Recent legislative reform has heralded changes to Prescribed Private Funds (PPFs) that have important consequences for their owners and charities alike. Vera Visevic and John McLeod outline what you need to know.

Key Changes to Prescribed Private Funds

By Vera Visevic, partner, Makinson & D’Apice Lawyers

In recent years, Prescribed Private Funds (PPFs) have become the philanthropic vehicle of choice for wealthy Australians looking to support the nonprofit community. However, in the last 12 months the federal government has reviewed the funds in consultation with a variety of stakeholders.

The result is that new legislation is due to come into effect this month, and the changes to PPFs will have a significant impact for both their owners and the nonprofits they support.

PPF becomes PAF

Under the new changes to the law, PPFs will now be referred to as Private Ancillary Funds (PAFs), and their sole purpose will continue to be to gift money, property or other benefits to charities and nonprofits with deductible gift recipient (DGR) status.

Corporate Trustees

The trustee of a PAF must now be a corporate trustee. This new requirement ensures that directors meet a minimum standard of behaviour and sets out circumstances under which an individual will be automatically disqualified from managing corporations.

This should provide greater confidence that PAFs are being operated and managed legally and in a manner consistent with their true purpose.

Penalties

Another significant change is that penalties can now be imposed on trustees who fail to comply with the new guidelines, and trustees can even be removed in cases where serious breaches occur.

Liability and Indemnity

Trustees and directors of PAFs are now jointly liable for any penalty. The rationale behind this is that corporate trustees of PAFs generally have very little capital; hence this liability will help ensure PAFs operate according to the guidelines.

In a similar vein, the new guidelines state that a PAF must not indemnify the trustee (or any employee, officer or agent of the trustee) for a loss or liability attributable to dishonesty or negligence.

Source of PAF Gifts

Under the old system, a PPF was able to solicit gifts from the public, however, under the new guidelines, PAFs cannot solicit donations from the public and, in any financial year, PAFs must not accept donations totaling more than 10% of the market value of its assets from other entities.

Investments

Owners of PAFs must now prepare and maintain an investment strategy. Previously there were complex rules governing accumulation targets for PPFs.

Distributions

Under the new rules there is a much simpler minimum annual distribution obligation, i.e. a PAF must distribute at least 5% of the market value of its assets. A trustee must now also prepare and maintain a distribution strategy for the PAF which sets out the anticipated quantity of donations to be given away, expected recipients of the donations, and the estimated size of the gifts.

Process for Establishing a PAF

Administration of the PAF regime will now fall under the complete authority of the Australian Tax Office. As at 1 October 2009, the Commissioner of Taxation will be responsible for determining whether a trust fund is a PAF and if that fund is entitled to be endorsed as a deductible gift recipient.

Many charities recommend that their regular ‘bigger’ donors consider establishing a PAF. This new process will make it easier for a PAF to be established by such a donor and endorsed.

Implications of the Changes to Running a PAF

By John McLeod, independent philanthropy consultant

The proposed changes are predominantly good news for PAFs and the charitable sector as they provide certainty, enable longevity, and should encourage the continued growth of charitable organisations on the receiving end of donations from PAFs.

The process and ‘almost’ end result (almost, as there are consultations progressing before the guidelines are finalised and commence) have provided a great example of the goodwill and shared common cause which operates within the combined philanthropic and charitable sector.

Benefits of the New 5% Asset Value Rule

Perhaps the most significant change has been the move from a complicated income related minimum payout to the 5% of asset value rule (simply calculated annually on market values at June 30 and every three years for property). This issue had concerned the owners of most existing and potential funds as it directly affected the viability of funds to exist in perpetuity and their simplicity of operation.

This will provide assurance and financial balance between modest fund growth and acceptable minimum distributions (notably higher than the 5% used in the US, which allows costs to be included) and ease of calculation. The effect of this change on overall distribution levels will obviously depend on financial market conditions and the degree to which some funds pay out more than the minimum required levels.

However, even in times of very poor market performance and/or high inflation it is likely that the 5% rule will have paid out more than a severely reduced ‘net income’ calculation under the old rules. For example, a diversified portfolio might have fallen by 25% but the funds net income after losses or CPI adjustment might have been zero.

Conversely, in times of boom, the 5% rule might have lagged the old rules. This effect of smoothing of distributions over time should be welcomed by nonprofits (who would prefer more in tough times) and, in the long run, produce around the same total level of payout. For PAFs, it might also mean less need to think of income versus capital growth when choosing investment assets and a greater focus on total returns, subject to the cash flow and liquidity requirements.

Benefits of Investment Strategy

A greater emphasis on preparing and maintaining an appropriate investment strategy for the PAF should be welcomed by all, but will likely require some additional work for most. The principles of matching investments with their purpose including diversification, risk management, liquidity and cash flow requirements – and, potentially, social or ethical issues – will now need to be considered, recorded and available.

A small number may also have collectables such as paintings as part of their assets, which will not be an allowed asset under the new rules. Those holding property will be allowed to retain this as an asset, subject to diversification, and can value the difference in any ‘sub market’ returns received from charitable groups as tenants, as part of their 5% distributions.

While these changes are welcomed, they will present some additional work, which in turn will generate useful debate among trustees.

Other Important Changes

There are three other smaller but important changes PAFs need to consider. Firstly, borrowings are no longer allowed. This may affect some investment decisions, particularly around funding share buybacks or for liquidity/timing for distributions and franking credit refunds.

Secondly, trustees will now be able to be paid a fair and reasonable remuneration for administering the fund. This may make it a little easier to access the required responsible person as trustee, a situation a number of funds have struggled with in the past.

Finally, there is now the ability to transfer from a ‘private’ to a ‘public’ ancillary fund (e.g. from a current PAF to a community foundation). While few may want to do that now, given they’ve only been recently established, the issue of succession planning for PAFs has not yet been widely considered.

If there are no family or friends with interest or willingness to take on the responsibilities of running an existing fund, then this option may prove compelling over time (similar in many ways to the self-managed versus public super fund options currently available).

Most owners of PAFs will be keen to adopt the new rules, and while the new changes might seem somewhat overwhelming at first, as a community we should celebrate these legislative amendments. On balance, they ought to enable PAFs to remain a viable and strong force in the philanthropic sector.

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