Tax exemption is the reduction or removal of a liability to make a compulsory payment that would otherwise be imposed by a ruling power upon persons, property, income, or transactions. Tax-exempt status may provide complete relief from taxes, reduced rates, or tax on only a portion of items. Examples include exemption of charitable organizations from property taxes and income taxes, veterans, and certain cross-border or multi-jurisdictional scenarios.
Tax exemption generally refers to a statutory exception to a general rule rather than the mere absence of taxation in particular circumstances, otherwise known as an exclusion. Tax exemption also refers to removal from taxation of a particular item rather than a deduction.
International duty free shopping may be termed "tax-free shopping". In tax-free shopping, the goods are permanently taken outside the jurisdiction, thus paying taxes is not necessary. Tax-free shopping is also found in ships, airplanes and other vessels traveling between countries (or tax areas). Tax-free shopping is usually available in dedicated duty-free shops. However, any transaction may be duty-free, given that the goods are presented to the customs when exiting the country. In such a scenario, a sum equivalent to the tax is paid, but reimbursed on exit. More common in Europe, tax-free is less frequent in the United States, with the exception of Louisiana. However, current European Union rules prohibit most intra-EU tax-free trade, with the exception of certain special territories outside the tax area.
Specific monetary exemptions
Some jurisdictions allow for a specific monetary reduction of the tax base, which may be referred to as an exemption. For example, the U.S. Federal and many state tax systems allow a deduction of a specified dollar amount for each of several categories of "personal exemptions". Similar amounts may be called "personal allowances". Some systems may provide thresholds at which such exemptions or allowances are phased out or removed.
Some governments grant broad exclusions from all taxation for certain types of organization. The exclusions may be restricted to entities having various characteristics. The exclusions may be inherent in definitions or restrictions outside the tax law itself.
Approaches for exemption
There are several different approaches used in granting exemption to organizations. Different approaches may be used within a jurisdiction or especially within sub-jurisdictions.
Some jurisdictions grant an overall exemption from taxation to organizations meeting certain definitions. The United Kingdom, for example, provides an exemption from rates (property taxes), and income taxes for entities governed by the Charities Law. This overall exemption may be somewhat limited by limited scope for taxation by the jurisdiction. Some jurisdictions may levy only a single type of tax, exemption from only a particular tax.
Some jurisdictions provide for exemption only from certain taxes. The United States exempts certain organizations from Federal income taxes, but not from various excise or most employment taxes.
Charitable and religious organizations
Many tax systems provide complete exemption from tax for recognized charitable organizations. Such organizations may include religious organizations (temples, mosques, churches, etc.), fraternal organizations (including social clubs), public charities (e.g., organizations serving homeless persons), or any of a broad variety of organizations considered to serve public purposes.
The U.S. system exempts from Federal and many state income taxes the income of organizations that have qualified for such exemption. Qualification requires that the organization be created and operated for one of a long list of tax exempt purposes, which includes more than 28 types of organizations and also requires, for most types of organizations, that the organization apply for tax exempt status with the Internal Revenue Service, or be a religious or apostolic organization. Note that the U.S. system does not distinguish between various kinds of tax exempt entities (such as educational versus charitable) for purposes of granting exemption, but does make such distinctions with respect to allowing a tax deduction for contributions. In November 2017, the GOP released a tax bill that would allow churches to keep their tax exemptions even if they endorse political candidates.
Most systems exempt internal governmental units from all tax. For multi-tier jurisdictions, this exemption generally extends to lower tier units and across units. For example, state and local governments are not subject to Federal, state, or local income taxes in the U.S.
Most systems do not tax entities organized to conduct retirement investment and pension activities for employees of one or more employers or for the benefit of employees. In addition, many systems also provide tax exemption for personal pension schemes.
Some jurisdictions provide separate total or partial tax exemptions for educational institutions. These exemptions may be limited to certain functions or income.
Other not-for-profit entities
Some jurisdictions provide tax exemption for other particular types of organizations not meeting any of the above categories.
Some jurisdictions allow tax exemption for organizations exempt from tax in certain other jurisdictions. For example, most U.S. states allow tax exemption for organizations recognized for Federal tax purposes as tax exempt.
Most states and localities imposing sales and use taxes in the United States exempt resellers from sales taxes on goods held for sale and ultimately sold. In addition, most such states and localities exempt from sales taxes goods used directly in the production of other goods (i.e., raw materials).
