Maintaining Non-Profit Tax-Exempt Status under Paragraph 149(1)(l) –

Irreconcilable Differences

Understand CRA’s Policies and Audit-Proof Your Entity

Esmail BharwaniFCCA, FCGA, MBA, MSc.(Entrepreneurial Studies), LL.B, TEP

2011 National Charity Law Symposium Toronto, Ontario

Friday, May 6, 2011

TABLE OF CONTENTS

A. Introduction.....................................................................................................................1

1. Scope...................................................................................................................22. CRA’s Shift in Policy ..........................................................................................23. Strict Interpretation of the Word “Profit”.............................................................34. Focus on CRA’s Pre-November 2009 Policies .....................................................3

B. Law.................................................................................................................................4

C. Operating Without Profit .................................................................................................5

1. What is Profit?.....................................................................................................52. Financing Future Capital Projects ........................................................................63. Entity Must Seek Other Sources of Revenues.......................................................8

D. Payment or Availability of a Personal Benefit to Members ............................................ 10

1. Can be Payable to or Otherwise Made Available................................................ 102. Exceptions ......................................................................................................... 13

E. The Concept of Not-for-Profit ....................................................................................... 18

1. Indicators........................................................................................................... 182. CRA’s View on Reasonable Reserve ................................................................. 20

F. Other Revenues are Not-for-Profit ................................................................................. 23

G. Setting-up an Organization ............................................................................................ 24

1. Different Forms of Organization and Issues Facing Incorporated Entities .......... 242. Perspective on Corporate Structure .................................................................... 27

H. Impact of Change in Policy ........................................................................................... 29

I. Precautionary Measures Before CRA Audit................................................................... 30

1. Review Corporation’s Enabling Documents....................................................... 312. Comply With All Tax Filing Requirements........................................................ 323. Consider Moving Assets to Another Entity Without Share Capital..................... 334. Next Step – Consider Amalgamation ................................................................. 345. Distribute Capital Gains to Shareholders............................................................ 356. Transfer of Shares Among Shareholders ............................................................ 357. Prepare Justification for Maintaining a Reasonable Reserve............................... 368. Maintain Good Record of Gifts and Sponsorship Receipts ................................. 369. Transfer Profit-Making Activity to a Separate Corporation ................................ 3710. Prepare Justification for a Reasonable Salary ..................................................... 3811. Consider Registering 149(1)(l) Entity as a Charity ............................................. 38

J. Appeal to the Minister of National Revenue .................................................................. 38

K. Conclusion .................................................................................................................... 40

Appendix 1: Tax Window File #2009-0337311E5, November 5, 2009.

Maintaining Non-Profit Tax-Exempt Status under Paragraph 149(1)(l) Entity –

Irreconcilable Differences

Esmail BharwaniFCCA, FCGA, MBA, MSc. (Entrepreneurial Studios), LL.B, TEP

A. Introduction

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 tax-

exempt 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, (5th 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.

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1. 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 non-

members 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.3

2 Tax Window File #2009-0337311E5, November 5, 2009.3 Canada Revenue Agency, Interpretation Bulletin IT496R, “Non-Profit Organizations” (August 2, 2001).

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3. 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, 2009. 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).

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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 was5

(a) 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

(b) 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)

(c) no part of the income of which was payable to, or was otherwise availablefor the personal benefit of, any proprietor, member, or shareholder (emphasis added by the author)

(d) 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.7

5 Supra Note 1 at 149(1)(l).6 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.”

7 Tax Window File #2009-0329991C6, October 9, 2009.

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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. 8

1. 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 Symes10 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 Limited12 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-

8 Supra Note 2 at para. 6.9 Supra Note 1 at s.9(I).10 Symes v. Canada, 94 DTC 6001 (S.C.C.).11 Robert E. Beam, Stanley N. Laiken and James J. Barnette Introduction to Federal Taxation Canada, 29th Ed.12 Canderel Ltd. v. Canada, [1998] 1. S.C.R. 147.

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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. 14

2. 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

13 Supra Note 2.14 Tax Window File #2004-0092851E5, November 25, 2004.

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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 anassociation’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 membersthat 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

15 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.

16 Supra Note 3 at para. 9.

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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).17

3. 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 gift18 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.

17 See Tax Window File #2009-0348621E5, December 15, 2009.18 Canada Revenue Agency, Gifts and Income Tax 2010 (P113(E) Rev. 10 at page 5.

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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

19 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”.

20 Canada Revenue Agency, “GST/HST Information for Non-Profit Organizations” (RC4081), page 12.

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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 Club23 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.

21 Supra Note 20.22 Supra Note 3.23 M.N.R. v. Lakeview Club Ltd. (Ex Ct.), 52 DTC 1164, reversing (T.A.B.) 51 DTC 415. See Tax Window File

#2002-0153887, August 14, 2009.

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In the case of Moose Jaw24 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

24 Moose Jaw Industrialization Fund Committee v. M.N.R., (T.A.B.) (1951), 51 DTC 325. See Supra Note 23.25 Tax Window File #2009-0332161E5, August 14, 2009.

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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

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Registered Canadian amateur athletic associations may receive gifts from

(a) corporations that are thereby entitled to a deduction in computing taxable income under paragraph 110.1(a); or

(b) 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. 27

2. Exceptions

Going back to the first part of the definition, CRA in its IT49628 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 reasonable29 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 Gabco30 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.

27 Supra Note 3 at paras. 12 and 13.28 Supra Note 3 further confirmed by Tax Window File #2005-0142911E5, September 22, 2005.29 Supra Note 1 at s.67.30 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.)).

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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 Nielsen32, 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

31 Safety Boss Ltd., [2000] 3 C.T.C. 2497 (TCC); Technical News 22; Views doc 2004-0092931R3.32 Nielsen Development Co., (2009) 5 C.T.C. 2322 (TCC).33 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. 2474 (TCC).

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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. 36

34 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.”.

35 Tax Window File #2003-0036531E5, January 22, 2004.36 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.

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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 Log37 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

37 Gulf Log Salvage Cooperative Association v. Minister of National Revenue, [1960] 60 D.T.C. 239 (TAB).38 L.I.U.N.A. Local 527 Members’ Training Fund v. Minister of National Revenue, [1992] 2 C.T.C. 2410.39 Tax Window File #2007-0221381E5, February 20, 2007.

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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.40

40 Tax Window File #2003-0053761E5, May 25, 2004.

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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;42

41 Tax Window File # 2010-0366051E5, May 11, 2010.42 The Gull Bay Development Corporation v. Her Majesty The Queen, [1984] 84 D.T.C. 6040 (F.C.T.D.).

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(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 non-

profit objectives will disqualify the entity from paragraph 149(1)(l).48

43 Woodward’s Pension Funds v. The Queen, 62 D.T.C. 1002; Tourbec (1979) Inc. v. Minister of National Revenue, 88 D.T.C. 1442 (T.C.C.).

44 Supra Note 3 at para. 8.45 Supra Note 3 at para. 9.46 Tax Window File # 2004-0092851E5, November 25, 2009; 2007-0248041R3, January 23, 2008.47 Supra Note 17.48 Tax Window File #2010-0366051E5, May 11, 2010.

