,I) NEW DISBURSEMENT QUOTA RULES

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1 ,I) NEW DISBURSEMENT QUOTA RULES )

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3 ) TABLE OF CONTENTS I. INTRODUCTION 1 II. THE NEW DISBURSEMENT QUOTA RULES 3 III. NEW CONCEPT OF ENDURING PROPERTy 5 IV. ABILITY TO ENCROACH ON ENDURING PROPERTy 7 V. NEW CONCEPT OF CAPITAL GAINS POOL 8 VI. REDUCTION OF DISBURSEMENT QUOTA ON CAPITAL ASSETS 9 VII. INTER-CHARITY TRANSFERS 10 A. ORDINARY GIFTS 10 B. ENDURING PROPERTY 10 C. SPECIFIED GIFTS 11

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5 I. INTRODUCTION One of the most onerous tasks of a registered charity is to meet the annual disbursement quota requirements imposed under the Income Tax Act!. In Canada Revenue Agency's ("CRA's") words, the disbursement quota is designed: 2 (a) (b) (c) to ensure that most of a charity's funds are used to further its charitable purposes and activities; to discourage charities from accumulating excess funds; and to keep other expenses (including administrative and fundraising) at a reasonable level. Failure to meet the disbursement quota requirements may result in the revocation of charitable status. 3 Revocation has serious implications for a charity: an immediate loss of tax-exempt status; an immediate cessation of the charity's ability to issue tax receipts; and the application of a revocation tax 4 In practice, however, revocation will likely only occur where there have been continuous failures to meet the disbursement quota requirements. s 1 R.S.C. 1985, c.1 (5 th Supp.), as amended (the "Act"). Unless otherwise indicated, all statutory references in this paper are to the Act. 2 RC 4108, "Registered Charities and the Income Tax Act" 3 See 149.1(2)(b), (3)(b) and 149.1(4)(b) of the Act. 4 See subsection 188(1.1) of the Act. The revocation tax is generally equal to the total value of the assets of the charity on the "valuation day" plus the amount of receipted donations and inter-charity gifts received by the charity after the "valuation day" less certain eligible disbursements. For revocations occurring after June 12, 2005, postrevocation divestiture can only be made to "eligible donees", which are defined under subsection 188(1.3) of the Act generally as non-deficient arm's length registered charities. Previously, divestiture could have been made to any "qualified donee"; a significantly broader category. 5 Under subsection 149.1(20) of the Act, a charity can use its disbursement excess in one year to offset a disbursement shortfall in the immediately preceding year. The ability to carry-back disbursement excesses for one year provides support for the view that revocation should not result from a single failure to meet the disbursement quota.

6 - 2- A charity can overcome a disbursement shortfall in a particular year in one of two ways. way is by carrying forward disbursement excesses from one of the preceding 5 years or carrying back a disbursement excess from the following year. 6 One A disbursement excess will result where the total amount expended in the year by the charity on charitable activities and on gifts made to "qualified donees"? exceeds its disbursement quota requirement for the year. 8 The second way of overcoming a disbursement shortfall is to apply to the Minister in prescribed form (Form T2094) to have the charity's disbursement quota reduced. 9 Not all expenditures count towards the satisfaction of the disbursement quota. Only monies spent directly on charitable activities or gifts to "qualified donees" can be used to meet the disbursement quota. Charitable activities include salaries and wages paid to persons who are actually performing charitable work and the purchase of equipment used in charitable activities. Charitable activities do not include "specified gifts" or amounts spent on management and administration activities, fundraising activities or political activities. lo Historically, the calculation of the disbursement quota varied, depending on whether the registered charity was a "charitable organization", a "public foundation" or a "private foundation". Under the new disbursement quota rules, the distinctions among the three types of charities have for the most part been removed. The only differences are that a charitable organization can exclude from the disbursement quota requirement a new category of "less than 6 See subsection (20) of the Act. 7 Generally, registered charities, registered Canadian amateur athletic associations, housing corporations resident in Canada constituted exclusively to provide low-cost housing for the aged, municipalities in Canada, the United Nations and its agencies, universities outside Canada listed in Schedule VIII of the Income Tax Regulations, C.R.C. c. 945, as amended (the "Regulations"), charitable organizations outside Canada to which Her Majesty in right of Canada (the federal government or its agents) has made a gift during the charity's fiscal period or in the 12 months immediately preceding the period and Her Majesty in right of Canada or in right of a province (the federal government, a provincial government or their agencies). An amendment is currently proposed under the July 18, 2005 draft legislation that would add "a municipal or public body performing a function of government in Canada" to the list of "qualified donees". 8 See subsection 149.1(21) of the Act. 9 See subsection (5) of the Act. Such an application will be successful only if the disbursement shortfall is due to extra-ordinary circumstances beyond the charity's control. 10 See 149.1(1.1) of the Act, which specifically excludes "specified gifts" and expenditures made on political activities, including incidental non-partisan political activities permitted under paragraphs 149.1(6.1) and (6.2) of the Act.

