The Canada Revenue Agency (the “CRA”) recently issued a ruling discussing the ability of a paragraph 149(1)(l) not-for-profit organization to invest excess funds in a taxable subsidiary. Due to various redactions in the ruling, it is unclear what the not-for-profit objectives of the organization were or how the organization at issue was able to accumulate funds. The facts in the ruling did indicate, however, that the organization was charged a management fee in each year by its parent and there was apparently evidence indicating that the amount of the fee paid to the parent was “unreasonable” in comparison to the work done for the fee. Without the management fee, it was noted, the organization would have shown a profit in the years under audit.
In ruling that the organization was likely not tax-exempt under paragraph 149(1)(l) of the Income Tax Act (Canada), the CRA reaffirmed its position that a not-for-profit organization can earn profits as long as those profits are “incidental” and arise from activities that are undertaken to meet the organization’s not-for-profit objectives, stating “[t]his means that where the amounts are not material and the profits result from activities that the entity carries out to meet its not-for-profit objectives, the entity will remain tax-exempt”. The maintenance of “reasonable operating reserves” or bank accounts required for ordinary operations were expressly cited as examples of activities undertaken to meet the not-for-profit objectives of an organization and the CRA confirmed that incidental profits arising from those reserves or accounts will not affect the tax-exempt status of a not-for-profit organization. In analyzing the facts with respect to the organization at issue in the ruling, the CRA was concerned by the “large amount of retained earnings”, the fact that the management fees paid to the parent were not set on a cost-recovery basis and the organization’s investment in a taxable subsidiary, commenting that these factors favoured a finding that the organization did not qualify for tax-exempt status. While the CRA confirmed its long-held position that a not-for-profit organization can carry on a for-profit business in a taxable subsidiary and that after-tax funding can flow to the not-for-profit organization from the taxable subsidiary, in the facts of this particular case, the not-for-profit organization’s investment in the subsidiary was found to have a profit purpose. The CRA appeared to come to this conclusion based on the fact that there was no evidence to support that the organization’s use of excess funds to invest in the subsidiary supported the organization’s not-for-profit objectives. The CRA reiterated its position, as articulated in paragraph 8 of IT-496R, that where accumulated funds are used for purposes unrelated to an organization’s not-for-profit objectives, the organization may be considered to have a profit purpose. Interestingly, the facts in the ruling indicate that a co-investor in the taxable subsidiary at issue was a corporation that was not a not-for-profit – one wonders how much of an impact this factor had on the CRA’s decision.
This ruling should serve as a caution to organizations that carrying on for-profit activities in a for-profit subsidiary will not automatically protect the organization’s tax-exempt status in every case. Rather, the CRA will look at whether an organization’s investment in the subsidiary is an activity that can be considered to support the organization’s not-for-profit objectives. Where it does not, the organization’s tax-exempt status may be at risk.