Chapter 7: Taxation
Primer for directors of not-for-profit corporations (Rights, Duties and Practices)
Registered charities and other not-for-profit corporations benefit from special tax treatment. All not-for-profit corporations are exempt from taxation on their income.Footnote 2 As well, registered charities can issue donation receipts, which entitle individual donors to a tax credit and corporate donors to a tax deduction.Footnote 2 To maintain their special status, not-for-profit corporations and registered charities must meet certain requirements of the Canada Customs and Revenue Agency. In Quebec, a parallel registration regime exists, which mirrors federal requirements.
The tax legislation and regulations governing not-for-profit organizations, and particularly charities, are quite restrictive. Depending on the goal, it may be possible to address certain regulatory restrictions by organizing activities into several inter-related corporations. A number of such interlocking structures are discussed at the end of this chapter.
Not-for-profit corporations that are not charities, and that fall within the definition of "non-profit organizations" set out in Section 149(1)(l) of the Income Tax Act, do not, in general, pay tax on their income, but are subject to tax on income from investments or property, and may be subject to other types of tax - e.g., Goods and Services Tax, sales tax or property tax. In some cases not-for-profit corporations may qualify for exemptions or preferential rates, by meeting the definition or requirements found in the legislation or regulations establishing the tax. Maintaining non-profit status for purposes of the exemption on income tax requires that the not-for-profit corporation not permit any income from corporate operations to flow as a personal benefit to members. There is a limited exception to this requirement for certain amateur athletic associations.Footnote 3
The Income Tax Act gives "registered charities" and "qualified donees" the right to issue donation receipts. Qualified donees, as defined in the Income Tax Act, include organizations that are not necessarily charitable at law but that the government deems worthy of donation support.Footnote 5
Qualified donees include, but are not limited to, registered Canadian Amateur Athletic Associations, Canadian municipalities, the United Nations and its agencies, and certain foreign universities and charities.
"Registered charity" is defined in the Income Tax Act as a "charitable organization, private foundation or public foundation" that is resident in Canada, that was established or created in Canada, and that is registered with the Minister of National Revenue.Footnote 6 "Charitable organization", "private foundation", and "public foundation" are each separately defined and regulated under the Act.Footnote 7
All registered charities must be "exclusively charitable" in purpose and in actual fact. While the Income Tax Act defines almost all of the permissible and impermissible activities of registered charities against this standard, it does not define "charity." Instead, the Canada Customs and Revenue Agency and the courts rely on the common law definition of charity.
There are two main sources for this common law definition: the 1601 Preamble to the Statute of ElizabethFootnote 8 and the test set out in the reasons of Lord Macnaghten in the 1891 House of Lords decision in Commissioner for Special Purposes of the Income Tax v. Pemsel.Footnote 9
… relief of aged, impotent and poor people … the maintenance of sick and maimed soldiers and mariners, schools of learning, free schools, and scholars in universities … repair of bridges, ports, havens, causeways, churches, seabanks and highways … education and preferment of orphans … the relief, stock or maintenance for houses of correction … marriages of poor maids … supportation, aid and help of young tradesmen, handicraftsmen, and persons decayed … relief or redemption of prisoners or captives, and for aid or ease of any poor inhabitants concerning payments of fifteens, setting out of soldiers and other taxes.Footnote 11
Although the Statute of Elizabeth was repealed long ago, the Preamble has been 'absorbed' into the common law, and continues to influence Commonwealth jurisprudence on the definition of charity. A modern reader is supposed to read it by analogy to their own time.
In Pemsel, Lord Macnaghten laid out the following classifications of charity:
"Charity" in its legal sense comprises four principal divisions: trusts for the relief of poverty; trusts for the advancement of education; trusts for the advancement of religion; and trusts for other purposes beneficial to the community, not falling under any of the preceding heads.Footnote 12
The Pemsel test is a classification, not a definition, but is a useful starting point for an analysis of "charity".
