Maintaining Non-Profit Tax-Exempt Status under Paragraph 149(1)(l) Irreconcilable Differences. Understand CRA s Policies and Audit-Proof Your Entity

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1 Maintaining Non-Profit Tax-Exempt Status under Paragraph 149(1)(l) Irreconcilable Differences Understand CRA s Policies and Audit-Proof Your Entity Esmail Bharwani FCCA, FCGA, MBA, MSc.(Entrepreneurial Studies), LL.B, TEP 2011 National Charity Law Symposium Toronto, Ontario Friday, May 6, 2011

2 TABLE OF CONTENTS A. Introduction Scope CRA s Shift in Policy Strict Interpretation of the Word Profit Focus on CRA s Pre-November 2009 Policies...3 B. Law...4 C. Operating Without Profit What is Profit? Financing Future Capital Projects Entity Must Seek Other Sources of Revenues...8 D. Payment or Availability of a Personal Benefit to Members Can be Payable to or Otherwise Made Available Exceptions E. The Concept of Not-for-Profit Indicators CRA s View on Reasonable Reserve F. Other Revenues are Not-for-Profit G. Setting-up an Organization Different Forms of Organization and Issues Facing Incorporated Entities Perspective on Corporate Structure H. Impact of Change in Policy I. Precautionary Measures Before CRA Audit Review Corporation s Enabling Documents Comply With All Tax Filing Requirements Consider Moving Assets to Another Entity Without Share Capital Next Step Consider Amalgamation Distribute Capital Gains to Shareholders Transfer of Shares Among Shareholders Prepare Justification for Maintaining a Reasonable Reserve Maintain Good Record of Gifts and Sponsorship Receipts Transfer Profit-Making Activity to a Separate Corporation Prepare Justification for a Reasonable Salary Consider Registering 149(1)(l) Entity as a Charity J. Appeal to the Minister of National Revenue K. Conclusion Appendix 1: Tax Window File # E5, November 5, 2009.

3 A. Introduction Maintaining Non-Profit Tax-Exempt Status under Paragraph 149(1)(l) Entity Irreconcilable Differences Esmail Bharwani FCCA, FCGA, MBA, MSc. (Entrepreneurial Studios), LL.B, TEP The term paragraph 149(1)(l) entity referenced in this article is used to distinguish such entities from other tax-exempt organizations, which, although not a charity is able to claim tax-exempt status in the same manner as a charity registered with the Canada Revenue Agency (CRA). However, paragraph 149(1)(l) prohibits the entity from making a profit. This type of entity has enjoyed liberal interpretation of the term profit from CRA over the years used in said provision of the Income Tax Act (Act). 1 CRA s shift in policy in 2009 has sent shockwaves through the not-for-profit sector and raises a serious alarm. The paragraph 149(1)(l) entity operators worry whether they will survive under the new policy. It is recognized that CRA s goal is to encourage compliance and to that end it is justified in developing any and all reasonable risk mitigation strategies including conducting audits of high risk cases. In the author s view, CRA is not justified in taking a position that is so contrary to its well publicised policy that it undermines the process, the will and power of an unintended group of people, some of whom may be helping the community in the name of a good cause and providing the community with a variety of services. There are hundreds, perhaps thousands of not-for-profit entities, which are not charities, but are able to make a claim for taxexempt status under paragraph 149(1)(l) of the Act. If CRA were to proceed on the basis of its new strict interpretation of the term profit, there is no doubt in the author s mind that CRA would have been successful in killing a group of paragraph 149(1)(l) non-profit-organizations. With this preamble, the author appeals to the Minister to tread carefully in applying the new policy because he may be about to destroy the will, power and the willingness of thousands of volunteers and business owners who are ready and willing to work for the good of the community and without motive for profit. 1 Income Tax Act, R.S.C. 1985, (5 th Supp.) c.l, paragraph 149(1)(e). Note: When other sections are quoted in this paper, unless otherwise specified, they refer to sections of the Income Tax Act.

4 Scope This paper focuses on related issues created by the shift in CRA s policy, discusses various aspects and difficulties in operating such an entity and suggests tips on the due diligence that must be carried out with respect thereto. The author s co-presenter focuses on CRA s shift in policy, the national audit initiative, analysis of what CRA s policy is and how that matches with the provision of the Act and how the current case law measures to the CRA s new policies. In writing this paper and in preparing for the presentation at the Symposium, the author will highlight irreconcilable differences between what taxpayers have believed and continue to believe is the proper treatment of transactions undertaken by their entities, and what CRA might present as the proper way to interpret the provision of paragraph 149(1)(l). The author has on purpose not referred to the term Not-for-Profit Organization (NPO) as that term has not been used in the Act. Besides, there are various other exempting sub-provisions for other types of organizations. Examples are, paragraph 149(1)(i) which applies to organizations that provide certain low-cost housing to the elderly; paragraph 149(1)(k), which applies to labour organizations; and paragraph 149(1)(f) which applies to registered charities. In the process of commenting on the challenges the entities face, the author will express his view on some of the issues germane to these entities and conclude with an appeal to the Minister of National Revenue. The paper excludes any in-depth discussion on aspects of whether an entity s activities include operating in a normal commercial manner, whether goods and services are sold to nonmembers and whether it operates in competition with taxable entities carrying on the same trade or business. 2. CRA s Shift in Policy On November 5, 2009, CRA published its response to a certain taxpayer inquiry. The taxpayer raised a number of questions regarding whether a particular entity in the circumstances described qualified for tax exempt status under the provisions of paragraph 149(1)(l) of the Act. 2 The position articulated by CRA overrides its prior published position and established legal precedence to which the author makes reference throughout this paper Tax Window File # E5, November 5, Canada Revenue Agency, Interpretation Bulletin IT496R, Non-Profit Organizations (August 2, 2001).

