On April 22, 2009, the Canada Revenue Agency released a set of questions and answers concerning the treatment of enduring property for purposes of the disbursement quota. These questions and answers can be viewed online at http://www.cra-arc.gc.ca/tx/chrts/plcy/csp/csp-e10-fqs-eng.html. The questions and answers deal with numerous issues concerning endowment fund agreements and the definition of enduring property in the Income Tax Act. Many of these issues are particularly relevant given the current state of the Canadian economy.
It should be noted at the outset that not all types of enduring property are the same or subject to the same restrictions. Bequests, life insurance proceeds, direct receipts from an RRSP or RRIF on the death of the annuitant are all considered as enduring property, but there is nothing in the Income Tax Act that restricts how these funds can be used by the charity or whether the capital or income can be spent. These issues would be determined by looking at the specific terms of the gift made and are not determined by the rules in the Income Tax Act. It is important that charities understand that unless the gift agreement contains restrictive language, enduring property, other than ten year gifts, are not subject to the encroachment restrictions noted.
The answers published by the CRA discuss certain restrictions on encroachment which in CRA’s view applies to inter vivos (during lifetime) gifts of enduring property (i.e., ten-year gifts).
The first question deals with how fund agreements define income. In particular, some fund agreements do not distinguish earnings on endowment portfolios among interest, dividends, and realized and unrealized capital gains. The question states that these items are all considered current earnings and the capital refers to the dollar value of the original gift to the endowment fund. The CRA states that such gifts may not qualify as enduring property. The CRA refers to paragraph (c) of the definition of enduring property in subsection 149.1(1) of the Income Tax Act and the fact that the gift received by the registered charity must be subject to a trust or direction to the effect that the property given or property substituted for the gift is to be held by the charity or by another registered charity for at least ten years. This is commonly referred to as a ten-year gift.
The CRA’s view is that realized and unrealized capital gains relating to the original property gifted to the charity or to property substituted for the gift, form part of the gift that is subject to this ten-year holding period. Therefore, where fund agreements allow the charity to expend these capital gains prior to the end of the ten-year period, the gift may not qualify as enduring property under paragraph (c) unless such expenditures do not exceed the permissible encroachment amount. However, it is arguable that it may be possible, with careful drafting of an endowment agreement, to allow access to increases in the value of a gift, whether realized or unrealized, such that only the original value of the gift is subject to this holding period. Given that this type of gift is essentially a trust, we think it is arguable that the trust consists of exactly the amount of the original gift. This would allow the charity to access increases in value and to expend those increases in value regardless of the encroachment limit applicable at any given time.
The second question posed of the CRA concerns encroachment on the capital of a ten-year gift to meet the disbursement quota where the terms of the gift permit encroachment. A charity is permitted to encroach on the capital of a ten-year gift within the minimum ten-year holding period to the extent of the amount determined for a taxation year by B.1 in the formula of its disbursement quota, i.e., the 3.5% disbursement quota requirement. There is nothing in the Income Tax Act which states a charity can only encroach where it cannot meet its disbursement quota. The response did not address this point.
The third question addresses the issue of a charity that has not tracked its capital gains pool and whether this inhibits its ability to encroach on the capital of an enduring property gift. A failure to track one’s capital gains pool does not inhibit a charity’s ability to encroach on capital as the rules permit encroachment on ten-year gifts up to the 3.5% disbursement quota requirement regardless of the capital gains pool balance. However, where a charity has not kept track of its capital gains pool or where the 3.5% disbursement quota requirement amount exceeds the balance of a charity’s capital gains pool, the charity will be limited in its ability to reduce its disbursement quota requirement. Tracking the capital gains pool allows a charity to reduce its obligation under element A.1 of the disbursement quota (i.e., enduring property spent or transferred to a qualified donee in a taxation year). If the charity does not track its capital gains pool, it will be unable to determine the amount of the reduction to which it is entitled.
