Non-Profits and Taxable Subsidiaries
By Arthur B.C. Drache, C.M. Q.C.
Tax planning for tax exempt entities often involves the creation of “sibling” or controlled taxable corporations. Properly executed, the created corporations can carry on activities which are either prohibited to the parent or carry some risk that the parent is not willing to undertake directly. The planning for charities which wish to undertake such an exercise is quite different than the planning for non-profit corporations.
In the case of non-profits under paragraph 149(1)(l) of the Income Tax Act, the general set of constraints is as follows.
In general terms, paragraph 149(1)(l) provides that the taxable income, including taxable capital gains, of a corporation is exempt from tax under Part I for a period throughout which a corporation meets all of the following requirements:
* it is a club, society or association;
* it is not a charity;
* it is organized and operated exclusively for social welfare, civic improvement, pleasure, recreation or any other purpose except profit; and
* it does not distribute or otherwise make available for the personal benefit of a member or shareholder any of its income, unless the organization is an association which has as its primary purpose and function the promotion of amateur athletics in Canada.
If it adheres to this framework, the non-profit is not subject to income tax.
In late October, the CRA published two ruling letters, each of which deals with this issue in generic fashion.
The first one raises the question of whether an organization claiming the exemption from tax provided by paragraph 149(1)(l) of the Act will jeopardize its exemption from tax if it incorporates a taxable subsidiary to carry on for-profit activities.
“The fact that an organization incorporates and holds the shares of a taxable subsidiary will not, in itself, cause the organization not to be exempt from tax under paragraph 149(1)(l) of the Act. As stated above, an organization claiming an exemption under paragraph 149(1)(l) must operate exclusively for any purpose other than profit.
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. Therefore, 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) 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). (our emphasis)
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. Further, an organization that has excess funds available to loan to a taxable subsidiary may not qualify as a 149(1)(l) entity, as the use of funds in this manner is generally not supporting the organization’s not-for-profit objectives. As stated in Interpretation Bulletin IT-496R, “Non-Profit Organizations”, where assets representing accumulated excess income are used for purposes unrelated to the organization’s not-for-profit objectives, such as long-term investments to produce property income, or loans to members, shareholders or non-exempt persons, profit may be considered to be one of the purposes for which the association was operated.”
This ruling gives a good generic overview of the rules as interpreted by the CRA.
The second ruling letter deals with a related situation alluded to in the first letter.
The question this time was whether an organization would compromise its tax exempt status under paragraph 149(1)(l) of the Income Tax Act by making loans to a taxable subsidiary. In this letter, unless otherwise expressly stated, all statutory references are to the provisions of the Act.
After a few hundred words of generic bumph, the letter goes on to sya:
“An organization claiming a paragraph 149(1)(l) tax exemption can earn a profit, as long as the profit is incidental and arises from activities directly connected to its not-for-profit objectives. For example, maintaining reasonable operating reserves or bank accounts required for ordinary operations will generally be considered to be an activity undertaken to meet the not-for-profit objectives of an organization. Consequently, incidental profits arising from these reserves or accounts will not affect the tax-exempt status of an organization.
In our view, the fact that a 149(1)(l) organization has funds available to provide loans to its 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. As a result of large reserves, a 149(1)(l) organization may also be earning large amounts of tax-free investment income on funds that are not necessary to meet its not-for-profit objectives. The earning of investment income used to meet for-profit objectives such as financing the activities of a taxable subsidiary may also indicate that an organization is not operating for a purpose other than profit.
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). (our emphasis)
The two letters taken together actually offer a kind of primer of what issues must be taken into account when a non-profit boar wishes to consider the incorporation of a taxable subsidiary and how, providing things go well, profits will enure to the non-profit parent.and what risks have to be assessed in making and implementing this sort of plan.
This is not the proverbial “rocket science” but especially these days when the CRA is more closely looking at non-profits and their activities, serious care and consideration should be given before embarking on this type of exercise.