5 Strict Interpretation of the Word Profit Paragraph 149(1)(l) entities operate not-for-profit activities of one type or another, but they also operate other activities. The CRA may interpret this later element as being the primary purpose, in other words a for-profit motive. An example would be that the CRA may interpret the net resulting profit, if substantial, as an indicator of an overall profit motive. Alternatively, the entity may have a large reserve (surplus), however defined and reported on financial statements, which CRA is willing to interpret as an indicator of profit motive, notwithstanding the surplus may have been necessary for providing a cushion for future expenses, or to provide for the replacement of equipment and property used in the non-profit activities of the subject entity. Or, if the legal structure of an incorporated entity in any way shape or form suggests, that a member, shareholder, or in the case of a partnership, a partner or, a proprietor had any right to receive profit by way of distribution of profit, the CRA is likely to interpret that as an indicator of profit motive. The challenge facing all paragraph 149(1)(l) entities is whether CRA will follow through on its new policy, and if so, what impact that would have on all existing entities which have either been poorly structured or carry a large surplus. Existing operators question if CRA would follow through on its new policy and disallow an entity to claim the tax-exempt status because under CRA s new determination criteria an entity has not met the requirements of paragraph 149(1)(l). 4. Focus on CRA s Pre-November 2009 Policies The focus of this paper is limited in scope to how CRA s change in policy in respect of paragraph 149(1)(l) entities will impact existing paragraph 149(1)(l) entities. 4 In order to appreciate the complexity the impugned policy change creates, the author will highlight CRA s policy and practices as they existed prior to November 5, The author will then compare the change in policy and how it might apply in practice, relying on the statements made by CRA in various publications. The primary question facing a paragraph 149(1)(l) entity is whether CRA will deem that entity to be conducting its activities for profit. An entity may have been contemplated to not generate a profit and as such was organized to serve its members on a cost recovery basis, but somehow, it 4 Charities claim their tax exemption. See Supra Note 1 at s.149(1).

6 - 4 - ended up having surplus that may offend CRA, and in turn CRA may determine the entity has a profit motive. The second question the entity faces is how closely will CRA scrutinize whether the entity has been duly incorporated and has proper constating documentation, which clearly outline its non-profit purpose, and prohibits operation as a charity. The third question is whether the constating documentation clearly restricts the ability of its members to receive any benefit. B. Law As a means of emphasizing their importance, certain key points have been listed separately. The provisions of the Act provide: No tax is payable under this Part on the taxable income of a person for a period when the person was 5 (a) (b) (c) (d) a club, society or association that, in the opinion of the Minister, was not a charity within the meaning assigned by subsection 149.1(1) 6 that was organized and operated exclusively for social welfare, civic improvement, pleasure or recreation or for any other purpose except profit (emphasis added by the author) no part of the income of which was payable to, or was otherwise available for the personal benefit of, any proprietor, member, or shareholder (emphasis added by the author) was a club, society or association the primary purpose and function of which was the promotion of amateur athletics in Canada There are two important aspects to make note of; one that the entity must not be a charity and must have been organized to conduct its activities for purposes other than to generate profit; and second that it must also be operating exclusively throughout the year for the purpose for which it was organized. CRA cautions that this is an annual test and must be satisfied in order for the entity to enjoy tax-exempt status Supra Note 1 at 149(1)(l). CRA states that Paragraph 149(1)(l) of the ITA states that in the opinion of the Minister, the taxpayer must not be charity. However, this paragraph does not require that the taxpayer obtain such an opinion. However, no advanced ruling will be issued confirming that the taxpayer operated in a manner which satisfies the conditions for the application of paragraph 149(1)(l) of ITA because it is a question of fact which can only be resolved by considering all the activities of the taxpayer during the year in question. Tax Window File # C6, October 9, 2009.

