A. THE PROBLEM
This article follows up on Bill Pashby’s article in our Winter 2009 Not-For-Profit Law Update. He suggested that with the recent downturn in the value of equities, charities “with endowments should look very carefully at their situation and the applicable legal requirements”. They should examine the documentation which accompanied the original donation of the funds.
This article summarizes the relevant income tax issues.
B. DISBURSEMENT QUOTA
Charitable foundations registered with Canada Revenue Agency are subject to disbursement quota requirements set out in the Income Tax Act (Canada) (the “ITA”). In general terms, a foundation is required to disburse each year:
- 80% of the amounts for which it issued a tax receipt in the preceding year (Factor A); and
- 3.5% of its capital that is not used in charitable activities (Factor B).
Factor A does not apply to “enduring property” which under the Act includes among other things:
- property that was transferred to the foundation by way of a bequest or of an inheritance;
- property which was the result of a gift where the donor directed that the property be held by the foundation for a period of not less than 10 years;
- enduring property gifted by a registered charity.
As a result of the present economic times, many foundations are faced with diminishing donations and a reduction of income from capital property. Therefore, a foundation whose donations and investment income does not exceed 3.5% after administrative expenses may be unable to meet its 3.5% disbursement quota by using its investment income earned during the year. The foundation is then faced with the situation of having to encroach on its capital to meet its disbursement quota.
C. THE OPTIONS
The following is a brief description of the options available to a foundation to legally encroach on its capital:
(a) The ITA allows a foundation to encroach on its capital to the extent of its “capital gains pool”. This pool consists of the total of all capital gains realized from the sale of enduring properties for taxation years after March 22, 2004 less past disbursements of realized capital gains from enduring property during the same period. These capital gains must therefore have been realized (not just accrued), tracked and reported in the foundation’s Charity Annual Return.
Once it has been determined that the foundation has a capital gains pool, it must be determined if the donor of capital property (by gift or will) provided for an encroachment within the holding period in the terms of the gift or bequest. If the donor did not originally allow for such an encroachment of capital, the foundation and the donor can agree to amend the terms of the gift accordingly. If a donor cannot be found or is deceased, the foundation should seek the representative of the estate of the donor or seek the authorization of the courts to allow for the encroachment.
(b) If the foundation does not have a capital gains pool or it is insufficient, it can use up disbursement surpluses from previous years and apply them to eliminate or reduce its current disbursement quota shortfall. The foundation may also contemplate being in a deficit situation vis à vis its disbursement quota for a year provided it is sufficiently confident that in the following year, it will realize a surplus that it will be able to carry back against the year in which it incurred a deficit.
(c) If none of the solutions above are available, the only alternative remaining to the foundation is to apply to the Minister for a reduction of its disbursement quota under section 149.1(5) of the Act.