On February 17, 2014, the Canada Revenue Agency (the "CRA") released its report (the "Report") on the Non-Profit Risk Identification Project (the "Project") and an accompanying Q&A. Our analysis of the Report and our predictions with respect to the federal government's consultation measures announced in Budget 2014 (the "Consultation") are discussed below.
The CRA commenced the Project following its release of
various technical interpretations that appeared to significantly
restrict the ability of non-profit organizations
to generate income. Among other things, the CRA's interpretations emphasized the following positions with respect to NPOs:
- While earning profits would not preclude an organization from qualifying as a tax-exempt NPO, the organization's profits had to be incidental and arise from activities undertaken to meet its non- profit objectives. The CRA interpreted this as meaning that profits generated by an NPO cannot be material and must result from activities the organization carries out to meet its non-profit objectives. What the CRA means by "incidental" and not "material" has continued to confuse many in the sector to date.
- An organization can retain a "reasonable reserve", but such a reserve must be for an identifiable operating purpose or a specific, future capital project. If the size of an organization's reserve fund is such that the organization could earn investment income from it, that may demonstrate a profit purpose on the part of the organization, which could jeopardize the organization's tax-exempt status. Any reserves should be funded by capital contributed by members, gifts and grants, and/or accumulated, incidental profits.
- Where an organization derives income from outside (i.e., non-member) sources and that income is used, for instance, to reduce members' fees or benefit the members in some other way, the organization may be considered to be making income available for the personal benefit of members, thereby jeopardizing its tax-exempt NPO status. However, the CRA has indicated that basic investment income earned on amounts contributed by members or member fees earmarked for a specific capital project, or on reasonable operating reserves, is not of as much concern in this context.
These CRA interpretations regarding what NPOs can and cannot do to fund their initiatives and the reserve amounts they can maintain for operating and capital projects created much anxiety in the NPO sector. Conceivably sensing that such anxiety related at least partly to the possibility that many organizations would not qualify for tax-exempt NPO status were the CRA's new interpretations to be strictly enforced, the CRA began to audit organizations claiming NPO status in 2009 as part of a three year project that recently wrapped up in late 2013.
The Report and the Q&A
Perhaps the only thing that was truly surprising about the Report, given that it covered three years of information-gathering, was how short it was. In light of the federal government's announcement of the Consultation shortly before the release of the Report, however, and the fact that the CRA has been targeting the same issues in the sector for the past few years, it may be fair to say that the length – and content – of the Report shouldn't have been unexpected. The highlights of the Report are as follows:
- An overview of the Project
- The CRA started the Project in 2009 and reviewed 1,337 files over three years.
- The Project was designed to provide the CRA with insight into
the way organizations claiming the non-profit exemption in
paragraph 149(1)(l) operate and, in particular, to:
- understand the compliance issues facing NPOs; and
- evaluate NPOs' level of compliance with the requirements in the Income Tax Act(Canada) (the "ITA").
- The organizations audited by the CRA pursuant to the Project were drawn from a random sample of 30,000 organizations identified through Statistics Canada. Due to the nature of the sample, only NPOs that had filed a T2 (corporation tax return), T3 (trust tax return) or T1044 (non-profit organization information return) were audited.
- Though NPOs have been audited in the past through the regular
T2 or T3 screening process, the Project is the first specialized
program focused on auditing NPOs from an income tax
- The exempting provision and the groups claiming the
benefit of it
- Paragraph 149(1)(l) was introduced in the Income War Tax Act, 1917. The CRA and the Department of Finance have both noted that this provision has changed little since it was introduced.
- The nature of the groups eligible for the exemption has evolved through the years and a wide variety of entities of all sizes now claim an exemption from tax under it.
- The number of NPOs in Canada is currently unknown (though the
CRA's estimate is 80,000), as there are no registration
requirements to qualify for the exemption and the filing
obligations of NPOs vary according to the type of entity. Many
unincorporated entities that are not trusts, for instance, do not
have any filing requirements under the current regime.
- Requirements to be a tax-exempt NPO
- The Project evaluated the NPOs sampled in accordance with the
following four factors in paragraph 149(1)(l) identified by the CRA
as being necessary for an NPO to qualify for tax-exempt status:
- Not a charity
- The CRA reiterated the position that an organization that is a charity at common law cannot be a tax-exempt NPO.
- The Project revealed a small number of charitable organizations that appeared to be claiming paragraph 149(1)(l) status, including registered charities erroneously filing Form T1044 and organizations that were actually charities under common law (i.e., having charitable purposes for the relief of poverty, advancement of education, advancement of religion or other purposes beneficial to the community).
- Organized for a non-profit purpose
- The CRA restated its view that making profits will not disqualify an organization from the NPO tax exemption as long as the profits are incidental and arise from activities undertaken to meet the organization's non-profit objectives.
- The Report noted that there were a small number of cases where an organization's governing documents indicated that it was not organized exclusively for a purpose other than profit.
- Operated for a purpose other than profit
- The Report indicated that there were a significant number of cases of organizations that were not operated exclusively for a purpose other than profit.
- The Project revealed a wide range of organizations carrying out a variety of activities with an apparent profit motive. The red flags identified in the Report indicating an apparent profit motive were disproportionately large capital or operating reserves resulting from surpluses generated by non-incidental profits.
- With respect to this third requirement, the Report observed
that there are common views in the sector that:
- an NPO must produce a profit for programs to thrive and capital assets to be maintained; and
- as long as profits are used to further an NPO's purpose, the source of funding shouldn't matter.