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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.”50

2. 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;

49 Tax Window File #2008-0268651E5, October 22, 2008.50 Tax Window File #2007-0224581E5, March 2, 2007.

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(ii) 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;

(iii) Whether an entity has a record of all assets, the asset profile

showing when and which of the assets will be replaced;

(iv) Whether the surplus is being invested in unrelated objects such as

long-term investments to produce property income;

(v) Whether the surplus is invested in expanded facilities and used for

normal commercial operations;

(vi) Whether funds are being used to loan to members, shareholders or

non-exempt persons;

(vii) 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;

(viii) 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. 51

51 Tax Window File #2001-0095285, November 21, 2001.

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In 2002 CRA explained further that:

The realization of a profit in a particular year is not necessarily indicative of for-profit motive, however, if a material part of the excess is accumulated each year and the balance of accumulated excess at any time is greater than the corporation’s reasonable needs to carry on its non-profit activities, profit will be considered to be one of the purposes for which the corporation is operated. This is particularly so where assets representing the accumulated excess are used for purposes unrelated to its objects such as the enlarging or expanding facilities used in normal commercial operations, making of loans to members, shareholders or non-exempt persons, or investing in long-germ assets for the purposes for which a corporation are operated are two-fold; to earn profits and carry out its non-profit purposes, it is our view that the test that the organization be operated exclusively for a purpose other than profit will not be met. 52 (Emphasis added)

In the same publication, CRA further clarified as follows:

It is situations where the organization devotes an unreasonable amount of its resources or energies to the investment activities, that would cause the organization to lose its tax exempt status under paragraph 149(1)(l). This is because the income generating activity would no longer be simply a means of funding the non-profit activities of the organization (i.e. a means to an end), but rather that the earning of income, in and of itself, has become one of the objectives of the organization.

In BBM, however the Court provided its view on how much weight can be placed on CRA’s administrative policies in the following words:

It has long been CRA’s view, published in Interpretation Bulletin IT496 “Non-Profit Organization”, that some things, such as the realization of significant profits or the accumulation of unreasonable reserves can be evidence of an unstated profit purpose. Other relevant considerations set out in the Bulletin are whether the entity’s activities are operated in a normal commercial manner, whether goods and services are sold to non-members, whether it is operated on a profit basis rather than a cost recovery basis and whether it is operated on a profit basis rather than cost recovery basis and whether it operates in competition with taxable entities carrying on the same trade or business. I agree that, in appropriate cases, these may be reasonable and relevant considerations, though they cannot all be requirements, they must be weighed appropriately in the circumstances of each case, and none will be determinative. However, in this case their consideration does not lead me to conclude BBM has an unstated profit purpose. 53 (Emphasis added)

52 Tax Window File #2002-0153887, August 19, 2002.53 Supra Note 15 at para. 46.

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F. Other Revenues are Not-for-Profit

There are some organizations which do not conduct commercial activity but receive their cash

flow through other activities such as conferences, seminars, gifts and sponsorship revenues. The

cash flow from these sources can be significant and which create current surpluses and

accumulated large balances which are then used in paying operating expenses of the entity as

well as for the replacement of equipment or purchase of building used primarily in the not-for-

profit activities. When CRA was asked if the surplus created from these activities jeopardized

the entity’s tax-exempt status, the CRA’s response was: “It should be noted that the relevant

provision of the Act is with respect to profit and not revenues.”54

This is consistent with the established definition of profit as discussed earlier in this paper. The

author maintains that as long as the entity meets the tax-exempt status, receipts from such

surpluses are not taxable.

In a 2007 ruling, CRA55 stated that a 149(1)(l) entity is not taxable on capital gains. Although an

entity cannot have profit as a motive, it can earn income. The particular circumstances of the

acquisition of a property as well as the use to which the organization puts the income will be

relevant.

In a 2009 ruling, CRA56 was asked by a society, which may or may not have filed income tax

returns in Canada, whether a gain on the disposition of real property by a paragraph 149(1)(l)

entity is taxable. CRA ruled that “A validly organized and operated paragraph 149(1)(l) entity is

generally not taxable on a capital gain.” However, “Corporations resident in Canada must file a

T2 for every taxation year.” CRA expanded its response as follows: “….and provided the

Society is organized and operated as a non-profit organization that satisfies the conditions in

paragraph 149(1)(l), the Society will not be subject to tax on the taxable gain from the sale of

real property that it owns and maintains in order to carry out its stated purposes.”

54 Tax Window File #2001-0095285, November 21, 2001.55 Tax Window File #2007-0224581E5, March 02, 2007.56 Tax Window File #2009-0347571E5, February 10, 2010.

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G. Setting-up an Organization

1. Different Forms of Organization and Issues Facing Incorporated Entities

A paragraph 149(1)(l) entity can be a proprietorship, partnership, society, or a corporation with

or without share capital. This paper focuses on the corporate structure, which is commonly

used57 as it offers protection against member’s liability, although a society in Alberta provides a

similar benefit. Pursuant to the advice many may have received, a paragraph 149(1)(l) entity

may have been incorporated under provincial corporate legislation with share capital. In the case

of a corporation with share capital, shares are issued to individuals or corporations to facilitate

the incorporation of an entity. Whether an individual who is issued shares is a shareholder for

tax purposes or not depends on the facts of the case. A shareholder is legally defined in the Act

to include “a member or other person entitled to receive payment of a dividend”.

In some cases the individuals who are issued shares volunteer their time to the organization for a

nominal salary, but beyond that they have no further interest in receiving any income. Shares are

often issued to volunteer workers just to set up a not-profit-entity to carry out the not-profit

objectives of the entity. The primary motive of paragraph 149(1)(l) entity and its volunteer

shareholders is to provide service at no charge or on a cost-recovery basis to the members of the

public and for the good of the community. Certain provincial legislation requires at least one

class of voting and one class of dividend paying shares be issued to at least one person in each

case so that the shareholder is able to elect directors, and the directors are then able to appoint

officers to manage the organization, and there is at least one class to receive dividends. As a

result, volunteer managers are also made officers and directors of an incorporated entity. These

volunteers hold their appointed positions for a set-term, after which they are replaced by newly

appointed volunteers.

Other entities operate as societies,58 and in a province where legislation provides for the

incorporation of an entity without share capital for not-for-profit purposes,59 some who wish to

avail themselves of the paragraph 149(1)(l) will wisely incorporate under such legislation.

57 The expression “club, society or association” is considered broad enough to include a corporation.58 In Alberta, for example, the Societies Act, R.S.A. 2000, c.S-14 permits registration of a society; there must be at

least 7 directors and their liability is limited.

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Paragraph 149(1)(l) entities that have been formed under provincial legislation used for

commercial enterprises, for example the Business Corporations Act (Alberta),60 and have issued

one or more shares trigger certain issues. The issued shares of a corporation must collectively

carry the right to vote, the right to receive dividends, and the right to participate in the

distribution of the corporation’s assets upon a winding-up or dissolution. The question that one

may ask is, does the shareholder having the right to receive dividends or the remaining property

upon a wind-up or dissolution create a problem for the entity’s tax-exempt status?

In a panic to rectify errors, some entities have reviewed their constating documents and informed

the author that their counsel is making sure that the articles of incorporation or the bylaws

provide that the incorporated entity provides for non-profit purposes, and that no dividend will

ever be paid or become payable to a member during the operation of the corporation. In one

case, counsel has even gone further to incorporate an amendment that on a wind-up of the

corporation, the retained pre-tax surplus of the corporation will be transferred to a paragraph

149(1)(l) entity or a charity, although no one holds the shares in trust for the charity. As will be

explained later, such a possibility exists without the charity or other entity owning shares in the

entity in question, but the process is different.

In the CRA communiqué,61 CRA writes “Several of the provinces have enacted legislation that

set out how an organization must be organized and operated if it wants to be considered…not-

for-profit for provincial purposes. ….While we cannot comment in detail on this legislation, we

note that it appears that the criteria contained in the provincial “not-for-profit” legislation and the

federal Canada Not-for-Profit Corporations Act are not the same as the criteria required to

qualify for the tax exemption provided by paragraph 149(1)(l) of the Act.”

CRA then argues that in particular both the Saskatchewan and Ontario statutes only require that

any profits or other accretions to the corporation be used in promoting the corporation’s objects

and activities. CRA’s concern in that case is that the organizations incorporated under these

statutes can operate with a profit purpose, as long as that profit is used by the organization to

59 In Alberta, Part IX of the Companies Act, R.S.A. 2000, c.C-21 permits incorporation of a not-profit entity with shares or without shares and holders are referred to as members. The legislation clearly excludes members from having any right to receive any benefit from the entity.

