Accumulation of Profits in a Non-Profit Organization
By Arthur Drache
A ruling letter released by the CRA at the end of 2012 offers some pithy comments on the situation where a non-profit organization has accumulated significant surpluses. The document has been so redacted vis a vis the factual background that details are sketchy but the “discussion” does offer some guidance to non-profit organization directors about potential difficulties
In order for an Association to qualify as a 149(1)(l) entity it must be organized and operated exclusively for any purpose other than profit. However, an organization claiming a paragraph 149(1)(l) exemption can earn a profit, as long as the profit is incidental and arises from activities directly connected to its not-for-profit objectives.
That having been said, large reserves may indicate that there is an accumulation of income for the purpose of earning investment income, which could also indicate a profit purpose. As stated in paragraph 8 of Interpretation Bulletin IT-496R, “Non-Profit Organizations”, an organization that retains excess funds in order to invest them and earn income is not considered to be operating exclusively for a purpose other than profit. 
Large reserves might also be for the purpose of increasing capital within the Association. A 149(1)(l) entity may fund capital projects, however, those projects should be identified and funded by capital contributed by members, from gifts and grants, or from accumulated, incidental profits. 
In this particular case, the non-profit created a subsidiary, apparently for investment though the facts are vague.
“In our view, the large amount of reserve funds could not have been accumulated through incidental profits. Further, the investment in the Subsidiary was made from the unrestricted capital reserve account of the Association, which suggests that the large reserves may be unnecessary for the purpose of carrying out its not-for-profit activities and may be accumulated for profit purposes.”
But the letter goes on to note that the fact that an organization incorporates and holds the shares of a taxable subsidiary will not, in itself, mean that an organization does not meet the requirements of paragraph 149(1)(l) of the Act. Generally, an organization claiming the exemption can earn a profit as long as the profit is incidental and arises from activities directly connected to its not-for-profit objectives. The name of the taxable subsidiary may indicate that it could be connected to the not-for-profit objectives of the Association.
If an organization holds shares to earn income from property, it may be considered to have a profit purpose, even if the income from those shares is used in furtherance of the organization’s not-for-profit objectives. However, the CRA has accepted that where an organization that otherwise qualifies for the exemption under paragraph 149(1)(l) of the Act engages in an income generating activity that is carried out in a taxable, wholly-owned corporation, and this corporation pays dividends out of its after-tax profits to the organization to enable the organization to carry out its not-for-profit activities, the organization may still qualify for the exemption as set out in paragraph 149(1)(l).
“Nevertheless, the fact that a 149(1)(l) entity has funds available to provide loans to taxable subsidiaries generally suggests that the organization has retained earnings larger than is necessary to meet the organization’s not-for-profit objectives and is therefore not operating exclusively for a purpose other than profit. Earning interest income on those loans also indicates a profit purpose. Moreover, where an organization receives management fees, rents, interest income, or other types of income from a taxable subsidiary, the receipt of that income may indicate a profit purpose that can only be determined by reviewing the facts. As previously stated, an organization claiming a paragraph 149(1)(l) tax exemption can, with certain restrictions, earn a profit; but those profits earned by the organization must be wholly expended in accordance with the organization’s non-profit purposes. In our view, using income, whether incidental or not, to finance profitable activities in a taxable subsidiary suggests that an organization is likely not using its income to support its non-profit objectives. Accordingly, based on the comments above, in our view, an organization that provides loans to a taxable subsidiary would likely not qualify for the tax exemption available under paragraph 149(1)(l) of the Act.”
The letter gives a good overview of the CRA’s stated views on the issue of non-profits accumulating income. That having been said, the case law clearly suggests that insofar as the courts are concerned, the determination of the issue is fact based. Those operating non-profits should familiarize themselves with the rules while bearing in mind that the case law suggests that the CRA interpretation of the law may be excessively narrow.
 Insofar as we are aware, there are no reported cases where a non-profit has lost its status because of profit accumulation but the case law is somewhat sparse.
 This was the basis of a successful arguments in the LIUNA case, 2 CTC 2410
 See for example The Canadian Bar Insurance Association v. R 2 CTC2833.