These two tests, and the substantial jurisprudence that interprets and applies them, have been especially important in the law of trusts where qualifying as "exclusively charitable" is essential to the validity of a purpose trust, subject to a few minor exceptions. The same requirement is imposed on entities seeking charitable registration under the Income Tax Act. In applying these tests, courts require that the purpose of the entity or trust be exclusively charitable and that the entity or trust be for the "public benefit". This means, in general terms, that the charity must pursue the relevant charitable purpose for the benefit of a large enough segment of society, "the public", in an effective way.
Charitable organizations are distinguished from foundations by their active orientation - generally, charitable organizations carry out their own charitable activities. A charitable organization must devote all of its resources to the charitable activities that it con-ducts. It must not distribute or make available any part of its income to, or for the benefit of, individuals or parties other than the intended beneficiaries.
Certain exceptions apply to various aspects of the standard requirements these organizations must meet. Charitable organizations may make grants totalling not more than fifty percent of their income in any one year to qualified donees. They are allowed to carry on a 'related business'. And they may disburse their income to an 'associated' charity.Footnote 13 Charitable organizations may be organized as trusts, corporations or associations.
Granting - an organization without a well-developed infrastructure in a geographical area that it is mandated to serve may make grants to a local organization (also a registered charity) in that location to achieve its purposes.
Related business - a social service organization may operate a thrift shop in support of its work, or a hospital may run a cafeteria and apply the profits from sales of food to its general revenues.
Associated charity - an organization may fund a related organization (also a registered charity) that is mandated to carry out a particular part of its work, such as the provincial chapter of a national organization.
Foundations are characterized by their passive orientation - generally, they fund charitable activities that are carried on by other organizations. Foundations must be constituted and operated exclusively for charitable purposes. "Charitable purposes" includes the disbursement of funds to qualified donees (including registered charities).Footnote 14 No part of a foundation's income may be available for the personal benefit of any individual or party that is not an intended beneficiary of the foundation's purposes.Footnote 15 Foundations must be organized as trusts or corporations. They may not be organized as unincorporated associations.Footnote 16
Executives of registered charities and sources of capital
The Income Tax Act includes provisions about the makeup of the executive (officers, directors, and trustees, etc.) of registered charities and about their sources of capital.
Generally, if the registered charity is to be a charitable organization or a public foundation, rather than a private foundation, more than fifty percent of its executive must deal with each other, and with each of the other members of the executive, at arm's lengthFootnote 17 and not more than fifty percent of its capital may have been contributed by one person or by one group of persons who do not deal with each other at arm's length. Determination of whether a relationship is arm's length is made by looking at the extent of the kinship and/or business or other connections between the parties. If the registered charity is classified as a private foundation, it is subject to more stringent regulations.
The Income Tax Act provides an exception allowing, in some instances, governments, charitable organizations, public foundations, clubs, societies, and associations to establish public foundations or charitable organizations by contributing fifty percent or more of the capital.Footnote 18
The charitable registration process
Canada Customs and Revenue Agency Charities Directorate examiners decide whether an organization applying for federal charitable registration qualifies based on an assessment of whether it meets the legal definition of charity discussed above.
The Canada Customs and Revenue Agency is not obliged to hear or receive submissions from the applicant. The Charities Directorate does, however, have in place a standard procedure for obtaining clarifications of, or additional information on, problem applications. The applicant may appeal a negative decision to the Federal Court of Appeal.
- failing to comply with the annual information return requirement;
- issuing an improper or false donation receipt;
- failing to continue to meet any of the requirements of registration, including:
- carrying on any business, if it is a private foundation, or an unrelated business, if it is a charitable organization or public foundation;
- if it is a foundation, acquiring control of any corporation or incurring certain types of debts;
- attempting to unduly delay its expenditure on charitable activities by making transfers to another charity;
- failing to disburse a set proportion of its assets or funds receipted in the previous year for charitable purposes or activities; or
- failing to keep proper records and books of account.
The decision to revoke a registration is made by the Minister under section 168(1) of the Income Tax Act. The Minister gives notice of his intention to revoke by registered mail and offers the charity an opportunity to respond.