7 - 3-5-year gifts" received from other registered charities (a charitable foundation cannot) and that a private foundation must expend 100% (as opposed to 80% for a charitable organization and a public foundation) of all amounts received from other registered charities in its preceding taxation year, other than specified gifts and enduring property. One of the biggest changes as a result of the new rules is a reduction in the inclusion rate applied to the average value of capital assets from 4.5% to 3.5% and an expansion of this component to charitable organizations for taxation years that begin after Also significant are the introduction of a de minimis threshold of $25,000 on the application of the 3.5% disbursement quota requirement and two new concepts: "enduring property" and "capital gains pool". II. THE NEW DISBURSEMENT QUOTA RULES The new disbursement quota formula, generally applicable for taxation years beginning after March 22, , is set out in the definition of "disbursement quota" in subsection 149.1(l) of the Act: A + A.l + A.2 + B + {C * [D - (E + F)]}/365 Where: A = 80% of the total of receipted gifts in the immediately preceding taxation year other than a gift that is (a) (b) an enduring property; or received from another registered charity. A.l = the amount by which the sum of (a) (i) 80% of all amounts which is the amount of an enduring property to the extent that it is expended in the year (other than enduring 11 For charitable organizations registered after March 22, 2004, the 3.5% disbursement quota requirement will apply to taxation years that begin after March 22, As noted above, there is an exception for the application of the 3.5% disbursement quota requirement for charitable organizations registered before March 23, Such charitable organizations will not be required to comply until after 2008.

8 - 4- property transferred by way of gift to a qualified donee, a specified gift or a bequest or an inheritance received before 1994); and (ii) the total of all amounts each of which is the fair market value, when transferred, of an enduring property (other than a specified gift) transferred by way of gift to a qualified donee exceeds (b) the amount, if any, claimed by the charity, that may not exceed the lesser of 3.5% of the amount determined for variable D and the "capital gains pool" of the charity for the taxation year. B = C = D = E = F = in the case of a charitable organization or a public foundation, 80% of the total of all amounts received by the charity in its immediately preceding taxation year from another registered charity (other than a specified gift or an enduring property), and for a privatefoundation, 100% ofsuch amounts. the number of days in the taxation year. the prescribed amount for the year, in respect of all or a portion of a property owned by the charity at any time in the 24 months immediately preceding the taxation year that was not used directly in charitable activities or administration if that amount is greater than $25,000 and, in any other case, nil.!3 the total of all amounts determined for subparagraph (a)(ii) of the description of A.I and 5/4 of the total of the amounts determined for A and subparagraph (a)(i) of the description of A.I for the year in respect of the charity. The 5/4 factor is used to bring these amounts back up to 100%. the amount equal to, in the case of a charitable organization or a public foundation, 5/4 of the amount determined for B in the year in respect of the 13 The calculation of variable D under the disbursement quota rules remains substantially the same as the definition prior to the proposed amendments except for the de minimis threshold of $25,000. The method for calculating the prescribed amount for the purposes ofvariable D is generally described in Appendix "A" to this paper.