7 - 5 - The definition raises many questions, not all of which can be discussed in this paper. The question of whether an entity operates exclusively for non-profit purposes would require a separate paper. Questions facing all small and medium size operations are: (1) what is profit and what does operating without profit really mean; (2) what type of indicators does CRA consider suggestive of a profit-making motive; (3) how can these entities fund their operations if profit cannot be made; (4) how they might audit-proof their entities; (5) in the event of an audit, how might these entities prepare; and (6) what options do they have to rectify any deficiencies. C. Operating Without Profit The concept of profit is engrained in the definition of paragraph 149(1)(l) entities to separate them from entities that are for-profit motivated. CRA states that whether an organization that has earned a profit qualifies for the tax exemption provided under paragraph 149(1)(l) of the Act is a question of fact What is Profit? To understand CRA s statement, the author examines the basic definition of what profit is from an accounting and tax perspective. The accounting concept of profit is determined in accordance with generally accepted accounting principles (GAAP) in the context of the business it relates to. The provisions of the Act do not define how the profit is to be computed, it just requires that income from a business is the profit. 9 In Symes 10 the Supreme Court stated that.it is more appropriate in considering the s.9(1) business test to speak of well accepted principles of business (or accounting) practice or well accepted accounting commercial trading. According to Beam, et. al. 11 GAAP is still to be considered but should be put into the context of overall business practices and should not stand alone. In Canderel Limited 12 Supreme Court of Canada stated, as a matter of principle, that well accepted business principles, which include but are not limited to the formal codification found in GAAP are not rules of law but are interpretive aids. To the extent that they may influence the calculation of income, they will do so only in a case Supra Note 2 at para. 6. Supra Note 1 at s.9(i). Symes v. Canada, 94 DTC 6001 (S.C.C.). Robert E. Beam, Stanley N. Laiken and James J. Barnette Introduction to Federal Taxation Canada, 29th Ed. Canderel Ltd. v. Canada, [1998] 1. S.C.R. 147.

8 - 6 - by-case basis, depending on the facts of the taxpayer s financial situation. The computation of depreciation for financial accounting differs from capital cost allowance computation for tax purposes. For the purpose of determining whether the entity is conducting its activities for profit, CRA s 2009 new policy states that: A profit is generally considered to be the (positive) difference between an organization s revenue and the expenses incurred to earn that revenue. See the review of the meaning of profit in BBM. We are of the view that in determining the expenses incurred by the organization to earn revenue, it is appropriate to take into account depreciation of capital assets as well as ongoing current expenses. However, it is not appropriate to take into account the anticipated cost of future capital projects, because that cost cannot, by its nature, be an expense incurred to earn the current revenue. Thus, in considering whether an entity has a profit purpose, regard must be had to whether the entity is intentionally generating profit in order to finance future capital projects. 13 (Emphasis added) CRA s position is consistent even when it comes to acquisition of a building for an entity s own use but has more space than is necessary for the entity to carry out its objects. CRA states that: Where income received from renting space is in excess of that currently needed by an organization is building that it owns or leases and in turn sub-lets, the exempt status of such an organization could be jeopardized. Generally, we would not be concerned when an organization rents space in its building which is in excess of its current needs to carry out its objects. We would be concerned, however, when an organization acquires property that is considerably in excess of what it might reasonably be expected to need in the foreseeable future, that the property may have been acquired for the purpose of earning income. Depending on the nature of the organization and the use to which these profits are put, this may or may not be objectionable Financing Future Capital Projects Almost all entities require some sort funding for the acquisition or replacement of those capital assets necessary to continue with their non-for-profit activities. This may include buildings, vehicles, office furniture and others. The only way these entities can procure capital is by creating surplus from profit. Other options are to receive gifts and sponsorship funding or raise Supra Note 2. Tax Window File # E5, November 25, 2004.

9 - 7 - debt, which they will not be able raise because of the lack of cash flow given the absence of profit. CRA s new 2009 position is: In our view if a 149(1)(l) entity could intentionally earn profit to finance future capital projects on the basis that this constituted operating at cost and therefore did not indicate a profit purpose, then any business where the members did not require income distributions could be organized and operated as a 149(1)(l) entity and accumulate wealth on a tax-free basis. It would not be difficult to maintain that there was no profit purpose, as the courts have pointed out that where a business provides services to its members at cost, [i]t would be difficult to impute a profit purpose. (BBM) 15 CRA s position prior to November 5, 2009, was as follows: Accumulating surplus funds in excess of its current needs may affect an association s status as a tax exempt NPO. However, in certain cases, when an association requires a time period in excess of the current and prior year to accumulate the funds needed to acquire a capital property that will be used to achieve its declared exempt activities, the association s tax exempt status may not be affected. (Emphasis added) if an association annually sets aside funds to provide for a special project such as the construction of a new building to replace an existing building when it deteriorates or no longer meets the association s needs. In such cases, any funds accumulated for this purpose should be clearly identified and all transactions concerning a special project should be clearly set out in the association s accounting records. Provided the funds accumulated for a special project are used for that project, an association s tax exempt status should not be affected. 16 Following the shift in the policy in 2009, CRA, in the case of a certain condominium corporation advised the enquiring taxpayer that: We understand that condominium corporations may levy amounts from members that are put aside for identified capital projects, for example, putting a new roof on a building. As the cost of such capital projects may be considerable, the condominium corporation may choose to collect these amounts over several years in order to raise the necessary funds. The CRA accepts that collecting amounts in this manner will not, in and of itself prevent the condominium corporation from being exempt under paragraph 149(1)(l) of the Act. Moreover, a condominium corporation can earn reasonable interest income with respect to this fund and continue to qualify for the tax exemption. However, a condominium corporation BBM Canada v. Her Majesty the Queen, 2008 TCC 341 (hereinafter abbreviated to BBM ) as quoted in Supra Note 2 by CRA in addition to the words preceding the quote. Supra Note 3 at para. 9.