60 Business Corporations Act, R.S.A. 2000, c.B-9.61 Supra Note 2 at p. 6.

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support its objectives. There is a similar provision in the Canada Not-for Profit Corporations

Act62 and provides that “no part of a corporation’s profits or of its property or accretions to the

value of property may be distributed, directly or indirectly, to a member…except in further of its

activities…” CRA concludes that “in our view, any profit purpose prevents an organization from

being a 149(1)(l) entity. (Emphasis added) Consequently it is possible for an organization to

meet the requirements of federal or provincial “not-for-profit” legislation, but not qualify for the

tax exemption provided under paragraph 149(1)(l) of the Act.”

In Alberta as long as an entity is organized under Part IX of the Companies Act of Alberta, CRA

would have little difficulty accepting that shareholders have no right to any dividends presently

or on a winding-up. The author has learned that some lawyers are working on amending the

legal structure of existing entities formed under corporate legislation by keeping the corporation

under the corporate legislation but amending shareholders rights by limiting their right to receive

any dividends during the corporation’s existence or on a winding-up. Some have even

considered entering into a shareholders agreement to agree not to demand payment of any

dividends during the corporation’s existence even on transfer of shares. The author has also

come across situations where some entities have proceeded to dilute the value of shares of all

shareholders except for one by issuing to that shareholder a larger number of shares. Although

the entity may be organized and operating as a tax-exempt entity and thus not a taxable

corporation, the author cannot with certainty say if the dilution of a member’s interest will

trigger a deemed disposition of the disposing member’s interest at fair market value. In

particular, the action being taken suggests that there is concern with the constating documents. If

the transferring member has a right to receive dividends the entity may be challenged by the

Compliance Branch as a result of being in breach of the provisions of paragraph 149(1)(l). If

CRA is successful, on dilution the transfer of interest may potentially give rise to tax

consequences.

62 S.C. 2009, c.23 c-7.75

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2. Perspective on Corporate Structure

A prospective entity requested CRA’s comments on a proposed transaction.63 The essence of the

question was, “Will a corporation that is being incorporated under provincial non-profit

legislation be tax-exempt under paragraph 149(1)(l) of the ITA?”A portion of CRA’s response

is as follows: “Whether an entity qualifies for the tax exemption can only be determined once

the entity is established, has been operating and has filed a tax return.” The CRA was unable to

provide a ruling but made general comments. Some of these comments are worth noting, which

the author has briefly summarized below:

The term “non-profit organization” does not have a specific meaning for federal

income tax purposes; the Act does not define or use the term “non-profit

organization”.

An organization can be incorporated by a federal or provincial statute that uses

the term “non-profit organization” (or something similar), but still not qualify for

the tax exemption.

The tax exemption only applies if all the required conditions of paragraph

149(1)(l) are met, no matter how the organization is otherwise described or how it

is set up.

The tax exemption available under paragraph 149(1)(l) is not determined by the

nature of an organization’s objectives. Because paragraph 149(1)(l) can apply to

any organization, even those organized primarily for business purposes, its

components must be strictly adhered.

Those entities that have been compliant with paragraph 149(1)(l), except for the concern that

CRA might challenge the reasonableness of payment of salaries to working members, are not

panicking to rectify deficiencies in their respective incorporating documentation to satisfy

CRA’s changed guidelines.

63 Tax Window File #2010-0366051E5, May 11, 2010, and refer to Supra Note 1 at ss. 149(5).

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In Begin64 a partnership was formed to sell beer and the partnership agreement provided that all

the profits from the sale of the beer would be distributed for purposes of social welfare, charity,

education and civic improvement. The partnership agreement also provided that if the

partnership agreement were dissolved, all of the remaining assets would be distributed for

charitable purposes. The court held that the partnership was operated as a non-profit

organization.

In Tourbec,65 the court gave the sense that choosing to incorporate under the proper legislation

by itself will not make an entity fully compliant:

The fact that the appellant was incorporated under Part III of the Companies Act, that is, under the provisions governing the incorporation of non-profit companies, is not the criterion that establishes whether it is in fact a non-profit organization within the meaning of paragraph 149(1)(l).

In Sutton,66 the Supreme Court of Canada stated, at page 1161, that:

The question to be decided is not as to what business or trade the company might have carried on under its memorandum, but rather what was in truth the business it did engage in. To determine this, it is necessary to examine the facts with care.”

Despite the fact that incorporating form and substance may not fully establish the compliant

status, in the author’s view, the importance of a corporation’s constating documents cannot be

understated. As to whether a particular entity is eligible for tax exempt status under paragraph

149(1)(l) is a question of fact. CRA states that it must be established that the entity is organized

and operated exclusively for non-profit purposes.67 When determining the purpose for which the

entity was organized, the instruments creating the entity will normally be reviewed. CRA

emphasises that a determination of whether an association was operated exclusively for, and in

accordance with its non-profit purpose in a particular year must be based on the facts of each

case, which can be obtained only by reviewing all of its activities for that year.

64 M.N.R. v. Begin, (Ex. Ct.) (1962), 62 DTC 1099, affirming (T.A.B.) 60 DTC 257 as quoted in Supra Note 52.65 Tourbec (1979) Inc. v. M.N.R. (1988), 88 DTC 1442 as quoted in Supra Note 52.66 Sutton Lumber and Trading Co. Ltd. v. M.N.R. (1953), 53 DTC 1158 as quoted in Supra Note 52.67 Tax Window File #2003-0042541E5, February 13, 2004.

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CRA states that to establish the purpose for which a corporation is organized:

…the CRA will normally look to the instruments by which it was created, e.g. letters patent, by-laws, memorandum of agreement, or articles of incorporation. Accordingly, in our view, the articles, the articles or by-laws of the Corporation should specifically prevent the distribution of income during the year, either directly or indirectly, to or for the personal benefit of any director or shareholder. Furthermore, the corporation should be specifically prevented from having the power, at any time in future years, to declare and pay dividends out of income and the possibility of dissolution, winding-up or amalgamation should also be dealt with. 68

H. Impact of Change in Policy

The author believes a large number of entities are affected by CRA’s new literal interpretation of

the term “profit”. The Supreme Court of Canada said in Canderel that GAAP principles must be

applied on a case by case basis in the context of the enterprise. CRA’s position is that “profit”

should be given its ordinary commercial meaning, which does not include deductions for

amounts related to capital expenditures. CRA wants to use the “matching” principle where only

those expenses that relate to income are deducted. Capital expenditures have a longer life and

for which only the depreciation can be provided and deducted from income. If an entity is not

allowed by the new policy to generate a surplus to invest in capital assets that is required, not for

investment purposes, but for the use in the day-to-day not-for-profit activities of an entity, that

would indirectly and gradually compel an entity to shut down its operations. This CRA policy

has the capacity to eliminate paragraph 149(1)(l) entities, most of whom do good humanitarian

work.

CRA also requires that entities generate no surplus at all except for incidental and unanticipated

profit and that only can result after a sound financial budget is prepared.

The CRA national audit project may focus on these issues and may find a large number of

entities have reported profit before provision for capital expenditure and accumulated surplus or

reserve earmarked for specific capital projects. If they are reassessed and asked to pay taxes, the

entities will be deprived of the funds they have to carry out their pre-planned activities.

68 Tax Window File #2001-0095285, November 21, 2001.

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In the new policy CRA has not mentioned the fact that the previous policy allowed the surplus to

be accumulated from profit for capital projects without any risk of adverse determination. CRA

is silent on clarifying whether it will grandfather existing situations and only look at applying the

new policy effective the date it became public.

Entities must now look for new sources of funding but they all have their inherent challenges.

