It found the rules were stacked against smaller operators while allowing commercial arms of large charities to claim income tax exemptions with little oversight.
"With about $16 billion flowing into charities a year, it is absolutely necessary to have effective regulation in place to maintain the public's trust in the sector," report author Jason Krupp said.
"Unfortunately we appear to have set the regulatory bar too high in some places, with many legitimate charities struggling to attain or retain registered charity status, which threatens the vital work they do in communities."
Under the Charities Act (2005), charities had little insight or say into how the Department of Internal Affairs assessed whether their purpose was charitable, the report said.
It also noted that appeals to the regulator's decision could only be made to the High Court, which was a costly option that many groups would not be able to afford.
At the same time, longstanding rules allowed the for-profit arms of charities to retain earnings within the business tax free, with little oversight by the regulator into how much of this money was distributed to charities, and what these charities did with the funds once it was distributed to them.
"What the rules do is create a situation where commercial groups like Ngai Tahu and Sanitarium, both of which operate under registered charitable status, pay no income tax on any profits retained within the business, potentially giving them a significant
advantage over taxpaying competitors," Mr Krupp said.
With an estimated 700 limited liability companies on the Charities Register that generate over $372 million in tax-exempt profits a year, the report calculated the Government foregos about $104 million in fiscal revenue.
"We are not suggesting that registered charities should not be allowed to have for-profit arms, just that these businesses should compete with private firms on an equal footing," Mr Krupp said.
Labour Party voluntary and community sector spokeswoman Louisa Wall said it was unacceptable that the big corporate-based charities claimed millions in annual income tax exemptions, while small community-based and operated non-profit organisations struggled to gain official charity status.
"[The report] is proof that our current charity system in New Zealand has been corporatised," she said.
The degree of separation from the communities in need and those providing important charitable work meant communities throughout New Zealand were missing out, Ms Wall said.
Community and Voluntary Sector Minister Jo Goodhew said Charities Services worked closely with organisations to advise them on registration requirements.
"Most applications for registration are approved. Only 11 per cent of applications have been declined since 1 July 2012," Ms Goodhew said.
"However, as charitable status brings many tax and other public benefits, charities law has to be applied consistently regardless of the size of the charitable organisation."
A charity could not be a for-profit entity, she said. Charities must continue to fulfil only charitable aims, and all their activities must remain charitable.
"Any profits or income generated by charities must only be applied to their charitable aims. The public can view this information in the yearly Annual Returns which are published online on the Charities Register."
The sector was monitored and regulated to ensure the public's trust and confidence remained well-placed and a number of initiatives taken by government over recent years have focused on this goal, Ms Goodhew said.
Fundraising Institute of New Zealand James Austin said it was a "well researched, helpful and very clear paper", which was worthy of discussion.
"If it generates a debate on where we can enhance and review the current charity sector acts, we can only support the general tenure of what's going on there."
It was a good time to have a thorough review of the sector that included the definition of charities, he said.
Report recommendations:
• The Government rebalance the regulatory landscape by fulfilling a 2010 commitment to review the Charities Act and the definition of charitable purpose
• Charities must be allowed to challenge the regulator's decision on charitable status at far lower level than the High Court, such as the District Court
• The Government must tax for-profit businesses owned by charities in the same way that private firms are taxed, while allowing unlimited deductions on distributions made to relevant charities