Certain classes of persons may be granted a full or partial tax exemption within a system. Common exemptions are for veterans, clergymen or taxpayers with children (who can take "dependency exemption" for each qualifying dependent who has lived with the taxpayer. The dependent can be a natural child, step-child, step-sibling, half-sibling, adopted child, eligible foster child, or grandchild, and is usually under age 19, a full-time student under age 24, or have special needs). The exemption granted may depend on multiple criteria, including criteria otherwise unrelated to the particular tax. For example, a property tax exemption may be provided to certain classes of veterans earning less than a particular income level. Definitions of exempt individuals tend to be complex.
In the Ottoman Empire, tax breaks for descendents of Muhammad encouraged many people to buy certificates of descent or forge genealogies; the phenomenon of teseyyüd – falsely claiming noble ancestry – spread across ethnic, class, and religious boundaries. In the 17th century, an Ottoman bureaucrat estimated that there were 300,000 impostors; In 18th-century Anatolia, nearly all upper-class urban people claimed descent from Muhammad. The number of people claiming such ancestry – which exempted them from taxes such as avarız and tekalif-i orfiye – became so great that tax collection was very difficult.
Most income tax systems exclude certain classes of income from the taxable income base. Such exclusions may be referred to as exclusions or exemptions. Systems vary highly. Among the more commonly excluded items are:
- Income earned outside the taxing jurisdiction. Such exclusions may be limited in amount.
- Interest income earned from subsidiary jurisdictions.
- Income consisting of compensation for loss.
- The value of property inherited or acquired by gift.
Among the types of income that may be included are classes of income earned in specific areas, such as special economic zones, enterprise zones, etc. These exemptions may be limited to specific industries. As an example, India provides SEZs where exporters of goods or providers of services to foreign customers may be exempt from income taxes and customs duties.
Certain types of property are commonly granted exemption from property or transaction (such as sales or value added) taxes. These exemptions vary highly from jurisdiction to jurisdiction, and definitions of what property qualifies for exemption can be voluminous.
Among the more commonly granted exemptions are:
- Property used in manufacture of other goods (which goods may ultimately be taxable)
- Property used by a tax exempt or other parties for a charitable or other not for profit purpose
- Property considered a necessity of life, often exempted from sales taxes in the United States
- Personal residence of the taxpayer, often subject to specific monetary limitations
Conditions imposed on exemptions
Exemption from tax often requires that certain conditions be met.
Many countries that impose tax have subdivisions or subsidiary jurisdictions that also impose tax. This feature is not unique to federal systems, like the U.S., Switzerland and Australia, but rather is a common feature of national systems. The top tier system may impose restrictions on both the ability of the lower tier system to levy tax as well as how certain aspects of such lower tier system work, including the granting of tax exemptions. The restrictions may be imposed directly on the lower jurisdiction's power to levy tax or indirectly by regulating tax effects of the exemption at the upper tier.
Jurisdictions may enter into agreements with other jurisdictions that provide for reciprocal tax exemption. Such provisions are common in an income tax treaty. These reciprocal tax exemptions typically call for each contracting jurisdiction to exempt certain income of a resident of the other contracting jurisdiction.
Multi-jurisdictional agreements for tax exemption also exist. 20 of the U.S. states have entered into the Multistate Tax Compact that provides, among other things, that each member must grant a full credit for sales and use taxes paid to other states or subdivisions. The European Union members are all parties to the EU multi-country VAT harmonisation rules.
- 26 USC 151, Allowance of deductions for personal exemptions. The amount per exemption is $3,650, subject to phase-out. UK tax free personal allowances vary.
- As an example, UK charities law defines the types of organizations which may qualify as registered charities, and places limits on their actions.
- 26 USC 501(a). The exemption from Federal income tax is longstanding. This exemption formed part of the Revenue Act of 1894. The 1894 Act was the first broadly applicable U.S. tax on corporate income, but was soon declared unconstitutional. Since ratification of the Sixteenth Amendment to the United States Constitution in 1913, the exemption for charitable, religious, and educational organizations has been included in all subsequent Federal income tax law. See Belknap, Chauncey, "The Federal Income Tax Exemption of Charitable Organizations: Its History and Underlying Policy," 1954, reprinted (very large file) as pages 2025-2043 of the Research Papers of the Commission on Private Philanthropy and Public Needs, Volume IV, 1977.
