabilit y. Revenue loss can be minimized by imposing
a cap on the amount of in come exempt from tax.
(c) Effects on Commercial Sector : This rule will likely give rise to
the strongest claims of unfair co mpetition. For example, if a
foundation established to aid the poor receives income from the
manufacture and sale of radios, such income would be tax free if
applied to public benefit purposes. Ho wever, this tax benefit might
allow the foundation to remain in the market even if it is less
efficient than its for-profit compet itors. Moreover, if NPOs take
advantage of this rule and engage in completely unrelated income-
generating activities, this may l ead the public to view NPOs as
nothing more than cleverly crafted businesses. Thus, this approach
potentially entails serious macroeconomic consequences for the
business sector and has the greatest chance of promoting public
distrust of the not-for-profit sector. It may also attract more
unscrupulous individuals seeking to use NPOs for tax evasion than
the other approaches.
(d) Effects on the Developm ent of the NPO Sector : When there is
no limit to the exemption, this approach provides the greatest level
of financial support to NPOs. Even if limits exist, NPOs still have
access to a defined level of tax exempt income from economic

activities. However, it is important to remember that time limitations
on the expenditure of income can create disincentives to the
formation of endowments, and other related accounting problems.
22
(e) Practical Implementation Issues : The most difficult
implementation issue is determi ning what constitutes a valid
expenditure in furtherance of an organizations public benefit
purposes. Specifically, what c onnection is required between the
expenditure and the NPOs purposes ? Money spent on food for the
poor is key to the goals of a f oundation fighting hunger. But is job
training (arguably enabling the benef iciaries to find employment
which will result in money for food) sufficiently related? What about
child care services which will enable the beneficiaries to search for
employment? Basically, it is di fficult to draft and implement
legislation or regulations which adequately define the required
connection between the expenditu re and the public benefit
purposes. Therefore, determinat ions must often be made on a
case-by-case basis.
A derivative of this rule, under which income from economic activity
below a certain threshold is tax-free, also raises interesting
implementation issues.
For example:
(1) what should be the threshold,
(2) should the limit be based upon gross revenue or net income,
and
(3) what can be done to prevent NPOs from dividing into multiple
organizations to avoid paying tax on economic income above this
threshold?
D. The “Relatedness” Rule
Under this approach, the income from ec onomic activities which are related to
the public benefit purposes of an NPO is exempt from taxation. Variations upon
the “relatedness” rule are in effect in m any jurisdictions, including the United
States, France, Germany, the Netherlands, and many CEE countries.
23
1. Theoretical Explanation and Rationale
A tax exemption for income from economic activities which are
related to public benefit purposes makes a great deal of theoretical

sense. Often the most effective way for an NPO to achieve its
purposes is to pursue them through economic means. For example,
NPOs which assist certain disadvantaged groups within society
would find it natural to produce an d/or distribute products which
serve that group (like m edical devices for people with disabilities).
NPOs supporting cultural causes often publish informational
materials or charge admission to cu ltural events. Such activities
have merit from a public relations standpoint, and are seen as a
logical extension of the goals of the NPO by the citizens and
government alike. As long as t he public benefit goals remain the
principle purpose of the NPO, and as long as the income is not
improperly distributed, there is ev ery justification for supporting
related activities with tax preferences.
In granting such tax exemptions, governments not only provide
additional revenue to NPOs, they also provide incentives and send
signals for NPOs to engage in ce rtain forms of behavior. The
traditional explanation for the prevalence of this practice is that by
providing tax exemptions, gover nments are trying to subsidize
certain activities of certain NPOs.
24 This subsidy is justified, many
argue, because NPOs often perform essential services that would
otherwise have to be performed by the government, and which
might be under-supplied without a tax exemption. Additionally, the
not-for-profit sector is often able to identify such needs more quickly
and meet them more efficiently than governmental bureaucracies.
25
While this argument can be used to justify any governmental
support for NPOs, the case is much more persuasive when it
concerns activities which are related to public benefit purposes.
The “relatedness” rule requires NPOs to focus the majority of their
activities on their public benefit purposes, thus reducing the
incentive to undertake economic activities merely because they
yield high profits. In addition, tax preferences are only provided for
publicly beneficial activities.
26 For these activities, which are
deemed particularly worthy of suppor t by society, claims of unfair
competition by for-profit organizations might deserve a less
sympathetic hearing.
2. Analytical Criteria
(a) Simplicity or Complexity of Administration : Unfortunately, it is
often difficult to distinguish “related” economic activities from those
which are “unrelated,” and hence this rule is often complicated to
administer.
27 While the general parameters of the necessary
relationship are clear, making many cases easy to resolve, the
absence of specific criteria makes borderline cases very