10 - 8 - cannot intentionally collect amounts in excess of what is reasonable to fund these identified capital projects, nor may it use these funds to aggressively earn investment income. Either of these two actions could result in a condominium corporation not meeting the criteria of paragraph 149(1)(l) Entity Must Seek Other Sources of Revenues In particular, the author believes that as CRA begins to apply the principled approach to defining profit pursuant to its new policy and discontinue allowing concession based on its own previously published policy, which many have followed in the past at their own peril as it seems now, the only options left for such an entity may be to create other sources of cash flow, which have less likelihood of being defined as profit. Some common examples include gifts and sponsorships. (a) What is a Gift? In most cases, a gift 18 of money or other property to a registered charity with the CRA registration number would be fully tax deductible to the donor who may be able to claim the federal as well as the provincial tax credits, generally between 40% to 50% of the fair market value of the donation on filing their tax return and upon production of an official receipt from the charity. A 149(1)(l) entity is not a charity and therefore cannot issue a tax receipt to the donor and the donor is unable to claim the contribution for tax purposes. This makes it difficult for the entity to attract donors of this sort. For a given payment to be considered a gift, it must be a voluntary transfer of property without valuable consideration to the donor. However under the recent changes, a transfer of property for which a donor received an advantage will still be considered a gift for purposes of the Act as long as the CRA is satisfied that the transfer of property was made with the intention to make a gift. An intention to make a gift will generally be presumed when the fair market value (FMV) of the advantage does not exceed 80% of the FMV of the transferred property. The tax consequences to the donor may vary depending on the nature of the gift See Tax Window File # E5, December 15, Canada Revenue Agency, Gifts and Income Tax 2010 (P113(E) Rev. 10 at page 5.

11 - 9 - A 149(1)(l) entity, in the author s view should not be taxable on the receipt of a gift as long as the evidenced intention was to make a gift. In addition as long as the entity satisfies the requirements of 149(1)(l), the receipt of gifts, even if otherwise taxable, would not be taxable as the entity is tax-exempt. When an entity receives a gift, it would not be considered income, as it is considered other revenue. The other revenue, which forms part of the total revenue, will not be considered by CRA as profit for the purpose of determining whether an entity operates with a profit motive. An entity is then able to use the cash received from gifts to acquire necessary assets in the operation of a not-for-profit entity consistent with its objectives. (b) What is Sponsorship? Sponsorship is not a defined term in the Act. Theresa L. M. Man writes: CRA takes the view that sponsorship fees are not gifts because the sponsor receives something in exchange and they are usually paid to support a charity even in return for advertising or some other consideration. 19 A 149(1)(l) entity often receives sponsorships from businesses to fund their activities. In return, the entity may provide the opportunity to the sponsor to advertise using its marketing material such as its logo, trade name, or any similar intellectual property, on vehicles, uniforms and in conference rooms. The entity may also allow the sponsor to publish material by way of acknowledgement of the sponsor in a program for a given event. If the payment by the sponsor is made primarily (more than 50%) for advertising on television or radio, or in a newspaper, magazine or other publication issued periodically, CRA will not consider the payment the entity receives to be a payment for a sponsorship, but rather for advertising services. 20 A donor may find this more attractive because the donor is able to expense the payment as marketing or advertisement expenses. The GST/HST does not apply to gifts or sponsorship payments, however, if sponsorship payment is for advertising services, GST/HST does apply. Receiving donations, grants, subsidies and Canada Revenue Agency Sponsorship (Summary Policy CSP-S13, September 3, 2003) as quoted in Theresa L.M. Man in her paper entitled Corporate Giving: A Tax Perspective. Canada Revenue Agency, GST/HST Information for Non-Profit Organizations (RC4081), page 12.