For example, the entities may seek donors who may be prepared to donate gifts in cash or in

kind. Gifts received by a 149(1)(l) entity is not taxable on receipt to the entity. Sponsorship

funding received, less related expenses may not be taxable to the entity as long as it meets the

149(1)(l) conditions. Nor is there any GST payable on it as it is not taxable supply.69 Even these

cash receipts may produce surplus for future replacement of assets. In the case of sponsorship

receipts, the receipts may be taxable except for the tax exemption. Will a surplus created by gift

and sponsorship receipts, pending investment in capital replacement assets, raise similar

concerns with respect to the determination of whether or not the motive for profit exists based on

the new policy?

I. Precautionary Measures Before CRA Audit

It is time that an entity that has claimed tax exempt status under paragraph 149(1)(l) prepare for a

potential CRA audit. The audit may examine all the organizational aspects as well as the

operational aspects. CRA, in its published guidelines, indicated many times that the

determination of whether an entity is meeting all the conditions of the provisions of paragraph

149(1)(l) will depend on the facts of the case. In BBM, the court was very emphatic that IT

Bulletins are not law but they may be relevant and reasonable considerations and therefore must

be weighed appropriately. In view of this, the author suggests the following precautionary

measures generically and readers should evaluate suggestions based on their individual

circumstances. The purpose behind the preparation is to make one as audit-proof as possible and

soften any of CRA’s adverse treatment of an entity that has allowed itself to go offside.

69 Foreign Convention and Tour Incentive Program, February 2008, G1-027 CRA states “Sponsor means the person who convenes and sells admissions to the convention ….Persons that support and event through sponsorship opportunities are not sponsors for GST/HST purposes.”

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1. Review Corporation’s Enabling Documents

The first step is to review the enabling documents for the organization of an entity. Review not

only the not-for-profit objects but also the corporation’s bylaws to ensure that they are not

contrary to paragraph 149(1)(l) and the CRA policies. If it is a corporation with share capital

ensure that the capital structure, constating documents and its stated objects are consistent with

both the provisions of the Act and CRA policies. Although other experts may argue that CRA’s

policies are not consistent with the case law, a challenge or legal fight of this magnitude would

be beyond the scope of a small to medium sized not-for-profit entity. If CRA adopts its strictest

interpretation, the enabling documents could pose an immediate problem for an entity and could

take away any tax benefit the entity may have. Ensure that the corporate structure has the

following characteristics:

(a) If the entity is incorporated under a corporate statute, amend the current

bylaws and if necessary enter into a unanimous shareholder agreement in

which directors agree that they will not authorize payment, and the

shareholders agree not to receive, demand, or expect to collect dividends

from the incorporated entity or to participate in the assets, property or

profits on a winding-up, and to authorize directors to transfer all of the

assets of the entity to another 149(1)(l) entity or a charity with similar

objects on a winding-up, thus eliminating any argument from CRA that

directors had the power to pay or shareholders had the right to receive and

may be paid dividends, or remain entitled to participate in the

corporation’s assets upon a winding-up. If done by way of unanimous

shareholder agreement, the agreement should address any and all

retroactive rights from the incorporation date. CRA has indicated that

such an amendment should avoid the deeming of the corporation not to be

tax-exempt from the commencement, of course, subject to Compliance

Branch adopting such a policy;

(b) Amend the current memorandum of objects or enabling documents to

include a specific provision that establishes that it is not a charity. The

Minister will not provide a ruling that a paragraph 149(1)(l) entity is not a

charity. Ensure that the entity does not have charitable objects.

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Alternatively, include an object that is not a charitable purpose such as

that the entity can enter into political activities; and

(c) If the entity has not yet been incorporated, consider incorporating a

149(1)(l) entity as a non-share capital corporation under the applicable

provincial legislation if it is only a regional operation. This would largely

eliminate any question of shareholders having a potential to receive

dividends.

2. Comply With All Tax Filing Requirements70

The next step in the process is to ensure that the entity has complied with all the filing

requirements. If the filing is deficient, that certainly would invite an audit, which would then

follow up with a more detailed examination of the entity’s operation. An incorporated entity is

required to file a T2 Corporate Tax Return or a T2 Short Return for Eligible Corporation within

6 months from the date of the corporation’s taxation year. 71

An entity, whether incorporated or unincorporated,72 whose main purpose is to provide dining,

recreational or sporting facilities for its members and where the deemed trust has tax payable

with respect to property income, or the trust has disposed or realized a taxable capital gain on the

disposition of any capital property that is not used directly in the course of providing dining,

recreational or sporting facilities to its members, a T3 Trust Income Tax and Information Return

must be filed within 90 days from the end of the deemed trust’s taxation year.73

70 Tax Window File #2010-0362851E5, April 26, 2010.71 Paragraph 150(10(a) of the Income Tax Act, R.S.C. 1985, c.1 (5th Supp.). In Supra Note 56, CRA emphasizes

that an entity as described under paragraph 149(1)(l) of the Act must comply with certain filing requirements under the Act. As also stated in para. 15 of Supra Note 3, a T2, Corporation Income Tax Return, is required pursuant to paragraph 150(1)(a) of the Act, to be filed for every taxation year if the entity is a corporation resident in Canada. Arthur B.C. Drache and Robert B. Hayhoe and David P. Stevens in Charities Taxation –Policy and Practice, in Chapter 16 write: “For example, the Part 1.3 large corporation is not applicable to corporations exempt under section 149 by virtue of paragraph 181.1(3)(c). Similarly, subsection 212(14) provides an exemption from Part XIII withholding tax which would otherwise be imposed on a non-profit organization earning income from Canada as does paragraph 219(2)(c) from the Part XIV tax on non-resident corporations, while subsection 227(14) provides exemption from tax pursuant to Parts IV, IV.1, VI, and VI.1. See para. 2 of Supra Note 3. Paragraph 57(1)(b) of the Corporations Tax Act, R.S.O. 1990.c.C.40 exempts from Ontario corporate income tax. Alberta Corporate Tax Act, R.S.A. 2000, c.A-15, s.35.

72 Subsection 149(5) generally overrides 149(1)(l) because the section deems an inter vivos trust to have been created for the entity’s property income purposes.

73 Supra Note 1, as required by para. 150(1)(c).

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In addition to the above (if applicable), a 149(1)(l) entity, whether incorporated or not must also

file Form 1044 – Non-Profit Organization (NPO) Information Return74 within 6 months after the

end of the entity’s fiscal period.75

An entity that is tax-exempt under paragraph 149(1)(l) and that is also a “registered Canadian

amateur athletic association” does not have to file a Form T1044, Non-Profit Organization

(NPO) Information Return described above. Such an association is to file Form T205276,

Registered Canadian Amateur Athletic Association Return of Information within 6 months of the

end of the association’s fiscal period.

A 149(1)(l) entity that is unincorporated, and therefore is not required to file a T2 Corporate Tax

Return and that does not meet any of the conditions outlined above may not be required to file

any forms for a particular taxation year.

The entity must also file all GST returns as required on a regular basis. Failure to file returns on

time may trigger audit of the entity.

3. Consider Moving Assets to Another Entity Without Share Capital

A 149(1)(l) entity incorporated under a provincial legislation which is generally intended to be

used by for-profit entities may potentially present a problem. A shareholder with growth shares

has entitlement to income and capital of the incorporated entity. CRA is likely to take the

position that shareholders of the entity have the potential to receive dividends and therefore the

entity is not eligible for the tax exemption. To minimize the impact, the author suggests

reincorporating under other provincial legislation that permits not-for-profit entities to register

with or without share capital, and with members having no rights to any dividends or to

participate on a winding-up. The author also suggests making a provision that on a wind-up of

the entity, all of the assets and liabilities of the entity will be transferred to a charity or a

74 Where (i) the total of all amounts received or receivable by the entity in the fiscal period for taxable dividends, interest, rentals, or royalties is more than $10,000; (ii) the total assets of the entity (determined in accordance with generally accepted accounting principles) at the end of its immediately preceding fiscal period exceeded $200,000; (iii) the entity had to file an NPO information return for a preceding fiscal period.