challenging. For example, if a museum opens a shop on its
premises to sell books about or copies of works in its collection, this
is clearly related to the purpos es of the museum and should not
give rise to taxable income. Howe ver, what if the museum opens a
retail store somewhere else which sells materials about art and
culture in general? Geographic loca tion can be important, since a
coffee shop on the museum premises would be seen as a natural
step to enable visitors to obtain refreshments, while such an
establishment on the other si de of town should clearly be
considered an unrelated activity. The problematical nature of
applying the concept of “relatedness” is demonstrated by the fact
that it tends not to result in the collection of much tax revenue.
28
Therefore, it is difficult to draft laws and/or regulations which codify
adequately the concept of “relatedne ss.” Guiding principles must
often be established on a case-by-case basis. After a body of
decisions or norms concerning applicat ion of the rule exists, this is
likely to be a less serious problem. But for countries in a state of
transition, where guidelines for t he not-for-profit sector need to be
established, the concept of “relatedness” creates a degree of
uncertainty concerning the tax tr eatment of income. This might
needlessly deter NPOs from certain types of activities, or subject
them to arbitrary administrative responses.
(b) Effects on Revenue Collection : The experience of countries
taking this approach suggests that the above-mentioned
administrative difficulties tend to result in greater revenue loss than
it should, and generally less revenue than universal taxation of all
economic activities. Nonetheless, this approach does tax
“unrelated” activities which coul d be exempt under the “destination
of income” test. Careful drafti ng and application of a “relatedness”
concept can limit the loss of tax revenue.
(c) Effects on Commercial Sector : This approach, at least
theoretically, provides NPOs with no tax advantages over for-profit
organizations in “unrelated” fields , thereby ameliorating concerns
about unfair competition. Basically, t here is little incentive for NPOs
to become involved in activities which are not “related” to their
public benefit purposes (unless there is significant after-tax profit to
be made, in which case the for-pr ofit sector will become involved
and compete on equal footing). Also, “related” activities are often
naturally within the jurisdicti on of the NPO, and may be of little
commercial interest to the for-profit sector. In addition, it is also
possible to cap the amount of “rel ated” income subject to tax to
reduce concerns that these ambi guities might be exploited and
abused.