12 sponsorships does not affect non-profit organization s entitlement to the GST/HST rebates or ITCs. 21 D. Payment or Availability of a Personal Benefit to Members 1. Can be Payable to or Otherwise Made Available As outlined at paragraph 4(B)(c) hereinabove Paragraph 149(1)(l) requires that no part of the profit is available to a shareholder or member. It is not sufficient that just the amount is not paid but also that the constating documents must not allow payment ever to go to shareholders or members. CRA states that to qualify for the exemption under paragraph 149(1)(l), no part of the income of an association, whether current or accumulated, can be payable to, or otherwise made available for the personal benefit of, any member of the association other than the exempted group described later herein. 22 It is important to note the words can be payable to, or otherwise made available. If these conditions are not met, CRA states that an association would not qualify as tax-exempt if; (a) it distributed income during the year, either directly or indirectly, to or for the benefit of, any member; or (b) it has the power at any time to declare and pay dividends out of income. This presents a challenge for some entities. Any corporation formed under a provincial Business Corporations Act must have at least one class of shares that is entitled to receive dividends. In some provinces, however, certain statutes provide the option to incorporate not-for-profit entities without shares or with shares which give no right to members to any dividends. In Lakeview Club 23 the golf club had the power to declare dividends but never did so, and it used it earned surpluses to make repairs or improvements or supply necessary equipment required by the club in its operation. The court held that the company was a profit-making organization since its by-laws permitted the payments of dividends to shareholders. This point becomes readily evident in this case Supra Note 20. Supra Note 3. M.N.R. v. Lakeview Club Ltd. (Ex Ct.), 52 DTC 1164, reversing (T.A.B.) 51 DTC 415. See Tax Window File # , August 14, 2009.

13 In the case of Moose Jaw 24 the taxpayer operated a flying club and had amended its articles to prohibit the payment of dividends. Subsequently the club went into voluntary liquidation, its assets were distributed to its shareholders. The Minister assessed for years prior to liquidation and was upheld by the court on the grounds that the liability did not attach to shareholders alone. In its 2009 ruling, CRA states: While we can confirm that while CRA s comments in paragraph 9 of IT 409 generally continue to represent the views of the CRA, it is always a question of fact whether any particular member of a non-share corporation is a shareholder as that term is defined in subsection 248(1) of the Act. Whether a member of a non-share corporation is a shareholder will generally depend on the rights given to the member by the by-laws or other constituting documents of the corporation. (Emphasis added) If a member is found to be a shareholder, subsection 84(2) of the Act may in fact apply upon the disposition of the membership. In most cases, a member of a non-share corporation will not be a shareholder and therefore, any cash received by the member upon wind-up would be viewed as proceeds of the member s interest. It follows from the comments in paragraph 9 of IT-409 that a member may incur a capital gain or loss on the disposition of a membership if the related proceeds of disposition are different from the membership s adjusted cost base. Paragraph 11 explains that when calculating a membership s adjusted cost base, only the amount initially paid for the membership is taken into account. 25 CRA further warns that an association that has been tax-exempt during the years of its operation, otherwise having met the other conditions of 149(1)(l), may fail to comply with this requirement on a winding-up, dissolution or amalgamation. If such were to be the case, the association will lose its tax-exempt status at the time when a determination is made that an amount of income will become payable to, or otherwise available for the benefit of, a member (other than the excepted group referred to elsewhere). This condition poses two problems. First, if an entity has been incorporated under the wrong legislation or has constating documentation that allow or potentially allow for the breach of a paragraph 149(1)(l) requirement, the tax-exempt status may potentially be lost upon a determination by CRA for the years it was in operation (for the reassessing period and/or also for non-statute barred period in the event of fraud or misrepresentation). Second, its tax-exempt Moose Jaw Industrialization Fund Committee v. M.N.R., (T.A.B.) (1951), 51 DTC 325. See Supra Note 23. Tax Window File # E5, August 14, 2009.

14 status would be lost on a winding-up, dissolution or amalgamation before a distribution is made in respect of shareholders or members whose shares (or otherwise) have the right to receive dividends under such circumstances. The author has assumed that CRA s Compliance Branch may choose to go as far back as the CRA sees fit. If there is no fraud or misrepresentation and if it is only a question of interpretation, the CRA may be limited in going back to cover the reassessing period (non-statute barred period). It is important to understand the rationale for this component of the provision. If the entity is not a taxable entity because it is formed to provide services to its subscribers or patrons on a cost recovery basis, the entity should not have any profit for distribution to members, proprietor, partners or shareholders. The fact that there is a current or accumulated surplus or there is a potential to accumulate surplus based on the budget of the entity, leaves room for the CRA to interpret that there is a likelihood that someday the entity may make payment for the benefit of the member, shareholder or proprietor. Even having the structure which leaves the door open for that potential to eventually to materialize, causes CRA to become suspicious that somehow the surplus may end up in the hands of the members. The provision of paragraph 149(1)(l) is very explicitly clear in that it states, no part of income of which was payable to, or was otherwise available for the personal benefit of, any proprietor, member or shareholder thereof unless the proprietor, member or shareholder was a club, society or association the primary purpose and function of which was the promotion of amateur athletics in Canada. The second part of the definition provides an exception and that exception only applies to entities whose primary purpose and function is to promote amateur athletics in Canada. The consequence of this exception is that a registered Canadian amateur athletic association is able to distribute the proceeds of the gifts it receives from its qualifying members without jeopardizing its status as a tax-exempt NPO or a registered Canadian amateur athletic association. 26 The CRA explains this point as follows: 26 Supra Note 3 at paragraph #13 provides that an association that is tax-exempt NPO described in paragraph 149(1)(l), whose main purpose and function is the promotion of amateur athletics in Canada on a nationwide basis, can qualify as a registered Canadian amateur athletic association as defined in subsection 248(1) if it