9 - 5 - charity, and in the case of a private foundation, the amount determined for B in the year in respect of the charity. The 5/4 factor is used to bring these amounts back up to 100%. III. NEW CONCEPT OF ENDURING PROPERTY The new concept of "enduring property" is defined in subsection (1) of the Act as follows: (a) (b) a gift received by the charity by way of a bequest or inheritance and a gift deemed by subsection 118.1(5.2) or (5.3) of the ACt. I4 if the registered charity is a charitable organization, a gift from another registered charity in respect of which more than 50% of the directors and trustees of the donor charity deal at arm's length with the recipient charitable organization, provided that the gift is subject to a trust or direction that the gift be held by the charitable organization for a period of not more than 5 years and expended: (i) (ii) to acquire a tangible capital property of the charitable organization to be \ used directly in charitable activities or administration; or in the course of a program of charitable activities of the charitable organization that could not reasonably be completed before the end of the first taxation year of the charitable organization ending after the taxation year in which the gift was received. (c) a lo-year gift received by an original recipient charity subject to a trust or direction that the gift, or property substituted for the gift, is to be held by the original recipient charity or by another registered charity for a period of not less than 10 years from the date the original recipient charity received the gift, except that the trust or direction may permit the original recipient charity or the transferee to expend the property before the end of 10 years to the extent 14 A gift of life insurance proceeds, a registered retirement income fund ("RRIF") and a registered retirement savings plan ("RRSP") made as a result of a direct beneficiary designation.

10 - 6 - permitted by the quotient {C * [D - (E + F)]}/365 in order to meet its disbursement quota requirement. (d) a gift received by the charity as a transferee of an enduring property under (a) or (C)15 above from either an original recipient charity or another transferee charity, provided that if it is an enduring property under (c), the gift is subject to the same terms and conditions under the trust or direction as applied to the original recipient charity. There are a number of significant changes to the disbursement quota rules as a result of the introduction of the new concept of "enduring property". First, gifts received by way of bequest or inheritance are no longer restricted to gifts of capital. I6 As a result, a testamentary income interest received by a charity will now initially be excluded from the disbursement quota requirement. Second, the inclusion of gifts made by way of direct designation under a life insurance policy, an RRIF or an RRSP in the definition of enduring property ensures that such gifts are specifically excluded from the disbursement quota requirement until the year in which they are expended, at which time an 80% disbursement quota obligation arises. I? Third, a new category of "less than 5-year gifts" received from other registered charities is created for charitable organizations. This new category of gifts will allow charitable organizations to delay the expenditure of certain gifts from other registered charities over a 5 year period and will be particularly helpful in raising funds for projects that cannot be completed within the regular disbursement quota period, being a maximum of 24 months. 15 The English version of the definition of "enduring property" contains a cross reference error in paragraph (d). The definition currently refers to paragraph (b) instead of paragraph (c). This error will be amended with the enactment of the July 18, 2005 draft legislation (Part 2 technical). 16 The previous exemption for the 80% expenditure requirement was for "a gift of capital received by way of bequest or inheritance". 17 Previously, gifts made by way of direct designation were not counted as gifts for the purposes of the definition of disbursement quota and therefore not included either on receipt or when expended. era had commented that this was an unintended result that would be remedied. See Technical Interpretation , "Gifts by direct designation", dated January 16,2003 and Registered Charities Newsletter No. 15.

11 -7 - Fourth, the uncertainty regarding encroachment on lo-year gifts is removed. Now, a charity can clearly encroach on lo-year gifts, but such encroachment is subject to the restrictions discussed in detail below with respect to encroachment on enduring property. Finally, the introduction of the concept of "enduring property" will have a significant impact on the ability of charities to accumulate assets and build-up endowments. There are two general methods in which a charity can accumulate assets: either by making an application to the Minister under subsection 149.1(8) of the Act for permission to accumulate property,18 or by encouraging gifts that are either completely excluded from the disbursement quota requirement 19 or excluded until the year in which they are expended. With the introduction of the new concept of "enduring property", the types of gifts that are either completely or initially excluded fr.pm the disbursement quota requirement have been expanded. IV. ABILITY TO ENCROACH ON ENDURING PROPERTY Variable Al has been amended to remove a cumulative disbursement quota obligation that existed in respect of 10-year gifts. Previously, when testamentary or 10-year gifts were encroached upon to satisfy the 4.5% disbursement quota of a charitable foundation, the amount expended was also brought into the 80% disbursement quota calculation under variable A.l. The result was that 80% of the expended capital amount was required to satisfy the 80% disbursement requirement under variable AI, leaving only 20% of the expended capital amount to satisfy the 4.5% disbursement obligation. This result has been particularly difficult for charitable foundations in the recent era of low interest rates. Variable Al is now reduced by the amount, if any, claimed by the charity that may not exceed the lesser of 3.5% of the amount determined for variable D and the "capital gains pool" of the charity for the year. This effectively imposes two limits on the ability of a charity to encroach upon enduring property. The first limit is the 3.5% calculation for the charity as a whole. The ) 18 There is no specific application form for this. The application, however, must specify the purpose for which the charity wants to accumulate funds, the amount required, as well as the length of time the charity will need to accumulate the funds. See RC 4108, "Registered Charities and the Income Tax Act". Ifthe application is approved, funds are deemed to be expended for the purposes of satisfying the disbursement quota in the year of accumulation and not deemed to be expended in any other year (including the year of actual expenditure). 19 For example, "specified gifts" or testamentary gifts received before 1994.