75 For more information, see the Canada Revenue Agency “Income Tax Guide to the Non-Profit Organization (NPO) Information Return” T4117.

76 Subsection 216(1) of the Canada Revenue Agency Income Tax Regulations C.R.C. c.945 requires such an association to file Form T2052.

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149(1)(l) entity with similar objects. Alternatively, the shareholders or members would transfer

their shares to a charity or another 149(1)(l) entity for proceeds of disposition equal to $Nil.

A third alternative would be for the existing entity to amalgamate with another entity, the

constating documents of which address the foregoing issues. This approach is elaborated upon

in the next section.

4. Next Step – Consider Amalgamation

After a new corporation has been formed, the NPO1 and NPO2 will amalgamate with a view to

eliminating shareholder’s right to dividends and distribution on a winding-up and without

making any distributions to shareholders in the process thereof. In a 2006 ruling, CRA approved

an amalgamation without any tax consequences.77 It was based on a specific set of

circumstances, however, the principles used in that ruling can be used, in the author’s view, in

other similar circumstances. These principles and circumstances included, among others:

NPO1 and NPO2 shared many of the same members;

NPO1 and NPO2 operated according to non-profit objectives;

Both become merged into one organization by way of amalgamation; section 87 which

CRA states is not applicable to these tax-exempt entities as they are not taxable

corporations;

The rights attaching to a member’s interest in Amalco was substantially the same as his

or her interest in NPO1 or NPO2; from the perspective of 149(1)(l) removing dividend

rights and rights to participate upon a wind-up did not change the interest of the

shareholder(s);

All of the property of NPO1 and NPO2 became the property of Amalco;

No member of either NPO1 or NPO2 received any amount or property from either NPO1

or NPO2 on the amalgamation of NPO1 and NPO2;

77 Tax Window File #2005-0142471R3, July 16, 2006.

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The amalgamation did not result in a disposition, by either NPO1 or NPO2 of any of its

assets or an acquisition by Amalco of any of the assets of NPO1 or NPO2 for purposes of

the Act;

None of the members of the NPO1 and NPO2 were considered to have received a gain on

the disposition of his or her membership in NPO1 or NPO2 or to have received a benefit

pursuant to subsections 15(1)78, 56(2)79 or 246(1)80 or Part XIII81 of the Act as a result of

becoming members of Amalco.

5. Distribute Capital Gains to Shareholders

It might be possible to declare stock dividends by capitalizing earnings and the redeeming the

share capital to create capital gains in the hands of recipient shareholder. CRA’s view is that

receipt by a shareholder of capital gains will not in and by itself disqualify an entity from tax

exemption. In other words, the capital gains in the hands of the 149(1)(l) entity is not taxable to

the corporation and if the retained earnings are paid out in the form of proceeds of disposition of

shares on a winding-up of the entity, the shareholder will pay tax on that amount but will not

jeopardize the tax-exempt status of the entity.

6. Transfer of Shares Among Shareholders

When a 149(1)(l) entity meets the organizational and operational tests, transfers from old

shareholders on record to future shareholders on record for no proceeds should not attract any tax

consequences as the entity is not a taxable corporation. The author’s view is that section 69

78 Applies to appropriation of corporate property including money by a shareholder. Benefit must have been conferred.

79 The provision provides: “A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a taxpayer to some other person for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person….shall be included in computing the taxpayer’s income to the extent that it would be if the payment or transfer had been made to the taxpayer.”

80 The provision provides: “Where at any time a person confers a benefit, either directly or indirectly, by any means whatever, on a taxpayer, the amount of the benefit shall, to the extent that it is not otherwise included in the taxpayer’s income or taxable income earned in Canada under Part I and would be included in the taxpayer’s income if the amount of the benefit were a payment made directly by the person to the taxpayer and if the taxpayer were resident in Canada, be (a) included in computing the taxpayer’s income or taxable income earned in Canada under Part I for the taxation year that includes that time; or (b) where the taxpayer is a non-resident person, deemed for the purposes of Part XIII to be a payment made at that time to the taxpayer in respect of the property, services or otherwise, depending on the nature of the benefit.”

81 Part XIII levies tax on non-resident’s income earned in or from Canada.

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would not apply, and even if it were to apply the proceeds of disposition would equal the

adjusted cost base resulting in no gain to the transferor. This would be a concern when volunteer

officers leave and the new officers take over the operation of the entity. Even where there is a

challenge, CRA will need to establish that the individual holding shares is a “shareholder” as

defined in the Act and that the shares held by him or her has an underlying value in form of the

corporation’s equity. However, if the bylaws prevent a shareholder from receiving any

dividends now or participating in a winding-up, one could argue that the individual is not a

shareholder as he or she has no entitlement to dividends or the property of the corporation. In any

event, this concern could be avoided if a corporation is established with no share capital and with

members having no right to receive dividends or the remaining property of the corporation on a

winding-up or dissolution.

7. Prepare Justification for Maintaining a Reasonable Reserve

CRA is certainly concerned about the level of reserve and the length of time it is held by an

entity. The entity must develop a justification schedule to show when the new equipment to

replace the existing old and used equipment will be purchased. It should also contain details of

how much money is planned to be set aside each year such that there will be an adequate amount

of capital to purchase replacement equipment. In the author’s view if CRA can be convinced

that holding a reserve in the present amount is necessary to maintain the integrity of the service

of the organization to meet its not-for-profit objectives and subsequent evidence can be shown

the amount was spent for the purpose for which it was set aside, very little, if any challenge can

be expected from CRA. CRA is not likely to raise concerns about the receipt of interest income.

The important consideration for CRA is whether the excess cash is held for the purpose of

earning income on a continuing basis.

8. Maintain Good Record of Gifts and Sponsorship Receipts

In the author’s view it is a good practice to require every donor to sign a Deed of Gift which

includes the essential ingredients of a gift. That way there is no misunderstanding and both the

donor and donee have a clear understanding that the cash or property being transferred is a gift

and the 149(1)(l) entity is not able to issue tax deductible receipts as it is not a charity. If any

benefit is being transferred to the donor, the entity should measure the value of the benefit and

deduct that amount from the gift and only provide a receipt for the balance. The entity will

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report the amount that is a gift as other revenue and the balance also as revenue but maintaining a

record of the two separate amounts would be useful for audit purposes.

If the donation is made by way of sponsorship payment, this presents a more complex problem.

The author recommends that a proper agreement be drawn specifying clearly what advantage the

donor has received. It is typical for a not-for-profit entity to provide promotional services to a

sponsor, or may allow the sponsor the right to use its logo, trade name, or any similar intellectual

property. CRA does not consider this to be a taxable supply and therefore GST may not apply.

In terms of reporting, the entity will need to report the sponsorship as other revenue for tax

purposes. A gift, on the other hand is also other revenue but it need not be reported as such for

tax purposes but simply added to the contributed surplus or retained earnings or otherwise as the

accounting standard (GAAP) dictates.

9. Transfer Profit-Making Activity to a Separate Corporation

Some have suggested that an entity with a division that runs commercial activity generating

profit should form a separate entity and move its commercial operations into the new entity and

that the new entity report income for tax purposes and pay the applicable taxes. At the same

time the existing paragraph 149(1)(l) entity would continue on with its non-profit activities, thus

safeguarding from CRA’s adverse treatment of the overall operation of the entity. CRA has in

2002 confirmed that:

Where an organization that otherwise qualifies as a non-profit organization proposes to engage in an unrelated profit making enterprise, it is our view that, if the organization were to carry out this unrelated activity in a taxable, wholly-owned corporation and this corporation were to pay dividends out of its after-tax profits to the organization to enable the organization to carry out its non-profit activities, the organization may qualify as a non-profit organization as set out in paragraph 149(1)(l) of the act.82

This action however may have other potential tax implications. If in the first place the entity is

unlikely to qualify as a 149(1)(l) entity, therefore not tax-exempt, would for all practical

purposes be a taxable corporation. Any transfer of assets would potentially be effected on a fair

market value basis. This may result in tax consequences assuming the fair market value is

82 Tax Window File #2002-0153887, August 19, 2002.

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greater than the adjusted cost based or the unamortized cost of depreciable capital assets. The

other alternative that many might consider is to complete the butterfly transfer to a sister

company with the same shareholders. However, that might also be denied, perhaps, because one

would be a 149(1)(l) entity and the other would be taxable corporation. The butterfly may not be

available to a tax-exempt corporation.