Most revocations stem from failure to file the information return. Occasionally, revocations are triggered by audits. Where revocation results from failure to file, organizations should not assume automatic renewal of registration once they file the proper paperwork. Changes in the legal definition of charity over time may mean they no longer qualify.
Revocation can happen as early as thirty days later by publication of the Minister's decision to revoke in the Canada Gazette, although usually the process goes on for some time. The charity may appeal to the Federal Court of Appeal.Footnote 20
The Income Tax Act and/or the Canada Customs and Revenue Agency regulate the investment, business, political, borrowing, granting, and international activities of charities. The Income Tax Act also man-dates certain levels of disbursements for all charities. The regulations pertaining to charitable organizations can be reduced to two basic rules:
1) A charity must be exclusively charitable.
Foundations must be "constituted and operated exclusively for charitable purposes." Charitable organizations must devote "all their resources ... to charitable activities carried on by the organization itself". This means a charity cannot pursue any other purpose - business, investment return, political - except to the extent that it is incidental and ancillary to the charitable purpose or is a means of achieving it. Many of the rules discussed in this chapter either apply more specific requirements to this standard or accommodate certain acceptable practices.
2) A charity must spend a certain percentage of its funds on charitable activity.
The Income Tax Act requires that charity be done to a certain quantified benchmark by requiring certain levels of disbursement of funds on charitable activity. These levels are different for charitable organizations and foundations. This required spending is known as the "disbursement quota".
Control of corporations
Foundations may not "acquire control" of a corporation. This prohibition does not apply, however, to a foundation gaining control of a corporation by gift.
The Income Tax Act does not require that a charity's investments earn a specific rate of return. It addresses the issue of investment return only indirectly, by imposing a 4.5% disbursement quota on foundations. Private foundations are subject to certain more detailed and restrictive rules to ensure against manipulation of transactions to artificially reduce the disbursement quota, and to preclude financial benefits being gained by non-arm's length individuals or parties dealing with the private foundation.footnote 21
A registered charity, whether it is a charitable organization or a foundation, is not allowed to conduct an unrelated business. Doing so would violate the exclusively charitable requirement.
Charitable organizations are allowed to carry on a related business. A charity that operates a related business is considered under the Income Tax Act to be devoting its resources to its charitable activities.
Nothing in the Income Tax Act makes reference to public foundations in this regard. They are, therefore, allowed to carry on related businesses.
Registered charities are permitted to engage in political activities under the Income Tax Act, but only to a very limited extent. Their right to do so is regulated by two sets of rules, the first related to the definition of charity, the second to the disbursement quota.
- Registered charities are allowed to engage in political activities that are ancillary and incidental to the charity's purposes. Political activity is accept-able provided that the charity devotes "substantially all" of its resources to charitable purposes, and only a part of its resources to non-partisan political activities of an "ancillary and incidental" nature. "Resources" includes all financial, physical, and human resources owned by or available to the charity, not just those that come from receipted donations. The Canada Customs and Revenue Agency defines "substantially all" as ninety percent or more of the resources.footnote 23
- Registered charities must respect their disbursement quota when allocating resources to political activity, creating an additional constraint on such activity. The amount a registered charity spends on political activities does not count as an expenditure on charitable activities or as a gift to a qualified donee for the purposes of satisfying the disbursement quota.footnote 24 Since these quotas are quite high, there is not much room in the budgets of most charities for permissible political expenses.
Charitable organizations are allowed to borrow, if the power to borrow is provided for in their bylaws. Foundations are not allowed to incur debts for purposes other than current operating expenses, purchase of investments and administration expenses.
A registered charity must be resident in Canada. This significantly restricts the capacity of Canadians and Canadian charities to do charity abroad. There are, how-ever, three ways under the Income Tax Act that a registered charity can do charitable work outside of Canada.
- A registered charity may carry on its own charitable activities abroad. Practically speaking, however, this option is open to only a few large and well-established charities, such as relief organizations, which have the financial and administrative resources to send their people abroad.