12 - 8 - second limit operates through a new notional account referred to as the "capital gains pool", which effectively limits encroachment to declared capital gains realized on enduring property. The capital gains pool is calculated as the total of all declared capital gains of the charity from the disposition of enduring properties after March 22, 2004, less any claims made by the charity against the capital gains pool in prior years. The calculation of the capital gains pool is discussed in greater detail below. It has been noted in the tax commentary that the new rules produce an unusual result for those charities who find themselves in a position of having to encroach upon enduring property held in fungible public securities, such a mutual funds, to meet their disbursement quota requirements. 2o For such charities, the new rules could require a sale of their total portfolio to realize sufficient accrued capital gains followed by a subsequent reinvestment of the original capital. The previously existing loop-hole regarding the expenditure of certain gifts received and expended in the same year has been removed. Prior to the new disbursement quota rules, testamentary gifts and 10-year gifts expended in the same year as they were received were not brought into the disbursement quota formula, but the expenditure would nevertheless count towards the satisfaction of the charity's other disbursement obligations. The previous requirement was that a gift be included in the disbursement quota formula under variable A.l only if it had previously been excluded from the charity's disbursement quota. Amounts are now included in variable A.l whether or not they have been previously excluded from the charity's disbursement quota. v. NEW CONCEPT OF CAPITAL GAINS POOL The calculation of the capital gains pool for a registered charity is complex. The phrase "capital gains pool" is defined as the total of all amounts, each of which is the amount of a capital gain of the charity from the disposition of an enduring property after March 22, 2004 and before the end of the taxation year (other than a capital gain from a disposition of a testamentary gift received by the charity before 1994) that is declared by the charity in its T3010 Information Return for the taxation year during which the disposition occurred that exceeds the total of all amounts each of 20 See Susan M. Manwaring and Robert B. Hayhoe, "Charities Update: 2004 Budget Proposals" Report of Proceedings offifty-sixth Tax Conference, 2004 Tax Conference (Toronto: Canadian Tax Foundation), 8: 1-28.

13 - 9 - which is the amount determined for a preceding taxation year of the charity that began after March 22,2004 that is the lesser of the following two amounts: (a) (b) the amount determined according to paragraph (a) of variable A.l; and the amount claimed by the charity under paragraph (b) of variable A.l. As noted above, the capital gains pool is essentially the total of all declared capital gains of the charity from the disposition of enduring properties after March 22, 2004, less any claims made by the charity against the capital gains pool in prior years. The annual calculation of additions to and deductions from the capital gains pool is voluntary. In practice, however, a charity should always calculate and report its realized capital gains from the disposition of enduring property on an annual basis and declare the same in its T3010 Information Return in order to preserve the ability to encroach upon its capital gains pool if and when it is required to do so in the future. VI. REDUCTION OF DISBURSEMENT QUOTA ON CAPITAL ASSETS In recent years, investment markets have averaged earnings at rates lower than the historical 4.5% inclusion rate. This has caused significant hardships on charitable foundations trying to meet the disbursement quota requirements under the Act. Many charitable foundations have had to sell capital assets where permitted in order to meet the disbursement quota or apply to CRA pursuant to subsection 149.1(5) of the Act for a reduction. In an attempt to alleviate this problem, the inclusion rate has been reduced from 4.5% to 3.5%. CRA has indicated that the rate will be reviewed periodically to ensure that it continues to be representative of long-term market rates of return. The 3.5% inclusion rate will apply to existing charitable organizations for taxation years that begin after The extension to charitable organizations recognizes that significant capital endowments can be held and in fact are held by both charitable foundations and charitable organizations alike. 21 For charitable organizations registered after March 22, 2004, the 3.5% disbursement quota will apply to taxation years that begin after March 22, 2004.