(d) Effects on the Development of the NPO Sector : This approach
creates incentives for NPOs to engage in economic activities
related to the organizations public benefit goals. Thus, this
approach promotes activities consi dered to be in the public benefit
and generally worthy of support. Th is approach also allows NPOs
to generate funds from economic activities. However, this approach
does provide less funds than the “destination of income” rule.
(e) Practical Implementation Issues : As discussed above, the
primary task associated with this approach is defining “related” and
“unrelated” activities. A country survey will be illustrative. Bulgaria
permits NPOs to engage only in “r elated” economic activities,
requiring that they directly support public benefit goals other than
by generating income. In France, the economic activity must
contribute directly to accomplishi ng the purposes of the association
to qualify as “related.”
29 In the United States, it is the tax authorities
who determine whether the activity is “substantially related” to the
public benefit purposes.
30 To meet this test, the activity must be
causally related to the NPOs public benefit purpose, and “contribute
importantly” to it.
31 Unfortunately, it is difficult to apply these
general standards into administrable and coherent practice.
To avoid some of the difficulties inherent in applying a definition of
“related” activities, some laws include an illustrative list. Hungary
has followed this approach, providing clearer guidance to NPOs
and government officials. A single lis t may apply to all public benefit
NPOs, or there may be separate lists for different types of
organizations.
32 It is common to include a “catch-all” provision,
allowing NPOs to pursue all other public benefit activities without
taxation.
One approach with particular merit is to pass a law covering the
basic provisions of “relatedness, ” but leave the task of preparing
and enforcing precise defin itions and practices to regulations or
decrees.
33 This guidance may take t he form of a list of exempt
activities, specific instructions , and/or explanations of examples.
Any listing of exempt activities should contain a “catch-all”
provision, to highlight its illustrati ve, rather than exhaustive, nature.
34 One practical possibility is to form a joint government-NPO
committee to help prepare this lis t for eventual promulgation.
Moreover, guidance provided by t he regulations will improve over
time, as tax officials and sect or representatives gain more
experience, and as a body of inst ructive decisions which may have
value at least as persuasive precedent develops. In addition, to
protect against uncertainty, some c ountries permit NPOs to obtain

an administrative ruling in advance from the authorities indicating
how income will be treated. 35
VI. Conclusion
As the countries of CEE and NIS study the subject of economic activities
undertaken by NPOs, the expe rience and practices of other countries around the
world need to be considered. Virtually a ll democratic countries have a vibrant
not-for-profit sector, and at least allow NPOs to engage in economic activities of
certain kinds. Once this basic principle is accepted, the principal issue is taxation.
36
Three general approaches to the taxation of income generated by the economic
activities of NPOs have been presented and analyzed. They are: (1) tax
ing all
such income, (2) exempting from taxati on all income which is devoted to the
public benefit purposes of the NPO, known as the “destination of income” rule,
and (3) exempting from taxation all income from economic activities which are
“related” to the public benefit purposes of the NPO. The results of this analysis
categorized along the lines of each of the five criteria identified are summarized
below.
1. Simplicity or Complexity of Administration
Taxing all economic activity is the simplest approach to administer.
Once economic activities are defined, NPOs are treated the same
way as for-profit organizations. The “destination of income” rule is
slightly more complex to administer. The main difficulty is
establishing and enforcing criteria for what constitutes an
expenditure in furtherance of public benefit purposes. A
“relatedness” test is the most complicated to apply, since the
necessary connection between the economic activity and the public
benefit purposes is difficult to specify.
2. Effects on Revenue Collection
The largest potential tax base is produced by the first approach,
since it subjects the greatest sc ope of NPO income to taxation,
although empirically it is unclear how much tax would in fact be
collected. In its purest form, the ” destination of income” rule has the
lowest potential to produce tax revenue, because all income from
whatever source is free from tax if it is applied to performance of
public benefit purposes. In practice, however, many countries
impose limits upon the amount of income that is exempt under the
“destination of income” rule, thus limiting potential losses to the
revenue base. The “relatedness” test also potentially reduces the
size of the tax base, but probabl y less than the “destination of