- Sections 110.1(1)(a) and 118.1(1) of the Income Tax Act allow deductions and credits for gifts to the United Nations or any of its agencies, to prescribed foreign universities and to charitable organizations outside Canada to which the Canadian government has made a recent gift. This permits a limited amount of international charitable activity, but the list of eligible donees is very restricted.
- A Canadian charity can enter an agency relationship with an entity, usually a foreign charity, which will do the actual charitable work abroad on behalf of the Canadian charity.
The Treatment of Gifts to Registered Charities and Qualified Donees
There is no definition of "gift" in the Income Tax Act. Therefore, the courts use the private law - i.e., common law or civil law - definition of the term when applying the provisions of the Act. The common law definition of a gift is stated in Friedberg v. MNR:footnote 25
Similarly, article 1806 of the Civil Code of Quebec defines a gift as follows:
Gift is a contract by which a person, the donor, transfers ownership of property by gratuitous title to another person, the donee; a dismemberment of the right of ownership, or any other right held by the person, may also be transferred by gift.
The Canada Customs and Revenue Agency's position on the meaning of "gift" is set out clearly and comprehensively in Interpretation Bulletin 110-R3, "Gifts and Official Donation Receipts."footnote 27 IT-110-R3 defines a gift as follows:
A gift ... is a voluntary transfer of property without valuable consideration. Generally a gift is made if all three of the conditions listed below are satisfied:
- some property - usually cash - is transferred by a donor to a registered charity;
- the transfer is voluntary; and
- the transfer is made without expectation of return. No benefit of any kind may be provided to the donor or to anyone designated by the donor, except where the benefit is of nominal value.footnote 28
A gift is a transfer of property, not of services. No donation credit is available for the performance of services rendered without remuneration or compensation.footnote 29 A professional who wants to receive a donation receipt for time and professional skill donated to a charity must first bill the charity for the services performed and then donate the amount he or she is paid back to the charity.
A gift can be a gift of a legal or an equitable interest, so the settlement of a trust which creates an equitable remainder interest in favour of a charity is a gift of that equitable remainder interest.
A loan of property is not a gift of property because no title or right passes by virtue of a loan.
Gifts in kind are gifts of property. A gift in kind is usually valued at the amount that would have been received for the property if it had been sold on the open market to an informed, unrelated party on the date the gift was made.
The transfer cannot be a transfer pursuant to a legal obligation. The Canada Customs and Revenue Agency has recently stated, for instance, that a gift made pursuant to a legal obligation to make it - e.g., a promise by a child to make a gift of property received by bequest from a parent - is not a gift.footnote 30
In order to be a gift, property must be transferred to the charity. But the transfer can, in some instances, be subject to conditions and restrictions. This allows for the creation of 'donor-advised' or 'donor-designated' gifts. Restrictions on the uses of the gift can also be imposed through creation of a charitable purpose trust.
The Canada Customs and Revenue Agency does not permit gifts to be directed to specified persons or families. This means that a charity cannot accept a gift on the condition that it gift the property to another person.
A transfer where any part of the transaction can be said to be for consideration usually will not constitute a gift.
The Canada Customs and Revenue Agency takes the position that a transfer of land worth $100,000, subject to a mortgage of $25,000, which the charity assumes, may not be a gift because the charity - in assuming liability under the mortgage - may be giving consideration to the donor. Specifically, if the donor has guaranteed the mortgage through a personal covenant, relief from this obligation constitutes consideration.
There are three exceptions to this: in IT-110R3, the Canada Customs and Revenue Agency states that it will permit a charity to issue a receipt for the gift portion of payments made to a charity at a fundraising event, such as a dinner or golf tournament. It takes a similar approach to tuition fees paid for religious education and to charitable gift annuities.
There have been a number of decisions in recent years that have been generally supportive of Canada Customs and Revenue Agency's position. It is worth mentioning one in particular. In Woolner v. The Attorney General of Canada,footnote 31 the Federal Court of Appeal found that donations to a church were not gifts. The taxpayers had made contributions to the their church and received charitable donation receipts in exchange. The church used the funds to award educational bursaries to the contributors' children. The Court found that the plaintiffs made their contributions in the expectation that their children would be provided with a bursary, not as a gift to the church.