10. Prepare Justification for a Reasonable Salary

CRA is aware that many organizations pay unreasonably large salaries to key members of

management which CRA might find offensive. An entity may be able to justify its

reasonableness based on entrepreneurial expertise management provides, and should be prepared

to do so. Where, however, CRA deems it to be unreasonable, it certainly has the potential to

determine that the entity has breached the provision of Section 67 and paragraph 149(1)(l) of the

Act.

In order to avoid such consequences, ensure that the basis for reasonableness is established by

means of hours worked, reasonable rate, level of expertise required for the job, and the market

salary for the employee’s work in a similar capacity. Keep a good record of each of these items

on an annual basis.

11. Consider Registering 149(1)(l) Entity as a Charity

The author has often considered the possibility of converting a paragraph 149(1)(l) entity into a

registered charity by amending its objects or purposes and making them charitable. If the object

is to provide service on a cost recovery basis and to rely on donor funds for support in paying for

repairs and replacement of capital assets, a charity structure attracts less CRA hassles. However,

a charity is expected to comply with other requirements. CRA has published model objects

which can be easily copied and used. A charity is also able to issue donation tax receipts to

donors. Donors are more inclined to donate to a charity than to a paragraph 149(1)(l) entity. A

further discussion on the topic is beyond the scope of this paper.

J. Appeal to the Minister of National Revenue

The author has reviewed most of the CRA Technical Interpretations from prior years including

the well enunciated and followed policy in IT496R. CRA, which administers this policy has led

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the public to believe that if they followed all CRA pronouncements, their operation, when

reviewed on an annual basis, would be accepted as being consistent with the policies. In other

words CRA would adhere to the principle of estoppel. The recent change in the policy is going

to create insurmountable challenges for paragraph 149(1)(l) entity operators. No change in

policy should have retroactive effect and no change in policy should be allowed to stand if it is

contrary to what the public was led to believe at their peril. This would be unfair and misleading

and not befitting the CRA’s profile in the public.

In various CRA Technical Interpretations that the author has made reference to, CRA has clearly

said that a paragraph 149(1)(l) entity would be allowed to accumulate a reserve as long as the

reserve was for the purpose of covering future operating expenses or the replacement of assets.

It was understood that the reserve can only accumulate from profit or surplus arising from the

activities of an entity. At no time in the past has CRA suggested that the surplus should come

from other sources but not from day-to-day activities of a non-profit entity. It was therefore fair

for the public to assume that having a surplus earmarked for replacement of assets used in the

not-for-profit activities was acceptable. As a consequence thereof, a vast number of entities have

accumulated reserves, which they are on an ongoing basis using to replenish their worn out

equipment, buildings, furniture and the like. Because the flow of cash for a not-for-profit entity

is uncertain, the entity may be compelled to accumulate reserves on a fluctuating basis.

The author appeals to the Minister for a clear statement as to whether entities with existing

surplus are going to be targeted for an audit and how harshly they are going to be treated. The

Minister knows that small entities are not able to fight in court because of costs and punishing

such entities would be devastating for the sector and which can only be accomplished at the

expense of the community.

Second, CRA has now proposed to apply commercial meaning to the term “profit” and in the

process deny the deduction for reserves set aside for replacement of assets or permit any

unintentional surplus to occur, for the purpose of the determination of whether an entity qualifies

for tax-exemption. This would be counter-productive and may render certain entities bankrupt or

their existence unnecessary. An entity needs fixed assets to operate and a reasonable reserve to

pay for them. An entity also has certain overheads and it needs cash flow to pay for them. Tax-

Exempt status would have no purpose if the entity cannot produce cash flow to meet its

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objectives. The Minister knows that it would be extremely difficult to raise funds exclusively

from gifts and sponsorships. There is a need to relax the interpretation for certain levels of

entities.

Third, the industry needs clarification on the taxation of gifts and sponsorship funds an entity

collects while it is a paragraph 149(1)(l) entity and on its ceasing to be such an entity.

Fourth, the industry needs a clear statement on errors made in incorporating by a number of

entities. To punish them for errors made by their advisors for lack of understanding of what

CRA’s expectations were, would be unfairly penalizing owners of entities, who set out to carry

out their purposes with good intentions. The Minister needs to give assurance to the sector that

errors made in the incorporation or setting up of an entity will not be punished and provide clear

direction to the operators as to the legislation under which if formed would be acceptable,

conditions or clauses which if incorporated (similar to model objects for charities on CRA’s

website), would be acceptable. The Minister should allow reasonable time for the sector to make

these changes so that the question of benefiting shareholders or members may be removed

permanently from their concerns.

K. Conclusion

Members of the public have organized and operated paragraph 149(1)(l) entities relying only on

IT496 and its revised version IT496R. Professionals who were able to access or took extra effort

to review available technical releases were able to review clarifications as and when they were

made available. Late in 2009, CRA published its response to a taxpayer inquiry which expressed

a view that was in sharp contrast to its previously published policy. The provision of the Act has

remained unchanged but the interpretation took a shift. The policies regarding making profit,

surplus and the use of profit for not-for-profit activities was changed. IT496 remains unchanged

and no grandfathering provisions have been announced offering relief to existing entities. CRA

shows no fairness to existing operations although its policies remain at odds with the

jurisprudence.

CRA’s shift in the policy and the fear that it may have devastating consequences led the CRA

Charities and Not-for-Profit Section to make this a topic for presentation at the Symposium. It is

a concern that even those who operate for the non-profit purposes and not to avoid tax will be

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caught in CRA’s trap. In BBM, the Court said, “I agree that, in appropriate cases, these may be

reasonable and relevant considerations, though they cannot all be requirements, they must be

weighed appropriately in the circumstances of each case, and none will be determinative.”

The CRA communiqué dated November 5, 2009 raises many concerns. CRA has previously

stated that the entities can create reserves from profits for expenses as well as for the replacement

of assets. Now CRA says the concept of profit is to be interpreted in accordance with its

commercial definition. CRA says that profit means revenue less expenses and no deduction for

any capital expenditure other than the amortization provision should be allowed. Drache, et. al.83

is concerned that although CRA “has not been successful in raising assessments against non-

profit organizations on the basis of asset accumulation, it is unfortunate that the courts have paid

lip service to this position of CRA in IT496R and predecessor IT496”. Drache, et. al. states that

“It is our view (contrary to CRA position) that a non-profit organization should be able to

accumulate assets for its non-profit purposes without any adverse inference being drawn.”84

In relation to the other part of the definition, CRA has not yet given a clear understanding of

what type of structure and bylaws and objects would be acceptable. It has not made any effort to

provide model enabling documentation with model objects and purposes similar to what it has

done for charities. Various rulings provide some indication of what CRA might like to see in

enabling documentation to establish that the shareholders or members will not be paid dividends

or directors would not have powers to pay dividends. CRA has so far not clearly provided

guidance although it is a pivotal part of the definition. The Courts although, have said that

incorporating documentation by itself may not provide information needed to establish whether

the entity meets the conditions of paragraph 149(1)(l).

The 149(1)(l) operators fear if CRA, as is rumoured, aggressively pursue audit of the members of

the industry and raise unfavourable reassessments, they have no doubt that CRA will put most of

the small to medium size operations out of business. The author predicts that unless the Minister

steps in promptly to clarify the confusion that it has created in the industry, in future, prospective

organizations would be discouraged from entering the field, at the expense of the community.

