Non-Profit Organizations and the Income Accumulation Minefield
Under section 149(1)(l) of the Income Tax Act, entities that meet the definition of a “non-profit organization” (NPO) are exempt from paying federal income tax. The section defines an NPO as a club, society or association that is not a charity but is organized and operated exclusively for any purpose except profit.
What seems like a straightforward proposition at first – operating exclusively for any purpose other than profit – quickly devolves into shades of grey. Is it okay to accumulate money if it eventually goes towards your charitable activities? The CRA’s answer is basically “it depends,” but where exactly is the line? Because NPOs’ tax-exempt status hinges on these questions, it is important for them to be knowledgeable about property accumulation and navigate it with care.
The CRA’s general position is that an NPO may earn a limited profit as long as it is incidental to and arising from activities that are directly connected to its not-for-profit purposes. This is essentially a given, as it is not practical to expect an NPO to spend every penny it earns in the same year that it earns it. There must exist some space for the organization to save up for larger projects or cushion itself against future shortfalls.
That being said, there are a few ways for an NPO to run into problems.
The CRA is suspicious of “large reserves” of property, a vague distinction that is generally considered to be an amount greater than the NPO reasonably needs to carry on its non-profit activities. If the CRA considers that an NPO is accumulating more than it reasonably needs, they will consider profit to be a purpose for which the NPO is operating. The CRA purports to look at each case on the facts to determine whether the funds could have conceivably been accumulated through incidental profits and whether they constitute a reasonable operating reserve.
Large reserves may also lead the CRA to suspect an NPO of increasing its capital by improper means. They are of the opinion that any capital projects must be funded by member contributions, gifts, grants, or accumulated incidental profits.
An overly-large reserve might also indicate the NPO is accumulating for inappropriate (i.e. for-profit) purposes.
A common ‘inappropriate’ purpose is the intention to earn investment income. Interpretation Bulletin IT-496R opines that using accumulated funds for long-term investments is ipso facto a for-profit purpose, taking the organization outside of the scope of section 149(1)(l). However, as is sometimes the case, the CRA takes this approach in the face of blatantly contradictory case law. The Tax Court of Canada considered IT-496R in 1992[1] and rejected its black-and-white approach to investment income in favour of determination on the facts of a particular case. Nonetheless, more than twenty years later the relevant language in the Bulletin has not changed.
Other uses for excess funds that will particularly attract the tax man’s attention include enlarging or expanding commercial facilities, investing in a term deposit that is regularly renewed from year to year, and making loans to members or shareholders.
As this overview illustrates, property accumulation is full of hazards and will probably require professional advice. Although the CRA’s position is frequently in conflict with case law like L.I.U.N.A, NPOs should avoid contravening CRA policy unless they are prepared to go to court over it.
[1] L.I.U.N.A. Local 527 Members’ Training Trust Fund v. Canada, [1992] 2 C.T.C. 2410 (TCC), followed in Canadian Bar Insurance Assn. v. R., [1999] 2 C.T.C. 2833 (TCC)