income” test. This is because it has the effect of channeling NPO
economic activity into specific areas often associated with public
benefit and because it provides tax benefits only for these “related”
activities.
3. Effects on Commercial Sector
The taxation of all NPO income from economic activities is most
favorable for the commercial sector , since there is no possibility of
unfair or prejudicial competition. T he “destination of income” rule, in
its purest form, does nothing to pr event unfair competition, since
the nature of the use of income may give NPOs a tax advantage
which their for-profit competitors do not share. Naturally, a limit on
this benefit reduces the compar ative advantage for NPOs. The
“relatedness” test minimizes unfair competition by encouraging
NPOs to focus upon certain activiti es most traditionally associated
with public benefit, and placing them on equal status with for-profit
enterprises when they venture into activities purely on the basis of
profit motive.
4. Effects on the Development of the NPO Sector
The taxation of all revenue reduces resources for the not-for-profit
sector, essentially transferring money away from NPOs and into the
governmental sector. It is generally accepted that NPOs devoted to
public benefit purposes, if not eligible for state subsidies, should at
the very least not be required to tr ansfer resources to the state (in
the same fashion as for-profit ent erprises). Taxing all NPO income
from economic activities eliminates the incentive to engage in
public benefit activities, and is most unfavorable to the not-for-profit
sector. At the very least, such taxes should be at a lower,
preferential rate compared to for-profit enterprises.
The “destination of income” rule provides the greatest potential
revenue to NPOs, since virtually any income can be made tax-
exempt. This benefit will vary with the level of any limit which might
be imposed. The “relatedness” test is less favorable to NPOs,
because activities which are under taken purely to obtain revenue
enjoy no tax exemption. Howeve r, the “relatedness” test still
provides significant tax benefits for NPOs, particularly when they
focus on activities associated with their public benefit purposes.
Moreover, the “relatedness” channel s NPO economic activities into
more socially useful directions t han the “destination of income” test
which encourages NPOs to engage in economic activities with the
greatest potential return.

5. Practical Implementation Concerns
Taxing all income from economic activities is the easiest approach
to implement, since there are uniform rules for NPOs and for-profit
organizations alike. The “destination of income” rule uses a
mechanical approach which is relatively easy to administer,
although it is necessary to define w hat constitutes an expenditure in
furtherance of public benefit purpos es, and supervise the actual
use of profits. Nonetheless, it is still necessary to monitor NPOs
and their use of funds, and this “policing” function may prove to be
administratively difficult. Moreover , this approach creates a greater
potential for abuse by unscrupulous individuals seeking to use
NPOs as vehicles for tax evasion. The “relatedness” test is
relatively difficult to implem ent, since a precise definition and
application of this concept is el usive, and tends to work best when
developed over time through administ rative practice. On the other
hand, this approach is most likely to give NPOs an incentive to
focus on the types of activities NPOs that benefit the public.
In this paper, no particular approach is being advocated above
another. Rather, this paper seek s to provide an analytical
framework within which policymak ers can weigh the benefits and
limitations of different approaches, given the conditions of their
particular countries. Moreover, it may be possible to combine
approaches, for example, exempt ing all income from related
sources as well as a certain amount of unrelated income.
Ultimately, the choice depends upon the social, economic, political
and legal traditions and conditions in each country. Hopefully this
brief exposition of issues will contribute to the effort to develop
appropriate, informed rules governing the economic activities of
NPOs.

1. The term “not-for-profit organizations” is used in a broad sense to encompass
organizations that are known variously as charities, nonprofit organizations, non-
governmental organizations (NGOs), private voluntary organizations (PVOs), civil society
organizations (CSOs), etc.

2. The Value Added Tax (VAT) implications of economic activities are discussed in a paper
by Ole Gejms-Onstad of the Norwegian School of Management, which is presented as an
appendix to this paper.

3. Many of the same rules apply for the taxation of “economic” or “commercial” activities
when they are undertaken by mutual benefit NPOs. For simplification, this paper will only
address public benefit NPOs.

4. These issues are treated in greater detail in ICNLs accompanying Issue Paper on Public
Benefit Status of NPOs.

5. Reasonable compensation for services rendered to an organization which are necessary
for the accomplishment of its charitable purpo ses and are appropriate in scope will not be

prohibited by this assumption, because such payments are not considered to have been
made out of net earnings.

6. We understand that some aggressive tax authorities in the CEE have attempted to
characterize grant revenues as taxable “fees for services.” Under US law, for a receipt to
be considered a “grant,” the contractual relationship between the donor and the donee
ordinarily requires that any benefits to the grantor are purely incidental and that charitable
beneficiaries are the primary targets of the funding.

7. These four terms are used interchangeably to describe any transfer of property to an
NPO in return for which the tr ansferor receives nothing of su bstantial value. Hereafter,
the term “donation” will be used.