- Income payable to or made available for the personal benefit of
a proprietor, member or shareholder
- The red flags identified by the Report with respect to this requirement include shareholder loans, the ability of an organization to pay dividends and the guaranteeing of personal loans. Other problematic activities that have been identified over the years, as discussed above, include income being made available for the benefit of members in situations where it is used to reduce the amount of members' fees that would otherwise have been payable by the organization's members, particularly where the income comes from non-member sources.
- The Report indicated that there were a small number of cases
where this requirement was a problem for an organization audited
under the Project.
- Not a charity
- The Project evaluated the NPOs sampled in accordance with the following four factors in paragraph 149(1)(l) identified by the CRA as being necessary for an NPO to qualify for tax-exempt status:
- Concluding notes on the Report
- The Report stated that the current legislative framework governing NPOs allows many different organizations with a wide variety of purposes and activities to claim the NPO tax exemption. In fact, almost any type of organization can qualify without restriction as to its activities or objectives (other than that they be non-profit).
- The Project revealed that many organizations have a different interpretation of the requirements imposed by paragraph 149(1)(l) than does the CRA.
- Many NPOs are administered by non-specialist volunteers who want to comply, but do not understand the requirements imposed by the legislation (or perhaps, more accurately, the requirements imposed by the CRA, which do not, in our view, necessarily align perfectly with the legislation).
- The Project has given the CRA a better understanding of the issues facing the NPO sector and has highlighted areas where the sector's understanding differs from that of the CRA.
- A significant number of the organizations sampled during the Project would fail to meet at least one of the four requirements needed to qualify for the NPO tax exemption.
- Regarding those organizations with compliance issues, the
Report divided them into the following higher risk and lower risk
categories (the risk being the loss of tax-exempt status):
- Higher risk
- A significant number of the organizations sampled by the CRA are in this category.
- Red flags here include the following (and the Report indicates
that organizations with these "high risk" indicators do
not qualify for tax-exempt status as an NPO and would need to be
reassessed if audited outside the Project):
- Non-incidental profits
- Profits unrelated to non-profit objects
- Disproportionately large reserves, surpluses or retained earnings
- Income payable or made available for the personal benefit of a shareholder, proprietor or member
- Lower risk
- Non-compliant organizations in the lower risk category include
those with "readily correctable" issues, such as making
filing errors and not providing enough information to substantiate
their non-profit purpose.
- Higher risk
- Action items
- The Report identifies education and outreach to the NPO sector as "critical".
- The CRA will work with representatives in the NPO sector and engage in "targeted outreach, client service and education".
- The CRA will review, revise and improve education materials and support.
- The CRA will provide the Department of Finance with a copy of the Report for the purposes of examining the legislative framework.
The Consultation Process And Future Directions
- Budget 2014 announcements
- As part of Budget 2014 tabled on February 11, 2014, the federal
government has indicated that it intends to review:
- whether the NPO tax exemption remains properly targeted; and
- whether sufficient transparency and accountability provisions are in place.
- Unsurprisingly, the federal government has identified risk areas in the NPO sector that are identical to the CRA's concerns, as described in the Report.
- Budget 2014 identified additional concerns with respect to the limited reporting requirements for NPOs, the limited ability of the public to adequately assess the activities of NPOs and the challenges faced by the CRA in evaluating the entitlement of an organization to the NPO tax exemption.
- The federal government will release a Consultation report for comment and the government will undertake further consultation with stakeholders "as appropriate".
- Further details on the Consultation will be provided by the
federal government in coming months.
- As part of Budget 2014 tabled on February 11, 2014, the federal government has indicated that it intends to review:
- What will the Consultation involve?
Now that the Consultation has been announced, the first step is to watch for the release of the Department of Finance's Consultation paper. Based on the areas of concern identified for NPOs in Budget 2014, we expect that the Department of Finance's views will generally be in line with those expressed by the CRA over the past few years.
We also anticipate stakeholder meetings between the Department of Finance and the sector to comprise a key part of the Consultation process, as well as, potentially, a call for submissions from the public on what direction potential new legislation should take. The NPO sector and any other interested parties should start thinking about their concerns – as well as what makes sense from their perspective with respect to the purposes for which they are organized and the way in which they operate – and be prepared to make submissions to the government as and when appropriate.
- What should the sector expect next?
Based on the Report and the Department of Finance's announcement of the Consultation, it seems clear that, at a minimum, two things will happen:
- The CRA will implement an NPO education initiative. What precisely this initiative will consist of remains to be seen, but we can likely expect some new webpages, publications and outreach by CRA staff on this front.
- The Department of Finance will consider amending the NPO tax
exemption in paragraph 149(1)(l). As mentioned above, it seems
likely that the Department of Finance's concerns regarding NPOs
are similar to those of the CRA's at this time – we
expect that the Consultation paper will provide more clarity on
this. However, whether or not a legislative amendment is made, the
CRA's administrative position on the ability of NPOs to earn
profits and maintain reserves could continue to affect NPOs in one
of two ways:
- If a legislative amendment to paragraph 149(1)(l) is not made, NPOs will likely be stuck with the CRA's administrative position, as described in the "Background" section above.
- If a legislative amendment to paragraph 149(1)(l) is made, it is possible that the Department of Finance will choose to make the CRA's administrative position law unless the sector makes a convincing case for something different.
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