15 Registered Canadian amateur athletic associations may receive gifts from (a) (b) corporations that are thereby entitled to a deduction in computing taxable income under paragraph 110.1(a); or individuals who, as a result are entitled to a deduction in computing tax payable determined by the formula in subsection 118.1(3). Without disqualifying itself under paragraph 149(1)(l), such an association may distribute income to, or for the benefit of any member that is an association the main purpose and function of which is the promotion of amateur athletics in Canada Exceptions Going back to the first part of the definition, CRA in its IT explains that it would allow certain exceptions for certain types of payments made directly to members or indirectly for their benefit, which will not, in and by themselves, disqualify an association from being tax-exempt under paragraph 149(1)(l): Salaries, wages, fees and honorariums for services rendered to the association provided the amounts paid are reasonable 29 and no more than those paid in arm s length situations for similar services. What is reasonable is a question fact based on the given circumstances. o In Gabco 30 the Exchequer Court held that the governing principle for applying section 67 is as follows: It is not a question of the Minister or this Court substituting its judgment for what is a reasonable amount to pay, but rather coming to the conclusion that no reasonable business man would have contracted to pay such an amount resident and created under a law in Canada. To apply for registration, such an association must complete and file Form T1189. Supra Note 3 at paras. 12 and 13. Supra Note 3 further confirmed by Tax Window File # E5, September 22, Supra Note 1 at s.67. Gabco Limited v. Minister of National Revenue [1968] C.T.C. 313 (Ex. C.R.). This decision was approved in Petro Canada v. The Queen [2004] 3 C.T.C. 156 (F.C.A.) (leave to appeal denied 2004 Carswell Nat 4108 (S.C.C.)).

16 o CRA s position as expressed in IT496R is that it would consider the amount as reasonable provided the amounts paid are no more than those paid in arm s length situations for similar services. In a number of cases, taxpayers have been successful in getting the courts to rule in their favour, in particular in following circumstances: A corporation can usually deduct unlimited salary or bonus payable to its owner-manager, on the principle that its ordinary profits are attributable to the owner s work. 31 In the author s view, in the case of a 149(1)(l) entity, the shareholder, member or proprietor is presumed not to be the owner entitled to either receive or have the potential to receive benefit; it is assumed that the ultimate beneficiary would be the charity but under no circumstances the benefit would ever pass to its members. In Nielsen 32, annual fees of $275,000-$300,000 to the owner s wife s company to manage a hotel were reasonable in light of the work she did. However, the Tax Court has disallowed management fees as a result of their payment being unreasonable in a number of other cases. 33 In order to avoid a determination by CRA that the entity operates for profit, the operator of an entity may attempt to eliminate the surplus by paying a large salary to the owner. The author will not be surprised if CRA questions payment of unreasonable salaries to an owner or operator of a paragraph 149(1)(l) entity. Payments made to employees or members of the association to assist them in covering their expenses to attend various conventions and meetings as delegates on behalf of the association for the purpose of furthering the aims and objectives of the association. Payment of campaign expenditures of a political party (other than payments to a candidate that are not reimbursements of reasonable expenses) which often result in an Safety Boss Ltd., [2000] 3 C.T.C (TCC); Technical News 22; Views doc R3. Nielsen Development Co., (2009) 5 C.T.C (TCC). Agricultural & Industrial Corp. v. Minister of National Revenue, [1991] 2 C.T.C. 2721; Pazner Scrap Metals Co. v. Minister of National Revenue [1991] 2 C.T.C. 2295; Bronson Homes Ltd. v. Minister of National Revenue [1993] 2 C.T.C. 2060; Burrows v. Minister of National Revenue [2007] C.T.C (TCC).

17 indirect benefit contemplated, are not the type of personal benefit contemplated by paragraph 149(1)(l) that would cause the party to be denied exemption under that paragraph. Payment of a distribution that comprises exclusively the payment of a share of net taxable capital gain (taxable capital gains less allowable capital losses) to a member. 34 CRA s long standing position as supported by the Department of Finance concluded that Consequently, there is no basis for allowing corporations that pay, or have the ability to pay, patronage dividends to qualify as non-profit organization within the meaning assigned by subsection 149(1)(l) of the Act. 35 And furthermore, it would constitute an offside distribution for the personal benefit of a member of the association. CRA provided the following response to a taxpayer s enquiry regarding the requirement of operating exclusively for any other purpose except profit with clarification on the issue of making the income available for the benefit of its members: a condominium corporation can only offer services for which the fees are approximately equal to the amount the condominium corporation expects to incur to provide such services. A condominium corporation cannot intentionally charge fees in excess of a cost; to do so is operating with a profit purpose. Thus, a condominium corporation that intentionally rents out a suite for an amount higher than the expected cost of maintaining and operating that suite does not qualify for the exemption provided by paragraph 149(1)(l) of the Act. This position applies to all activities a condominium corporation might choose to undertake, such as the operation of a parking lot, laundry facilities or a fitness/health centre Pursuant to subsection 149(2) of the ITA which states, For the purposes of paragraphs (1)(e), (i), and (l), in computing the part, if any, of any income that was payable to or otherwise available for the personal benefit of any person or the total of any amounts that is not less than a percentage specified in any of those paragraphs of any income for a period, the amount of such income shall be deemed to be the amount thereof determined on the assumption that the amount of any taxable capital gain or allowable capital loss is nil.. Tax Window File # E5, January 22, Supra Note 17 clarifies CRA s position expressed in Income Tax Technical News #4, which commented that most residential condominium corporations will qualify as non-profit organizations under paragraph 149(1)(l) it also indicates that this because it was assumed that such entities normally operate exclusively for any purpose except profit.