- 26 USC Subtitle D excise taxes are imposed on particular goods or services, generally without exemptions. Certain of these taxes apply primarily to tax exempt organizations. See, e.g., 26 USC 4911, tax on excess expenditures to influence legislation. 26 USC 3101 and 3301 generally impose social security and unemployment taxes on all organizations. Note that income from certain types of services, such as services as a minister, may be exempt from the definition of income for these taxes. Employees of certain nonprofit and governmental organizations are eligible to participate in different sorts of deferred compensation plans than employees of other organizations. Compare 26 USC 401, IRS Publication 560 and others vs. 26 USC 403(b), IRS Publication 571.
- Note that under the U.S. system each state is entitled to raise its own taxes. 43 of the states impose a [state income tax]. Some states incorporate or make reference to Federal definitions for parts of their tax laws. See, e.g.,.
- 26 USC 501(c)
- 26 CFR 1.501(a)-1(a)(2).
- 26 USC 501(d).
- See IRS Publication 557.
- Tax exempt entities with gross receipts over US$25,000 are required to file annual tax returns on Form 990. Those with less than $25,000 must file a simplified return. The IRS granted an extension of time for such organizations to file for 2009 until October 15, 2010. Charities falling under that revenue threshold have had no regular filing mandate in the past. One list of small organizations is at http://www.501exempt.com.
- Weaver, Dustin (2017-11-02). "GOP tax bill would allow churches to endorse political candidates". TheHill. Retrieved 2017-11-02.
- For a discussion of UK taxation of charities, see the 1999 Review of Charity Taxation Consultation Document.
- 26 USC 115 specifically excludes from taxable income all income of states or municipalities, as well as income of public utilities. This operates as an exemption from tax for state and municipal governments.
- Examples include: a) The United States taxes beneficiaries of trusts, not trusts (with exceptions), but exempts under 26 USC 402 beneficiaries of a pension trust meeting certain qualification; b) Canada ; c) The United Kingdom exempts income and gains of a registered pension scheme from taxation under Income Tax Act section 186, as discussed in the Registered Pension Scheme Manual.
- See, e.g., 26 USC 409 providing exemption to owners of Individual Retirement Accounts until funds are distributed.
- See, e.g., Malaysian Ministry of Higher Education chart of exemptions and benefits for private higher education institutions.
- See, e.g., New York City's veterans property tax exemption.
- See, e.g., [26 USC 107] which excludes from income the rental value of a parsonage provided by a church to a clergyman.
- Presti and Naegele Newsletter, February , 2012.
- See the New York City rule cited above.
- Canbakal, Hülya (2009). "The Ottoman State and Descendants of the Prophet in Anatolia and the Balkans (c. 1500–1700)". Journal of the Economic and Social History of the Orient. 52 (3): 542–578. doi:10.1163/156852009X458241.
- Acun, Fatma (2002). "The Other Side of the Coin: Tax Exemptions within the Context of Ottoman Taxation History". Bulgarian Historical Review. 1 (2).
- Contrast 26 USC 101-140 exclusions from gross income to UK non-taxable income.
- See International tax for a discussion of territorial tax systems. Most systems exclude from the tax base income of nonresidents from sources outside the taxing jurisdiction. U.S. states and Canadian provinces provide for formulary apportionment of certain business income to achieve a similar result. See, e.g., the Multi State Tax Compact, discussed in a note below.
- See, e.g., 26 USC 911, 912.
- See, e.g., 26 USC 103, excluding from U.S. Federal taxable income certain types of interest income received on bonds issued by states or political subdivisions thereof.
- See, e.g., 26 USC 104, excluding compensation for sickness or injury.
- The transfer of such property is often taxed separately to the transferor or the transferee. See Estate tax and Gift tax.
- See, e.g., 26 USC 131 relating to certain foster care payments.
- See, e.g., the Texas Sales Tax rules, providing very specific lists of items that are exempt from sales tax. For shortened list of examples of such, see the Grocery and Convenience Stores flyer from the state.
- See, e.g., the Homestead Exemption granted in Florida.
- See, e.g., Japan's prefecture taxes, UK local rates, etc..