CRA comments on eligibility for Non-Profit Organization status

The CRA recently released document 2012-0455501I7 which comments on a corporation’s eligibility for tax-exempt status as a non-profit organization (NPO) under the Income Tax Act. The document suggests a narrower approach to NPO status than previously espoused by the CRA. The document is therefore of interest both in the context of the specific circumstances discussed therein as well as in the larger context of the CRA’s ongoing NPO Risk Identification Project [http://thor.ca/tax-alerts/npo-education-letters/].

Pursuant to paragraph 149(1)(l) of the Income Tax Act, an organization seeking to qualify as a NPO must, among other requirements, be organized and operated exclusively for social welfare, civic improvement, pleasure, recreation or any other purpose except profit. A further requirement for eligibility under paragraph 149(1)(l), is that the organization must not pay or otherwise make available any part of its income for the personal benefit of, any proprietor, member or shareholder (except in the case of certain amateur athletics associations). In document 2012-0455501I7 the CRA found that neither of these requirements were met by the organization at issue.

The facts in 2012-0455501I7 involved a non-share capital corporation (the “Corporation”) that held shares of a taxable corporation (Subco). The Corporation had one member (“Parent’”) that was also a non-share capital corporation filing its tax returns as a NPO. The Parent provided management services to the Corporation in exchange for management fees. Although the precise amount of the fees is not specified in the document, the CRA described the fees paid in respect of the management services as “unreasonable in comparison to any actual work done.” Without the management fees, the Corporation would have had a profit as a result of earnings it derived from investment activities.

The CRA identified three main issues which in its view likely rendered the Corporation ineligible for NPO status under paragraph 149(1)(l). First, the CRA noted that the “large amount” of retained earnings reported by the Corporation evidenced a profit purpose. The CRA has previously accepted that maintaining operating reserves or bank accounts required for ordinary operations can be considered an activity undertaken to meet the not-for-profit objectives of an organization. Presumably, therefore, the CRA’s comments in 2012-04555501I7 stem from the large size of the earnings reported.

Second, the CRA expressed the view that ownership of the Subco shares might also indicate a profit purpose. Specifically, the CRA reasoned that the availability of excess funds to invest in Subco without evidence that such an investment supported the Corporation’s not-for-profit objectives suggested a profit purpose. These comments adopt a stricter approach than previous CRA statements. For example, in document no. 2002-0153887, August 19, 2002, the CRA accepts that “many organizations will undertake activities, including the purchase of investments… specifically to generate a profit, and that this will not necessarily cause the entity to cease to be exempt under paragraph 149(1)(l).” The CRA also previously accepted that in certain circumstances, an organization could intentionally earn a profit or plan for a surplus without being found to be operating with a prohibited profit motive (see for example, IT-496R). Accordingly, the availability of excess funds to invest in a subsidiary should not itself be understood to be objectionable. Again, it is not clear whether the strict tone of the CRA’s comments in 2012-0455501I7 can be attributed solely to the particular facts of the situation presented.

Third, the CRA noted its concern that the management fees paid to the Parent were not on a “cost recovery basis” and could therefore be seen as a profit distribution to a member. No mention is made of the Parent’s status as an NPO and presumably the CRA considered this factor to be irrelevant. Although the comments are made in the context of the member-benefits prohibition, the suggested elevation of the “cost recovery basis” to an expected practice may also suggest a subtle widening of the CRA’s stance regarding when an organization will be found to be operating with a profit purpose.

As noted above, the CRA’s comments in document 2012-0455501I7 arrive in the context of the CRA’s NPO Risk Identification Project, which is in its third and final year. According to the CRA, the NPO Project is an “information gathering and education initiative” that it hopes will “provide insights regarding the way non-profit organizations (NPOs) operate under the provisions of the ITA.” Although, the CRA has stated that the project is currently only an information gathering initiative that will not result in reassessments in the short term (except in “egregious cases”), the intensified focus on the NPO sector suggests an increased risk that NPOs may have their status reviewed. In this regard, it is important to note that an organization must meet all the requirements under paragraph 149(1)(l) of the Income Tax Act throughout the period for which returns are filed in order to qualify for NPO status. When an organization’s status changes (when it becomes or stops being an NPO), it is considered to have disposed (and then reacquired) its assets at fair market value. In addition, a new tax year begins each time an entity becomes or stops being an NPO. For these reasons, in light of the increased attention being placed on the NPO sector, it may be a good time for NPOs to review their activities and governing documents and speak to their advisors to confirm continued tax-exempt status, or to develop compliance strategies.