There are thousands of small to medium size operators in this field and to punish them all,

83 Supra Note 71 at p. 13.84 Supra Note 71 at Chapter 16.5.1.

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including those who rely on volunteers and workers who work for low salaries, would be unfair.

The author is not suggesting or questioning the need for an audit. All that the author is stating is

that if there are a handful of large entities that are abusing the tax-exempt privilege, there is no

need to scare others and confuse all other industry members. Such action would be counter-

productive. The industry hopes CRA would reconsider its position.

Whether an entity has been scheduled for an audit or not or whether a particular entity is picked

up for an audit, all entities need to review their enabling documentation, their compliance status,

the reserve status and to reconsider their future strategy on how they plan to run their operations,

how they plan to raise additional funding from other sources, or how they are going to account

for it. It is time to seek professional help and bring sophistication to their accounting methods,

record keeping, reporting forms and to have information ready for CRA when called upon to

produce.

Appendix 1: Tax Window File #2009-0337311E5, November 5, 2009.

Source:CCH Tax/Federal Income Tax/Tax Window Files/Tax Window Files/2000s/2009/November/[2009-0337311E5]

November 05, 2009

Window On Canadian Tax Commentary

Document number: 2009-0337311E5

Income Tax Act: 149(1)(l)

Please note that the following document, although believed to be correctat the time of issue, may not represent the current position of the CRA.Prenez note que ce document, bien qu'exact au moment émis,peut ne pas représenter la position actuelle de l'ARC.

PRINCIPAL ISSUES: (i) Can a 149(1)(l) organization earn a profit? (ii)If the profit is intentional but used to fund the activities of theorganization will the organization qualify for the 149(1)(l) exemptionfrom tax? (iii) Can a 149(1)(l) organization engage in commercialactivities? (iv) Does the CRA maintain a list of organizations thatqualify for the exemption provided by 149(1)(l)?POSITION: (i) Yes, but only if incidental and generally unanticipated.(ii) No (iii) Yes (iv) NoREASONS: (i) To qualify for the exemption an organization cannot beorganized or operated with a purpose of earning a profit. (ii) It doesnot matter what the profit is used for, a 149(1)(l) organization cannothave any profit earning purpose. (iii) Paragraph 149(1)(l) does notrestrict an organization to any particular activities, other thanrequiring activities not to be undertaken for profit. (iv) The CRA doesnot maintain a list of 149(1)(l) organizations as these organizations arenot required to register with CRA.

XXXXXXXXXX 2009-033731L. Zannese(613) 957-2747

November 5, 2009

Dear XXXXXXXXXX :

Re: Tax Exemption-149(1)(l)

We are writing in response to your emails of August 18 and September 17,2009, in which you asked for our views regarding the tax exemptionprovided by paragraph 149(1)(l) of the Income Tax Act (the "Act") . Wealso acknowledge our telephone conversations regarding this issue(Erskine/XXXXXXXXXX ).

Specifically, you have asked the following questions:

(i) Can an organization that qualifies for an exemption from tax underparagraph 149(1)(l) of the Act compete against taxable entities?

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(ii) Can an organization earn a profit and continue to be exempt fromtax under paragraph 149(1)(l) of the Act? Can an organizationintentionally earn a profit, and still be exempt from tax under149(1)(l), as long as that profit is used solely for the purpose ofsupporting its objectives?

(iii) Is it possible for an organization to incorporate under Part IIIof the Ontario Corporations Act, but not qualify for the exemption fromtax provided under paragraph 149(1)(l) of the Act?

(iv) Does the Canada Revenue Agency ("CRA") maintain a list oforganizations that qualify as non-profit organizations for purposes ofprovincial legislation, but do not qualify for the tax exemption providedunder paragraph 149(1)(l) of the Act?

(v) The recent Tax Court of Canada decision, BBM Canada v. The Queen,2008 DTC 4129 ("BBM") concluded that an entity describedin paragraph 149(1)(l) of the Act may conduct commercial activity butmust conduct this activity at cost. If the XXXXXXXXXX provided acommercial procurement contract to an organization, and the organizationgenerated a profit from this activity, would the organization be able toqualify for the tax exemption provided under paragraph 149(1)(l) of theAct?

If the above questions relate to a specific taxpayer and either acompleted transaction or an ongoing situation, you should submit allrelevant facts and documentation to the appropriate Tax Services Office("TSO") for their views. A list of TSOs is available on the "Contact Us"page of the CRA website, www.cra-arc.gc.ca. Although we cannot commenton any specific situation, we are prepared to provide the followinggeneral comments, which may be of assistance.

Our Comments

(i) Paragraph 149(1)(l) of the Act.

Paragraph 149(1)(l) of the Act provides an exemption from tax for theincome of organizations that meet all of the conditions set out in thatprovision. Among other criteria, the organization is required to beorganized and operated for "any other purpose except profit";consequently, it is common to refer to organizations qualifying for thistax exemption as "non-profit organizations". However, the term"non-profit organization" does not have a specific meaning for income taxpurposes-the Act does not define or use the term "non-profitorganization". For purposes of this letter we will refer to anorganization that qualifies for the tax exemption provided by paragraph149(1)(l) as a "149(1)(l) entity".

Paragraph 149(1)(l) of the Act provides an exemption from income tax forthe income of

"...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) andthat was organized and operated exclusively for social welfare, civicimprovement, pleasure or recreation or for any other purpose exceptprofit, no part of the income of which was payable to, or was otherwiseavailable for the personal benefit of, any proprietor, member orshareholder thereof unless the proprietor, member or shareholder was aclub, society or association the primary purpose and function of whichwas the promotion of amateur athletics in Canada;"

Very generally, then, in order for an organization to be a 149(1)(l)entity, the organization must not be a charity, must be organized andoperated for a purpose other than profit, and its income cannot bepayable to or made available for the benefit of its members.

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You have asked whether an organization can compete against taxableentities and still qualify for the exemption provided by paragraph149(1)(l) of the Act. The wording of paragraph 149(1)(l) does notrestrict an organization from undertaking any particular type ofactivity, including commercial activity. This issue was most recentlyreviewed by the courts in BBM, 1 in which the Tax Court of Canadacommented:

"While these are very strict and rigid requirements, and potentiallypermit a very broad review or inquiry into an organization's purposes,the analysis can be considerably abbreviated by the fact that thestatutory language does not mandate a qualifying purpose but permits theorganization to have any purpose or purposes other than the onedisqualifying purpose of profit."

Consequently, an organization can compete against taxable entities andstill be exempt from tax under paragraph 149(1)(l) of the Act.

(ii) 149(1)(l) Entity-Earning, Retaining and Using a Profit

You have asked whether a 149(1)(l) entity can earn a profit, and whetherthe answer to this question depends on how the entity uses this profit.Specifically, you would like to know if a 149(1)(l) entity canintentionally earn a profit as long as the profit is used to support theobjectives of the 149(1)(l) entity.

Paragraph 149(1)(l) of the Act requires that an organization be organizedand operated "exclusively" for "any other purpose except profit" in orderto be exempt from tax under that provision. In our view, the use of theword "exclusively" indicates that while an organization may have manypurposes, none of those purposes may be to earn a profit. Thus, where anorganization intends, at any time, to earn a profit, it will not beexempt from tax under paragraph 149(1)(l) even if it expects to use oractually uses that profit to support its not-for-profit objectives.

The CRA accepts that a 149(1)(l) entity can earn a profit; otherwise, thetax exemption provided would be unnecessary. Earning a profit, in and ofitself, does not prevent an organization from being a 149(1)(l) entity.However, the profit should generally be unanticipated and incidental tothe purpose or purposes of the organization. For example, anorganization might budget with the intention of not earning a profit, butultimately find itself with a profit because of expenses that were lessthan anticipated or that were reasonably expected but not actuallyincurred. If the original budget was reasonable, the profit earned wouldnot, in and of itself, cause the organization to cease to be a 149(1)(l)entity.

