Canada: Further Commentary By Canada Revenue Agency On Paragraph 149(1)(l) – Profit Motive And Distribution Of Income To Members

Last Updated: February 14 2013
Article by Eric Koh

Canada Revenue Agency ("CRA") recently released Document 2012-0455501I7 on whether certain transactions and investments jeopardized a corporation's (the "Corporation") tax exempt status as a not-for-profit organization ("NPO") under paragraph 149(1)(l) of the Income Tax Act (the "Act"). The Corporation was being audited, and the auditor sought additional guidance from the Income Tax Rulings Directorate ("Rulings") at CRA. The issues examined in document 2012-0455501I7 primarily pertained to whether the Corporation was operated for a purpose other than profit, and whether the Corporation distributed income to its sole member. 


In this case, the Corporation was a non-share corporation. The only member of the Corporation was another non-share corporation (the "Parent") that filed its returns as a tax exempt NPO. The Corporation also owned common shares in a taxable corporation ("Subco"). When it was first established, the Corporation extended loans to other entities, and found itself holding accumulated funds which were subsequently invested. Furthermore, the Corporation earned income from its primary activity, and interest from its bank accounts. The Parent provided management services to the Corporation and was compensated for such services by the Corporation. Rulings indicated that there was evidence that the amount of the management fees paid to the Parent was unreasonable in relation to the actual management services provided. Absent the management fees, the Corporation would have earned a profit in the years that were under audit. Finally, in one of the fiscal years examined by CRA, the Corporation derived capital gains from the disposition of property.   

Rulings' Position

Upon reviewing the facts presented, Rulings concluded that the Corporation did not qualify for tax exempt status under paragraph 149(1)(l) as it had a profit motive, and made income available to its sole member.

1) Profit Motive

Generally, whether an entity has a profit motive when carrying on a business is a question fact, the determination of which may vary between different activities carried out by an NPO, and between different NPOs with similar activities. 

In document 2012-0455501I7, Rulings specifically identified the large retained earnings of the Corporation and investment in Subco as indicators that the Corporation had a profit motive. Although Rulings did not specifically comment on the Corporation's capital gains, it may be reasonably inferred from the language adopted by Rulings that the capital gains were also relevant to its conclusion.

According to Rulings, an NPO claiming tax exempt status under paragraph 149(1)(l) of the Act is allowed to earn a profit so long as the profit "is incidental and arises from activities directly connected to its not-for-profit objectives". Rulings further stated that the amount of profit has to be immaterial. Therefore, Rulings opined that the large amount of the Corporation's retained earnings indicated that the Corporation "has not operated for a purpose other than profit". Presumably, if the amount of the Corporation's retained earnings was immaterial, Rulings would not have imputed a profit motive.

This is consistent with Ruling's recent position on the accumulation of operating and capital reserves by NPOs. In general, NPOs are allowed by CRA to maintain such reserves for ordinary operations and planned capital expenditures respectively without jeopardizing their tax exempt status. Interest earned on such reserves are also tax exempt. Nevertheless, CRA has stated that the amount of reserves must be reasonable in light of the organization's purpose, operations and planned capital expenditures. 

Besides the Corporation's retained earnings, Rulings also pointed to the Corporation's investment in Subco as an indicator of a profit motive. 

According to Rulings, CRA accepts that an NPO may receive dividend income from a taxable, wholly owned corporation to enable the NPO to carry out its not-for-profit activities, and still qualify for tax exempt status under paragraph 149(1)(l).  However, pursuant to the Supreme Court of Canada's decision in Woodward's Pension Society,1 Rulings also stated that an entity cannot qualify for tax exempt status under paragraph 149(1)(l) if it was unable to accomplish its not-for-profit objectives unless it realizes profits with which to do that. 

In this case, Rulings stated that there was no evidence that the Corporation's investment in Subco supported the Corporation's not-for-profit objectives. 

2) Making Income Available

Rulings also expressed concern over the fact that the management fees paid by the Corporation to the Parent were not paid on a cost recovery basis. Therefore, Rulings concluded that the "Corporation may have made income available to its members by transferring amounts to its Parent in excess of costs". 

The fact that the member or Parent of the Corporation was itself an NPO was apparently irrelevant to Rulings' analysis.  Although not explicitly cited as a reason, Rulings appeared to have placed considerable weight on the fact that the Corporation would have earned a profit in each of the years under audit had the management fees been paid on a cost recovery basis. 

Whether Rulings would have arrived at a similar conclusion on this issue had the Corporation been operating at a loss during the years under audit was not addressed by Rulings. Another interesting issue not raised or examined is whether the Parent's tax exempt status would be threatened by receiving management fees in excess of its cost of providing the management services.

Concluding Remarks

Document 2012-0455501I7 highlights the pitfalls and complexities faced by an NPO in relation to investments in taxable organizations and profit generating activities. Besides CRA's increased scrutiny of NPOs, there are indications that CRA is taking a more restrictive approach to interpreting the requirements in paragraph 149(1)(l) for tax exempt status. Therefore, careful planning and organization is recommended before an NPO undertakes any activity that has the potential to generate a profit. For NPOs that are already engaged in such activities, these NPOs should regularly review their activities and transactions, and take remedial actions where necessary lest they jeopardize their tax exempt status.


1 62 DTC 1002 (S.C.C.)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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