Tax-Related Incentives and Expense Allocation in Non-Profit Organizations: Evidence from Japan

The research problem This study investigates the relationship between the incentive of Japanese non-profit organizations to avoid losing their tax-exempt status and the extent of tax-motivated expense allocation. Motivation Prior studies have shown that for joint overhead expenses, organizations can lower their tax burden by transferring costs from non-taxable to taxable activities. However, tax authorities may also investigate non-profits that report excessive profits without incurring expenses for non-taxable activities and penalize them by depriving them of their tax-exempt status. This deprivation of tax exemptions specific to non-profit organizations causes serious problems for such organizations in terms of the economic impact of increased income taxes and the loss of social value from donors. In Japan, non-profit organizations are deprived of tax-exempt status if the ratio of expenses from taxable activities to total expenses (TaxExpRatio) exceeds a regulatory threshold of 50%. We estimated the tax-motivated expense allocation and non-taxable activities, defining the term TaxExpRatio before the allocation as TRBA. In addition, we assumed that a larger board of directors has a stronger incentive to protect the non-profit’s tax-exempt assets because individuals or organizations that provide resources to non-profits often become board members, who thus conduct stronger monitoring to avoid losing the tax-exempt status. The test hypotheses We hypothesized that when the TRBA exceeds the regulatory threshold, non-profits allocate less discretionary expense to taxable activities. We further posited that board size moderates the relationship between the TRBA exceeding the regulatory threshold and allocation of discretionary expenses to taxable activities. Target population We specifically considered the Japanese regulatory environment related to public-interest incorporated associations and foundations (PIIAs and PIIFs, referred to as Japanese non-profit organizations), which are tax-exempt organizations engaged in a wide range of public work. Adopted methodology We estimated the expense allocated from non-taxable to taxable activities in a non-profit organization based on Hofmann (2007) and Omer & Yetman (2007). We also estimated regressions using pooled cross-sectional and ordinary least squares (OLS) regression models. Analysis By using 12,027 firm-year observations (4,763 distinct non-profit organizations in Japan), we estimated the regression model for the incentive to avoid losing tax-exempt status in non-profit organizations. Findings We found that non-profits with TRBA over the regulatory threshold tend to allocate less expenses to taxable activities. In addition, the empirical results show that the relationship between TRBA over the regulatory threshold and allocated expenses to taxable activities is moderated by board size. This finding suggests that larger boards in non-profit organizations are more incentivized to reduce tax avoidance behavior that may result in losing their tax-exempt status.