The Supreme Court of Canada commented on the issue of a purported149(1)(l) entity earning a profit in Woodward's Pension Funds v. TheQueen, 62 DTC 1002 ("Woodward's"):

"... it is true that ... the appellant was organized for the statedobject and purpose of assisting in the provision of funds for pensions tobe paid to employees and ex-employees of the stores. Nevertheless, thislast-named purpose could not be achieved without the share sale planwhich was designed to make a profit to enable the payments to be made tothe pension trustees. ... The appellant has entirely failed toestablish that it was organized and operated exclusively for a purposeother than profit and the findings of the learned President that it wasboth organized and operated for a profitable purpose are unassailable."

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The Tax Court of Canada followed the Woodward's decision in Tourbec(1979) Inc. v. M.N.R, 88 DTC 1442 ("Tourbec"). Tourbecinvolved an organization that sponsored travel for young people throughthe operation of a travel agency. On the issue of whether theorganization operated for a purpose other than profit the court found:

"What effectively happened was that Tourbec used the revenues that itreceived from its regular sales, that is the sales to the general public,to subsidize to a certain extent certain services that were reservedexclusively to its customers who were students and young people."

...

"Given the facts, I cannot accept the appellant's submissions to theeffect that it was an organization whose sole purpose was among thosereferred to in section 149(1)(l) of the Act. The philanthropic aspect ofits operations was only incidental to its primary purpose which was tocarry on a travel agency business. That incidental aspect could not havebeen achieved unless it had been able to make profits from its primarybusiness."

While the reference to a "primary purpose" in Tourbec suggests that asecondary, profit-making purpose might be acceptable for a 149(1)(l)entity, we are of the view that the decision in Tourbec means that, forparagraph 149(1)(l) of the Act to apply, an organization's "sole purpose"(or only purposes) must be something other than earning a profit. 2 Inour opinion, the decisions in Woodward's and Tourbec support the positionthat where an organization would be unable to undertake itsnot-for-profit activities but for its profitable activities, theorganization cannot be a 149(1)(l) entity because it has a profitpurpose.

We acknowledge that a 149(1)(l) entity may earn a profit as long as thatprofit is generally unanticipated and incidental to carrying out theentity's exclusively not-for-profit purposes: The Gull Bay DevelopmentCorporation v. Her Majesty the Queen, 84 DTC 6040 (FCTD)("Gull Bay"). In Gull Bay the court found that the corporate entity inquestion was

"operated "exclusively" for the purpose set out in section 149(1)(l)pursuant to its charter, even though it may raise funds for this purposeby its commercial lumbering enterprise."

We note that the situation reviewed by the court in Gull Bay was veryunusual and that the decision of the court turned greatly on theparticular facts of that case, especially with respect to the findingthat the profits were strictly incidental to the not-for-profitobjectives. Also, the decision in Gull Bay must be read in light of thecourt's view that the corporation might be a "charitable corporation" andin light of subsequent court decisions such as Tourbec and BBM.

It is always a question of fact whether an organization is operating forthe purpose of earning a profit. A "profit" is generally considered tobe the (positive) difference between an organization's revenue and theexpenses incurred to earn that revenue: see the review of the meaning of"profit" in BBM. We are of the view that in determining the expensesincurred by an organization to earn revenue, it is appropriate to takeinto account depreciation of capital assets as well as ongoing currentexpenses. However, it is not appropriate to take into account theanticipated cost of future capital projects, because that cost cannot, byits nature, be an expense incurred to earn the current revenue. Thus, inconsidering whether an entity has a profit purpose, regard must be had towhether the entity is intentionally generating profit in order to financefuture capital projects.

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In our view, if a 149(1)(l) entity could intentionally earn a profit tofinance future capital projects on the basis that this constitutedoperating at cost and therefore did not indicate a profit purpose, thenany business where the members did not require income distributions couldbe organized and operated as a 149(1)(l) entity and accumulate wealth ona tax-free basis. In this situation, while members could not access thebusiness' income immediately, the value of the organization, andconsequently the value of the membership interests, would clearlyincrease. It would not be difficult to maintain that there was no profitpurpose, as the courts have pointed out that where a business providesservices to its members at cost, "[i]t would be difficult toimpute a profit purpose" (BBM). Consequently, it is our view that indetermining whether there is a profit purpose, "profit" should be givenits ordinary commercial meaning, which does not include deductions foramounts related to future capital projects.

There are instances when a 149(1)(l) entity may have funds on hand inexcess of its immediate operating requirements. While retaining excessfunds may be evidence that an organization is operating with a profitpurpose, generally, this will not in and of itself result in theorganization failing to qualify as a 149(1)(l) entity. For example, inour view, a 149(1)(l) entity may accumulate members' contributions over aperiod of years in order to finance a planned, future capital project.Also, we acknowledge that the entity may earn reasonable investmentincome with respect to such accumulated funds, even though such incomemight otherwise be considered anticipated profit. However, if the excessfunds were collected for the purpose of earning investment income ratherthan for the purpose of funding a specific capital project, then thiswould be a profit purpose and the organization would no longer be a149(1)(l) entity.

(iii) Provincial Legislation and the Income Tax Act

Several of the provinces have enacted legislation that sets out how anorganization must be organized and operated if it wants to be consideredeither charitable or not-for-profit for provincial purposes. Forexample, the Province of Saskatchewan has enacted the Non-ProfitCorporations Act, 1995, and the Province of Ontario has similarlegislation contained in the Corporations Act. Canada recently enactedthe Canada Not-for-Profit Corporations Act.

While we cannot comment in detail on this legislation, we note that itappears that the criteria contained in the provincial "not-for-profit"legislation and in the federal Canada Not-for Profit Corporations Act arenot the same as the criteria required to qualify for the tax exemptionprovided by paragraph 149(1)(l) of the Act. In particular, both theSaskatchewan and Ontario statutes only require that any profits or otheraccretions to the corporation be used in promoting the corporation'sobjects and activities. This suggests that organizations incorporatedunder these statutes can operate with a profit purpose, as long as thatprofit is used by the organization to support its objectives. Similarly,the Canada Not-for Profit Corporations Act provides that "no part of acorporation's profits or of its property or accretions to the value ofthe property may be distributed, directly or indirectly, to amember....except in furtherance of its activities..."

As discussed above, in our view, any profit purpose prevents anorganization from being a 149(1)(l) entity. Consequently, it is possiblefor an organization to meet the requirements of federal or provincial"not-for-profit" incorporation legislation, but not qualify for the taxexemption provided under paragraph 149(1)(l) of the Act.

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(iv) 149(1)(l) Entities-Registration

The CRA does not maintain a list of organizations that qualify for theexemption provided by paragraph 149(1)(l) of the Act. Unlike charities,these organizations are not required by the Act to register with the CRA.

(v) XXXXXXXXXX Procurement Contract

Whether an organization that has earned a profit qualifies for the taxexemption provided under paragraph 149(1)(l) of the Act is a question offact. If the profit was incidental and unanticipated, the organizationmay still qualify as a 149(1)(l) entity. However, if the organizationplanned to earn a profit when it entered into the contract-for example,if the contract specifically contemplated a "mark-up"? the organizationwould not qualify for the tax exemption.

We trust that these comments will be of assistance.

Yours truly,

Eliza ErskineA/ManagerNon-Profit Organizations and Aboriginal IssuesFinancial Sector and Exempt Entities DivisionIncome Tax Rulings DirectorateLegislative Policy and Regulatory Affairs Branch

ENDNOTES

1 See also Canadian Bar Insurance Association v. Her Majesty the Queen,99 DTC 653 (TCC).

2 See also the comments of Bowman J. from L.I.U.N.A. Local 527 Members'Training Trust Fund v. HMQ, 92 DTC 2365 at page 2380,where he refers to the taxpayer having neither a primary nor secondaryprofit purpose.

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