18 With respect to the second question, CRA confirms that: when a condominium corporation reduces members fees as a consequence of intentionally charging rent in excess of expected costs, this would generally be considered to be making the income of the condominium corporation available for the personal benefit of its members CRA has a position that if members benefited from a reduction in fees, this will affect the tax exempt status of the corporation. In Gulf Log 37 the association was organized to carry on a station for salvaged logs and return them to their owners and to provide these services at cost. The association had no power to pay dividends to its shareholders. The court held that it was a non-profit organization since revenue was generated on a cost-recovery basis. In L.I.U.N.A. 38 the court examined the issue of availability of the fund s income to the members. The trust agreement provided absolute discretion to trustees to distribute any remaining surplus in such manner as they saw fit. The court held that this power held by the trustees did not entitle the members payment of current income in the year it was earned. Until the wind-up or such a period as the determination is made by trustees to pay out the surplus to members, no payment would be made. The court held that: Where the trust document does not specifically permit the trustees to pay income to the members it is not until a determination is made on winding-up to pay a portion of the income to the members that any part thereof becomes payable to or available for the personal benefit of a member. It is the year in which that is done that the exemption is lost. (Emphasis added by the author) In a 2007 ruling, 39 CRA was asked whether, based on a specific provision in its original enabling documents, there was a risk that the organization might be reassessed as a taxable entity. The specific wording referred to by the taxpayer involves the original wording of the Organization s Letters Patent. Upon incorporation, the Letters Patent included an Article stating that upon liquidation or winding-up of the Organization, all of its remaining assets after payment of its liabilities would be distributed among the members. This Article was amended approximately Gulf Log Salvage Cooperative Association v. Minister of National Revenue, [1960] 60 D.T.C. 239 (TAB). L.I.U.N.A. Local 527 Members Training Fund v. Minister of National Revenue, [1992] 2 C.T.C Tax Window File # E5, February 20, 2007.

19 three years later to provide that upon liquidation or winding-up of the Organization, all of its remaining assets after payment of its liabilities would be distributed by the directors of the Organization in their sole discretion. The taxpayer asked whether the Organization was at risk of being reassessed as a taxable entity for the period from incorporation to the amendment of its Letters Patent. CRA responded by stating that to qualify as tax-exempt NPO, one of the requirements outlined in paragraph 149(1)(l) of the ITA is that the entity be organized and operated such that no part of its income is payable to or otherwise available for the personal benefit of a member. CRA referred the taxpayer to paragraph 11 of IT 496R and stated that: An NPO may run into difficulty with this prohibition upon wind-up. For this reason, it is recommended that the enabling documents provide that on wind-up, a NPO s assets and accumulated income will be transferred to another NPO or a registered charity with similar objects. CRA Rulings Directorate keeps reminding us that all will rest with the Compliance Branch but then says: In the unique circumstances of the Organization, its members are themselves NPOs and it appears likely that the Organization and its member NPOs have similar and overlapping objects. Given these factors, together with the fact that the wording in question was amended prior to being acted upon, it is unlikely that the CRA would consider that the Organization did not qualify as an NPO from its creation. (emphasis added by the author) As a completed transaction involving an assessment question, this determination and any assessing action would be the responsibility of the Compliance Programs Branch of the CRA. Even in the following case, CRA warned that the entity s tax-exempt status could be jeopardized: an association is providing dance costumes to students of the dance school who may be members or related members of the association would not, in and by itself, jeopardize the status of the non-profit organization provided the provision of the costumes furthers the objectives and purpose of the association, as described in its instruments. However, as we have not reviewed the instruments creating the association (such as its letters patent, bylaws, etc.) we cannot conclusively make this determination Tax Window File # E5, May 25, 2004.