14 - 10- The new 3.5% inclusion rate only applies to registered charities if the value of their capital assets calculated in the prescribed manner under variable D is greater than $25,000. Where the value of their capital assets calculated in the prescribed manner is equal to or less than $25,000, variable D will be nil. This de minimis threshold is an attempt to alleviate the obligation of small charities to meet the disbursement quota requirement with respect to capital assets. VII. INTER-CHARITY TRANSFERS Prior to the new disbursement quota rules, transfers from registered charities to charitable organizations were exempt from the 80% disbursement quota. Now all transfers from one registered charity to another will be subject to the 80% disbursement quota requirement (100% for transfers to private foundations) except transfers involving enduring property and specified gifts. There are now 3 categories of gifts between charities: transfers of ordinary gifts; transfers of enduring property; and transfers of "specified gifts". A. ORDINARY GIFTS 22 Under the new disbursement quota rules, the transferor charity will be able to utilize the transfer of an ordinary gift to satisfy its disbursement quota obligation in the taxation year in which the transfer is made. The transferee charity will be required to expend 80% of such gifts (100% in the case of private foundations) in the taxation year following receipt. B. ENDURING PROPERTy 23 The transfer of enduring property by a charity will give rise to a 100% disbursement quota requirement in the taxation year of the transfer as a result of (a)(ii) of variable A.I. However, the transferor charity will be able to offset this requirement with the transfer of the enduring gift, producing a net neutral affect on the transferor charity. The transferee charity will not be required to expend 80% (100% in the case of a private foundation) of such amounts in the year 22 An ordinary gift is a gift of property where the transferor charity does not designate the gift as a "specified gift" and where the property is not an enduring property. 23 The definition of enduring property is described in detail above. New Disbursement Quotu Rules

15 ) following receipt. When, however, the transferee charity does expend such amounts, the expenditure will give rise to a disbursement quota obligation under variable A.I, ensuring that 80% of such expenditures are spent on charitable activities. C. SPECIFIED GIFTS 24 The transferor charity will not be permitted to utilize the transfer of a "specified gift" to satisfy its disbursement quota obligation for the year of transfer because a "specified gift" is not deemed to be an expenditure on charitable activities nor a gift made to a qualified donee. 25 As a result, a transferor charity may be hesitant to designate an amount as a "specified gift" unless it has a sufficient disbursement excess. Similarly, the "specified gift" does not create any disbursement quota obligation on the transferee charity, neither in the year following receipt (given the exclusion from variable B) nor in the year of expenditure (given the exclusion from variable A.I). Provided that the "specified gift" is eventually expended on qualifying charitable activities, the expenditure can be used by the transferee charity to satisfy its other disbursement quota obligations in the taxation year that it spent. 24 A "specified gift" is defined under subsection (1) of the Act as "that portion of a gift, made in a taxation year by a registered charity that is designated as a specified gift in its information return for the year". 2S See paragraph 149.1(1.l)(a).

16 APPENDIX "A" Prescribed Amount for Variable D The method for calculating the prescribed amount of a charity for the year for the purposes of variable D is set out in Regulations 3700 to Essentially, the calculation is an averaging of the value of a charity's capital assets. The Regulations have not yet been amended to include a reference to charitable organizations. Presumably such amendments will be forthcoming. The following are the three basic steps to the calculation of the prescribed amount: Step I: Divide the 24 months immediately preceding the fiscal period covered by the return (i.e., a charity filing a return for a 2005 calendar year would report on the value of its investments in 2003 and 2004) into 2 to 8 equal periods (i.e., 2 periods of 12 months each, 3 periods of 8 months each, 4 periods of 6 months each, 6 periods of 4 months each, or 8 periods of 3 months each). The charity is free to choose any of the foregoing number of periods. However, once selected the number of periods cannot be changed without the consent of the Minister. Step 2: Determine the value of the charity's investment property at the end of each period selected. The method for doing this is set out in Regulation 3702 and varies with the specific type of property in question. Certain properties are ascribed a value equal to nil, namely, a contribution that is the subject of a pledge, an interest in property if the charity does not have present use or enjoyment of the interest and a life insurance policy (other than an annuity contract) that has not matured. Step 3: Aggregate the values determined under Step 2 and to divide the sum by the number of periods determined under Step 1.