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.
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 federal government's consultation measures announced in Budget 2014 (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:
1. 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 non-profit ("NPOs") 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 perspective.
2. 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.
3. 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:
(a) 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).
(b) 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.
(c) 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.
(d) 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.
4. 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
- 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.
5. 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.
- As part of Budget 2014 tabled on February 11, 2014, the federal government indicated that it intends to review:
- whether the NPO tax exemption remains properly targeted; and
- whether sufficient transparency and accountability provisions are in place.
- The federal government will release a Consultation report for comment and the government will undertake further consultation with stakeholders "as appropriate".
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:
(a) 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.
(b) 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.
Both of these possibilities should provide NPOs with a compelling reason to be pro-active and get involved in the Consultation process. Otherwise, NPOs that find themselves offside the CRA's views on how NPOs can generate revenue will either have to muster the will and resources to challenge the CRA's position in court or find another way to deal with the risk to their status, such as by becoming taxable, for-profit entities
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