Question four suggests charities should track every ten-year gift they receive separately. For a ten-year gift to meet the definition of enduring property and therefore be excluded from element A of the definition of disbursement quota (i.e., the total eligible amount of tax receipted gifts), each ten-year gift must be subject to a trust or direction that it be held for a minimum of ten years. This minimum holding period applies to each such gift received by a charity.
Question five confirms that to the extent a charity has a disbursement quota excess, it is not precluded from encroaching on the capital of its ten-year gifts, provided that it is otherwise permitted to do so by the terms of the gift. We should note that it is essential that the terms of the gift agreement provide this right; otherwise encroachment may not be permissible. Where encroachment is not permitted by the terms of a gift, a subsequent encroachment may taint the gift and it may no longer qualify as enduring property.
Question six deals with fund agreements that allow for encroachment on capital to cover administration fees and investment management fees. The CRA has stated in its response that this may be a concern and that such gifts may not qualify as ten-year gifts. Where the fund agreement allows the charity to encroach on capital to cover administration and investment management fees, provided that such fees will not exceed the permitted encroachment amount, these gifts may qualify as enduring property. However, if the administration and investment management fees exceed this amount, the CRA states that gifts may not qualify as ten-year gifts. We query the correctness to the CRA’s conclusion on this issue.
Question seven seeks to clarify whether encroachment amounts should be recognized on line 5710 of a charity’s T3010 Information Return as amounts of enduring property spent in a taxation year and whether these amounts will create an 80% disbursement quota requirement in the following year. The CRA clarifies that enduring property expended in a taxation year will impact the charity’s disbursement quota requirement in the taxation year in which the property is expended. Enduring property spent in the taxation year should be reported on line 5710 of the T3010 return. This will create an 80% disbursement quota requirement under element A.1 of the definition of disbursement quota. Thus, where a charity encroaches on the capital of a gift of enduring property, this amount should not be reported on line 5710. The CRA also notes that enduring property transferred to a qualified donee in a taxation year should be reported on line 5060 of the T3010 Return and that such a transfer will result in a 100% disbursement quota requirement. The analysis in this answer should apply to all types of enduring property.
Question eight deals with a charity’s inability to meet its disbursement quota in 2009 because of the current financial crisis. Where a charity has failed to meet its disbursement quota due to unforeseen circumstances that are beyond its control, the charity may apply for relief under subsection 149.1(5) of the Income Tax Act.
This relief will be granted only under extraordinary circumstances. The CRA directs readers to its policy CPC-029 for further information. This policy was released on March 20, 2009. A charity wishing to apply for such relief can do so on Form T2094. The CRA reminds charities that regardless of its disbursement quota status, the Income Tax Act requires that it file an annual information return in form T3010 within six months from the end of the charity’s taxation year. Please note that the CRA has recently released its new form T3010B, which must be used by all charities for fiscal years ending on or after January 1, 2009. For fiscal years ending after March 22, 2004 and up to and including December 31, 2008, charities must use form T3010A.
The final question deals with the treatment of an encroachment on a ten-year gift. Where the terms of an agreement permit the charity to expend a portion of the property gifted in excess of the permitted encroachment amount, the ten-year gift may not qualify as enduring property and 80% of the gift may be required to be included in component A of the formula for the charity’s disbursement quota in the taxation year subsequent to the year in which the gift was made. Where a portion of a ten year gift that qualifies as enduring property is expended, generally 80% of the amount spent and 100% of the amount transferred to qualified donees is required to be reflected in A.1 of the formula for the charity’s disbursement quota in the taxation year that the amount was expended or transferred. These rules would apply to a permitted encroachment on ten-year gift property.
In these difficult financial times, we have received many questions from our clients on a whole host of issues relating to endowed funds and the treatment of enduring property in those agreements. Charities faced with the issues outlined above, or others, are encouraged to contact us for assistance in this area as uncertainty continues to exist surrounding the definition of enduring property under the Income Tax Act.