The treatment of receipted donations
The credit for individuals
Individuals who make donations to registered charities and other qualified donees are entitled to a federal tax credit. This applies to donations of up to 75% of the donor's income in the year. This increases to 100% of the donor's income in the year of death and in the year preceding death. "Cultural gifts" and "ecological gifts" may be used to the entire extent of an individual's income in the year. These are defined terms under the Income Tax Act.
The federal credits are equal to 16% on the first $200 donated and 29% on the remainder. Provincial credits vary from province to province, from a high of 24.5% in Quebec to a low of 11.16% in Ontario.
Donation credits may be carried forward five years.footnote 32 The tax credit for gifts made by the taxpayer in the year of death can be carried back to the preceding year to the extent that they cannot be used in the year of death.footnote 33
Individuals may claim credits for receipts issued in a spouse's name.
Registered charities are required to devote a specific percent of their income to charitable activities or to gifts to qualified donees. Generally speaking, it is accepted that the direct administrative costs of functioning as a charity qualify as charitable activities, but that fundraising costs and legal and accounting costs do not.
The quota for charitable organizations
A charitable organization must spend at least 80% of its previous year's receipted donations on its charitable activities or on gifts to "qualified donees". Twenty percent represents the government's view as to how much of a charitable organization's revenue should be used for non-charitable expenses, such as the cost of administration, fundraising and political activities. The fact that only receipted gifts are included means that gifts from tax-exempt organizations (governments and non-profits) and non-residents and unreceipted gifts do not form part of the pool of gifts required to be disbursed. Gifts from donors who do not require tax receipts are excluded, as are gifts made by way of bequest or inheritance and gifts subject to a trust or a direction that the gifted property (or property substituted) be held for at least ten years.footnote 34 Gifts from one registered charity to another are also excepted.footnote 35 The point of these exceptions is to permit charitable organizations to build up capital endowments with gifts intended for that purpose.
There may be occasions where the disbursement quota cannot be met. In these situations, the charitable organization may apply to the Minister to obtain a discretionary exemption for the shortfall.footnote 36 There is also provision in the Income Tax Act for carrying any disbursement quota excess forward five years and back one year.footnote 37 The Minister also allows shortfalls in meeting the disbursement quota in one year to be corrected by increased expenditures the next year.
The quota for public foundations
The quota for public foundations is the total of a number of distinct elements.
- Public foundations must disburse 80% of receipted donations from the preceding year, except for those received as capital gifts or from other charities.
- Public foundations must also disburse 80% of all gifts received from registered charities in the pre-ceding year, except for those received as "specified gifts". The specified gift provision permits tax-neutral transfers of capital between charities. If the donating charity has invoked the specified gift designation, it may not count as part of its own disbursement quota.
- Public foundations must also disburse 4.5% of the average total value of all their investment property, as calculated in a specified way, owned during the preceding twenty-four month period.footnote 38 The underlying expectation is that the foundation should be earning a real rate of return on its investments close to or a bit more than 4.5%. The disbursement quota is calculated so that there is little opportunity for capital growth due to investment earnings over the long term.
The provisions that provide for exceptions to the disbursement quota of charitable organizations at the discretion of the Minister and allow charities to carry forward and back disbursement quota excesses also apply to public foundations.
The quota for private foundations
The disbursement quota for private foundations is the same as that for public foundations except that a private foundation must disburse 100% of the value of its non-specified gifts from registered charities, instead of 80%, as in the case of public foundations.
Quota shopping and disbursement avoidance
The Minister has the power to designate a charity as being registered in any one of the three classifica-tions.footnote 39 This power is used to prevent a charity from avoiding more onerous disbursement quotas by manipulating the classification system.
There are many varieties of planning which can be implemented which address some of the difficulties and challenges presented by the rules governing charities discussed in this chapter.