8. Passive income includes earnings from “royal ties, rents, dividends, interest, annuities,
and, to the extent of any gain, sales or exchanges of stock or securities.” JACOB
MERTENS, JR., MERTENS LAW OF FEDERA L INCOME TAXATION, 41B:120 (1995).
Some countries choose to tax passive income, either at reduced or full rates, while others
choose not to tax it at all.

9. BRUCE R. HOPKINS, THE LAW OF TAX- EXEMPT ORGANIZATIONS, 12.3 (1992);
Trevor A. Brown, Note: Religious Not-for-profits and the Commercial Manner Test, 99
Yale L.J. 1631, 1641 (1990). See also James Bennett and Gabriel Rudney, A
Commerciality Test to Resolve the Commercial Not-for-profit Issue, Tax Notes, 1095
(September 14, 1987).

10. In Croatia, NPOs that sell goods or services only to members of the NPO are
definitionally considered not to be engaging in “economic” activity.

11. SELECT LEGISLATIVE TEXTS AND COMMENTARIES ON CENTRAL AND EAST
EUROPEAN NOT-FOR-PROFIT LAW , edited by Douglas Rutzen, published by ICNL, the
European Foundation Centre Orpheus Programme, and the Union of Bulgarian
Foundations, Romania Country Report, prepared by Lucian Mihai.

12. In England it is necessary to establish a subsidiary to conduct economic and commercial
activities. This is also the case under the recently passed Law on Foundations in
Lithuania.

13. These two approaches illustrate, but do not exhaust t he list of possible options. In
Canada, for example, a relatedness test is used to determine not only tax issues but also
whether an NPO may engage in the economic activity at all. In addition, some experts in
the region have suggested that strict disclo sure rules concerning economic activities
would help ensure that NPOs do not engage in excessive or inappropriate economic
activities, but it is unclear whether public scrutiny would actually achieve these results.

14. Law Governing Profit Tax on Corporate Pe rsons of 15 February 1992, Art. 17, as
amended 1995.

15. Select Legislative Texts and Commentaries on Central and East European Not-for-Profit
Law, Czech Republic Country Report, Page 9, prepared by Petr Pajas.

16. See, e.g., Ole Gejms-Onstad, The Taxation of Unrelated Business Income of Nonprofit
Organizations , 9-15 [on file with ICNL].

17. John Copeland & Gabriel Rudney, Business Income of Not-for-profits and Competitive
Advantage , Tax Notes, 747, 749 (1986) (discussing pre-tax comparative advantages of
NPOs).

18. Additionally, proponents argue that NPOs enjoy competitive advantages over for-profit
organizations prior to tax exemption, which eliminate the need for further subsidization.
First, it may be easier for NPOs to market their goods and services to the public as a
result of the perception that they offer hi gher quality and lower prices than their profit-
seeking counterparts. Managers of NPOs are sometimes perceived as having a fiduciary
relationship with their customers. Second, NP Os often have lower labor costs, particularly
if they use volunteers. Third, while for-profit organizations receive
income only from the
sale of goods and services, NPOs may also receive government funds and private
donations. However, as previously noted, thes e sources of income are limited in many
CEE and NIS countries, and in general these argu ments carry less weight in countries in

a state of transition. (In contrast, some commentators assert that this tax regime actually
disadvantages NPOs vis-à-vis businesses beca use businesses are able to reinvest in
ways that give rise to deductions which r educe net profits and tax, whereas NPOs, which
make distributions for net profits for public benefit purposes, are often not able to obtain
these deductions and are effectively taxed more heavily.)

19. In some instances, there is a time limit within which net profits must spent on public
benefit purposes in order to avoid taxation .. However, oversight can be problematical
because money is fungible. In addition, such limitations make it difficult to build an
endowment, since money must be spent during the prescribed period, regardless of
whether this is efficient. Finally, such a ru le can complicate multi-year agreements and
contracts. For these reasons, Poland elimi nated its two-year time limitation upon the
destination of income exemption in 1995.