20 E. The Concept of Not-for-Profit 1. Indicators CRA looks at a variety of factors in making the annual determination of profit motive. Some of these indicators and some particular examples of various determinations are as follows: (a) Retaining excess funds is indicative of an organization operating with a profit motive, however, having a surplus by itself will not in and of itself result in the organization failing to qualify as a 149(1)l(l) entity; (b) If the funds were collected for the purpose of earning investment income rather than for the purpose of funding a specific capital project. A certain taxpayer asked CRA whether it would be acceptable for a 149(1)(l) entity to receive cash donations, which it subsequently invested to earn income and which income it then used to support its activities (and otherwise met the 149(1)(l) conditions). The CRA s response was the activity of investing cash (or other assets) is generally considered to be undertaken specifically to earn a profit, which is contrary to the conditions of paragraph 149(1(l). where cash or other income-generating assets will themselves be used directly to meet an organization s not-for-profit objectives within a reasonable time frame in other words, the expectation is that the capital property will either be spent or used directly, within the foreseeable future, on not-for-profit objectives. maintaining capital property for the purpose of generating income for the organization means the organization has profit purpose among its other purposes. 41 (c) The subject entity will be exempt as long as a profit that a 149(1)(l) entity earns, is generally unanticipated and incidental to carrying out the entity s exclusive non-profit purposes; Tax Window File # E5, May 11, The Gull Bay Development Corporation v. Her Majesty The Queen, [1984] 84 D.T.C (F.C.T.D.).

21 (d) Where an organization would be unable to undertake its not-for-profit activities but for its profitable activities, the organization cannot be a 149(1)(l) entity; 43 (e) CRA interprets incidental or unanticipated profits as those which resulted after the entity prepared a reasonable budget with the intention of not earning a profit, but ultimately finds itself with a profit because of expenses that were less than anticipated or that were reasonably expected but were not incurred; (f) If a material part of the excess is accumulated each year and the balance of accumulated excess at any time is greater than the association s reasonable needs to carry on its non-profit activities; 44 an accumulation equal to more than one year s reasonably anticipated expenditures on its non-profit activities may be excessive but in another cases more than a shorter period may be excessive; 45 (g) If an entity rents space in a building and sub-lets a portion of that space, it is normally not offside, but if it acquires property considerably in excess of what it might reasonably expect to need in the foreseeable future, it may be considered to have acquired the property for the purpose of earning income. 46 (h) A condominium corporation makes a profit on a rental suite and thus reduces the members fees, will not be exempt; 47 (i) An entity investing donations to earn investment income to fund its nonprofit objectives will disqualify the entity from paragraph 149(1)(l) Woodward s Pension Funds v. The Queen, 62 D.T.C. 1002; Tourbec (1979) Inc. v. Minister of National Revenue, 88 D.T.C (T.C.C.). Supra Note 3 at para. 8. Supra Note 3 at para. 9. Tax Window File # E5, November 25, 2009; R3, January 23, Supra Note 17. Tax Window File # E5, May 11, 2010.

22 However, if a cooperative housing corporation receives from its members/shareholders amounts for the purpose of making future major repairs and replacements to the particular residential property, and if it turns out that there is an excess balance in members condominium fees and contribution over the corporation s expenditures for the year, the excess is not considered income of the corporation on the assumption that it would be considered a 149(1)(l) entity; 49 (j) When a benefit is made available to members through payment of dividends or provision of indirect benefit, it will not be exempt; and (k) Although the purchase of a property for the purpose of earning rental income could suggest a profit motive, this determination is question of fact states CRA. Relevant considerations in such a situation would be the duration of the profitable rental situation and whether the income earned during the transition period is used for the NPO s not-for-profit objectives CRA s View on Reasonable Reserve The previous policy permitted an entity to accumulate a reserve or a surplus for the purpose of replacing or acquiring assets for use in the non-profit activities. That policy has not changed, however the new 149(1)(l) policy has restricted the ability of an entity to accumulate a reserve from profit because CRA has adopted a purely commercial meaning of the word profit. Therefore, existing entities with a large surplus which has accumulated from tax-exempt profit over the years need to remain aware that: (a) The large reserve suggests to CRA that there exists a profit motive and CRA may likely investigate the following: (i) Year by year accumulation and the source of accumulation; Tax Window File # E5, October 22, Tax Window File # E5, March 2, 2007.

23 (ii) (iii) (iv) (v) (vi) (vii) (viii) Whether the entity has a plan in place as to when and how the reserve will be used and whether the assets acquired would be used for non-profit purposes; Whether an entity has a record of all assets, the asset profile showing when and which of the assets will be replaced; Whether the surplus is being invested in unrelated objects such as long-term investments to produce property income; Whether the surplus is invested in expanded facilities and used for normal commercial operations; Whether funds are being used to loan to members, shareholders or non-exempt persons; Whether the funds are invested in term deposit and guaranteed investment certificates that are regularly renewed within a year and from year to year, and whether the principal is adjusted from time to time; Whether the present balance of accumulated excess is considered excessive or an annual excess is regularly accumulated that is greater than an association s needs to carry on its non-profit activities. In 2001 CRA stated: Interpretation bulletin IT496 sets out certain practical guidelines which the Department applies in administering paragraph 149(1)(l). Essentially the bulletin is no more than a notice to the public that if too much is earned or if large surpluses are accumulated the Minister will draw an inference of fact that the fund is being operated for profit. While I do not wish to give the bulletin a legal effect that it clearly does not have I can see no reason for criticizing the guidelines set out in paragraphs 8 and 9. Their application, however, depends upon the facts of the particular case Tax Window File # , November 21, 2001.