One common difficulty encountered by some charities is the restrictions placed on charities conducting political activities. The following structure is commonly used to address the difficulty:
A not-for-profit corporation unable to qualify for charitable status, typically because of advocacy activities, may establish a parallel not-for-profit corporation to carry on the charitable aspects of its mandate (such as education) (Figure A). Each organization would carry on its own activities separately, although it might be possible to share needed space and to share employees. If so, these arrangements must be commercially reasonable such that no plausible argument can be made that the charitable corporation is subsidizing the political corporation's activities.
There are a variety of ways to ensure an appropriate link between the two or control by one of the other. In law, they are autonomous entities and the charity will be required to abide by all the income tax requirements and all the requirements under provincial law. However, through the device of overlapping boards or membership, as illustrated in Figure A, the functions of both corporations can usually be co-ordinated in a satisfactory way.
Another frequently encountered scenario is a charity that wishes to carry on some commercial activity beyond what is permitted under the Income Tax Act. Suppose, for example, that a charity discovers and develops a commercial opportunity in a business that is not related. Provided certain conditions are met, it might be possible for the charity to own the shares of a corporation that carries on the business. That corporation, in turn, could gift or dividend some or all of its income to the charity (Figure B).
If the not-for-profit corporation is not a charity, it is taxable on its property income from the for-profit company (dividends and interest, if any) and on its capital gains arising on the sale of the shares of the for-profit company. If the not-for-profit is a charity, it would usually be entitled to issue a donation receipt for any gift made to it by the for-profit corporation.
Foundations (but not charitable organizations) cannot, it will be recalled, acquire control of a corporation. This rule does not prohibit foundations from being in a position of control by virtue of receiving the shares by gift. In Ontario, the Charitable Gifts Act prohibits a charity from owning directly or indirectly more than 10% of a business. To address these difficulties, the structure in Figure C might be used.
The technique of overlapping boards and/or members can be used to ensure that the appropriate level of control is maintained.
Sample Questions For Prospective Directors to Ask the Organization
- What is the tax status of the corporation?
- What measures are in place to ensure that it makes the necessary Canada Customs and Revenue Agency filings to maintain that status?
- What measures are in place to ensure that it meets all its other regulatory obligations under the Income Tax Act?
- If the stakeholders have created an interlocking corporate structure to accomplish their objective(s), has this structure been set up properly, and are there safeguards in place to ensure that any necessary legal distinctions between the various entities are maintained?
Sample Questions for Directors to Ask the Organization
- Are the corporation's tax and information filings up-to-date?
- Do the corporation's revenue-generating activities comply with the requirements for maintaining its current tax status? Could creating a different type of corporate structure better facilitate this type of activity?
- Do the corporation's advocacy/political activities comply with the requirements for maintaining its current tax status? Could creating a different type of corporate structure better facilitate this type of activity?
- If the corporation is a charity, is it meeting its disbursement quota?
- If the corporation is a charity, does its receipting policy meet Canada Customs and Revenue Agency requirements?
|Subject||To Be Conducted By||How Often||Comment|
1. Tax/Information filings
Full board, audit or finance committee
Are the corporation's required filings being submitted on a timely basis?
2. Tax status
At inception of the corporation, and when the mandate of the corporation changes
Does the corporation have the appropriate tax status (registered charity or non-profit) in light of its purposes and activities and given the regulatory requirements associated with the different types of tax status?
3. Non-profit status
Is the corporation undertaking any activity that could be considered as conferring a personal monetary benefit on its members?
4. Charitable status
Is the corporation meeting its disbursement quota, and complying with regulatory requirements relating to receipting of donations?
5. Revenue-generating activities
Do existing or contemplated revenue-generating activities require that a different tax status be sought, or that an interlocking corporate structure be created to facilitate them?
6. Advocacy/political activitiy
Do existing or contemplated advocacy/political activities require that a different tax status be sought, or that an interlocking corporate structure be created to facilitate them?
* B.A., LL.B. Practise based in Toronto.
** This chapter is adapted from a paper first published by The Canadian Tax Foundation. See 2001 Conference Report: "Impacts on Charity Taxation".
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