20. SELECT LEGISLATIVE TEXTS AND COMMENTARIES ON CENTRAL AND EAST
EUROPEAN NOT-FOR-PROFIT LAW, Croatia Country Report, Page 6, prepared by
Gojko Bezovan.

21. Pajas, supra note 13, at 9. The Czech Republic taxes profits derived from related
commercial activities, but exempts up to 3 m illion CZK, or 30% of the organizations tax
base, whichever is less, if those profits are used to pay expenses for public benefit
activities. This approach combines the “destination of income” rule with a requirement
that the economic activity be related to public benefit purposes, which can become
complicated to administer.

22. See note 17 supra.
23. Some countries, including Bulgaria, and Canada, employ a form of the “relatedness” test
to determine which commercial and econom ic activities an NPO may conduct. For
example, Bulgarian NPOs may engage in “auxilia ry economic activities” if they (1) are
limited in scope when compared to the organizations activities as a whole, and (2)
directly support the purposes of the org anization other than by generating funds.

24. For an analysis of the importance of exempti ons for subsidizing organizations deemed to
be valuable by the public, see Mark A. Hall & John D. Colombo, The Charitable Status of
Not-for-profit Hospitals: Toward a Donative Theory of Tax Exemption , 66 WASH. L. REV.
307 (1991).

25. See The Role and Purpose of the Not-for-Profit Sector by Leon Irish, delivered at the
Regulating Civil Society Conference in Sinaia, Romania, May 1994 [on file with ICNL].

26. Even without a tax incentive to enter “relat ed” fields, NPOs may choose this course
because they are familiar with the market, because they already have useful personal
contacts and physical facilities, and because this is what their constituents expect.

27. Because of these problems, “relatedness” conc epts are often incorrectly handled by local
tax inspectors — they are inclined to look onl y at the nature of the activities and not the
public benefit purposes of the organization.

28. See Susan Rose-Ackerman, Unfair Competition and Corporate Income Taxation , 34
STANFORD L. REV. 1017 (1982).

29. That is, a direct link must exist between the statutory activity and the commercial activity.
In addition, for the commercial activity to be tax-exempt under French law, (1) the
administration of the association must uphol d the non-distribution constraint, (2) the
association must not systematic ally strive for the generation of profit, (3) profits must be
used for the purposes stated in the organiza tions statute, and (4) the commercial activity
must reveal a certain social utility by coveri ng needs which are not sufficiently covered by
the local commercial market.

30. I.R.C. 513(a) (1996). In addition, generating funds which can be used for public benefit
purposes is not sufficient to ma ke an activity “related.” Otherwise, this would be the same
as the “destination of income” approach. In stead, there must be a “substantial” or
“causal” connection between the public benefit purposes and the economic activity. The
activity should in and of itself support the goal s of the NPO, or be intertwined with them.

In the absence of such a connection, the activity is “unrelated,” and the income should be
subject to tax.

31. Treas. Reg. 1.513-1(d)(2) (1987). See Carol S. Niccolls et al., Unrelated Business
Income Tax and Unfair Competition: Current Status of the Law, 15 J.C. & U.L. 249
(1989).

32. Two lists of public benefit activities exist in Hungary. List A applies to associations and
foundations. List B applies to public benefit companies. SELECT LEGISLATIVE TEXTS
AND COMMENTARIES ON CENTRAL A ND EAST EUROPEAN NOT-FOR-PROFIT
LAW, Hungary Country Report, Page 12, prepared by Gábor Gyõrffy.

33. Since it is much easier for the government to change a regulation than to amend a law, it
is prudent to include the list in a regulatio n. The government will then be able to make
modifications more expeditiously, wi thout engaging the legislative process.

34. Of course, the list is definitionally too restrictive and the catch-all provision (if meaningful)
in some sense vitiates the need for a list. Nonet heless, the list provides some guidance to
implementers, thus promoting more cogent decision-making.

35. In the United States, this is called a private letter ruling .
36. Other related subjects concerning NPO finances, such as government subsidies,
privatization, and procurement rules, are beyond the scope of this paper.

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