A recent CRA ruling conveniently breaks down some of the rules about how a non-profit organization (NPO) may distribute its assets on dissolution. In this discussion, an NPO is specifically the kind of tax-exempt entity defined in paragraph 149(1)(l) of the Income Tax Act: one that is not a ‘charity’, but is organized and operated exclusively for any purpose other than profit, and
no part of the 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 ruling is a response to a question from an entity that received shares of a private business for a nominal sum, which then significantly increased in value. The entity wanted to transfer ownership of the shares (or the proceeds of their sale) to some of its members before or during its wind-up. The question was whether this would jeopardize its tax-exempt status.
Distributing Capital Gains
First, it’s important to remember that using assets for a purpose unrelated to its objects may threaten an NPO’s tax-exempt status in itself: holding on to investments (like shares) in the long term could be considered as operating for the purpose of profit. However, when selling such assets, the NPO must be careful what it does with the proceeds.
The main question here is whether a certain amount falls into the definition of ‘income’ as it’s used in the part of paragraph 149(1)(l) quoted above. If an amount is ‘income’ in this sense, then it cannot be distributed to the NPO’s members (putting aside the exception for entities that promote amateur athletics) without forfeiting the NPO’s tax-exempt status. So, what part, if any, of an entity’s capital gain would be considered income? According to this ruling, neither the taxable nor the non-taxable portions of capital gains count as income. This means an NPO can distribute capital or capital gains to its members and retain its tax-exempt status.
Distributing Assets on Wind-Up
The rule against distributing income to members still stands during the wind-up of an NPO. The only member excepted from this rule is one that meets the exact description in paragraph 149(1)(l) regarding promotion of amateur athletics. All other types of members are barred from receiving income, regardless of whether they are tax-exempt entities or even qualified donees themselves, or whether they have purposes consistent with the NPO’s, or whether the NPO receives a charitable donation tax receipt in return. This prohibition includes the distribution of any assets on wind-up which would result in any part of the income being distributed.
Where Tax-Exempt Status is Lost
As soon as an NPO does something that invalidates its tax-exempt status, the following things are deemed to happen in immediate succession: first, it is deemed to have disposed of all its assets and immediately reacquired them at fair market value (while still tax-exempt); second, it loses its tax exempt status; and third, its capital dividend is reduced to nil. Because of the order in which these events are deemed to occur, any amount added to the capital dividend account as a result of the deemed disposition is not available to be paid out to the members.
Distribution as a Gift
The ruling clarifies that characterizing a distribution as a gift to the members is rarely a viable work-around. The CRA will determine whether the distribution was truly a gift based on the circumstances, including the type of entity the NPO is, and the nature, timing and purpose of the payments.
If the NPO is a corporation, the CRA will almost certainly consider the payments to be a shareholder benefit (they take the position that non-share capital corporation members are shareholders for this purpose). On clear evidence, the CRA may accept the explanation that the transfer was a payment of a dividend, a return of capital, or a membership refund.
If the NPO is unincorporated, the nature of the pay-out will depend on its purpose. During a wind-up, for example, a pay-out may be consideration for the disposition of the member’s rights. Since those rights are capital property, this would result in a capital gain for the member.
However, even if the transfer is clearly a gift, the rule still stands: if the gift is part of the NPO’s income, distributing it to the members will cause the NPO to lose its status.
The tax repercussions of losing status can be significant. If an NPO is considering making any pay-out to a member, whether before or during wind-up, it had better keep the statutory definition of a tax-exempt NPO in mind and consult an expert if uncertain. Drache Aptowitzer LLP has experience assisting NPOs operate within the law and would be pleased to assist you.