New Tax Rules Introduced for Charities
On March 23, 2004, Finance Minister Ralph Goodale tabled the 2004 Federal Budget. The budget contains numerous proposals related to the administrative and regulatory framework for registered charities which have not been significantly updated since 1983. The proposals are in response to the March 2003 Joint Regulatory Table report "Strengthening Canada's Charitable Sector: Regulatory Reform", which included 75 recommendations for improvements to the tax rules governing charities. The purpose of the report was to uphold the integrity of the tax rules that apply to charities and build the public trust in the work of charities. According to the Canada Revenue Agency (CRA), 60 changes were fully supported, 9 were partially accepted and only 6 will not be pursued.
The budget proposals can be broken down into four categories, as follows:
- A new compliance regime;
- An objection and appeals system that is more in line with the rules for taxpayers in general;
- An improved system of providing information to the public on charities; and
- Substantial changes to the disbursement quota rules.
Most of the rules will be effective for taxation years that begin after March 22, 2004. Therefore, for charities with a calendar year-end, the new system will be operational beginning on January 1, 2005. Although many of the changes will be beneficial to registered charities, some changes will force affected charities to change their practices and procedures.
The following is a summary of the more important items of interest.
New compliance rules and penalties
New penalties and sanctions
Under current rules, the only sanction available to apply against a registered charity that does not comply with tax rules and regulations is the deregistration of the charity. This results in a loss of tax-exempt status and the ability to issue tax receipts. A deregistered charity must also transfer its assets within one year from its revocation to one or more registered charities (any remaining property passes to the government - referred to as a "revocation tax").
Due to the harshness of these rules, deregistration is rarely imposed. However, the government is determined that all rules must be enforced, and therefore a number of intermediate taxes and penalties have been proposed. The main sanctions are as follows:
Revenue from prohibited activities that generate income will be taxed - This tax will apply to:
- Private foundations that carry on a business activity;
- Charitable organizations and public foundations that carry on unrelated business activities; and
- Foundations that acquire control of a corporation through means other than those allowed under the existing tax rules.
Suspension of tax-receipting privileges for use of donated funds for other than charitable purposes - Where the penalty applies, the charity will be prohibited from issuing official receipts to donors and receiving funds from other charitable organizations for a period of one year. The charity will also be required to advise potential donors of its suspension. All of a suspended charity's administrative and regulatory obligations will continue during the suspension period. A common situation where this penalty will apply is where a registered charity provides undue benefits to its trustees.
Penalties for failure to file an annual information return on time - Registered charities currently have six months from the end of their fiscal year to file an annual information return. Where a return and the other required information is not filed on time, monetary penalties will apply. In addition, the names of late-filers and non-filers will be published. Where a demand to file is issued by the Minister of National Revenue, and a return is still not filed, the charity will have its registration revoked. Revoked charities will be allowed to apply for re-registration within one year provided they file the missing returns, pay all outstanding penalties and other taxes, and otherwise comply with the tax rules. Otherwise, a revoked charity will be subject to the revocation tax. A number of other sanctions and penalties have been proposed and they are set out in the appendix to this tax bulletin.
These changes will apply in respect of taxation years that begin after March 22, 2004.
For all penalties and sanctions, charities will have the right to object to the Minister, and subsequently, to appeal to the Tax Court of Canada. Changes to the objection and appeal process are discussed later in this bulletin.
Payment of penalties and sanctions
To ensure the new penalties and sanctions do not deprive the charity sector of funds, the payment of a penalty will generally be satisfied by a transfer of the amount of the penalty or sanction to another charity (where the amount exceeds $1,000). Only gifts to an "eligible donee" will count. An eligible donee is a registered charity that meets the following conditions:
- The charity itself is not subject to any tax, penalties or suspensions at the time;
- It is not subject to a certificate pursuant to the Charities Registration (Security Information) Act; and
- More than 50% of the members of the donee's board of directors or trustees deal at arms' length with each member of the board of directors or trustees of the charity that has been penalized or sanctioned.
Revocation of charitable status
The government will retain the right to revoke the registered status of a charity for severe breaches of the tax rules including continued, repeated or cumulative infractions, and in cases where it is clear that the organization is being operated for purposes that are not charitable. In addition, it is proposed that revocation can occur where the charity obtained its registration under false pretenses.
The "revocation tax" will also be amended. Currently, where charitable status has been revoked, the charity has one year to divert assets by way of gift to registered charities or other qualified donees. Any assets remaining then revert to the Crown as a tax. It is proposed that the rules will be tightened to ensure that gifts can only be made to the eligible donees described above. This change will prevent revoked organizations from making gifts to non-resident organizations.
To protect assets from misuse during the one year revocation period, it is proposed that the organization's assets will be effectively frozen. However, transfers to eligible donees will still be allowed.
Annulments
The rules will also be amended to provide explicit authority to the federal government to annul an organization's registration in circumstances where the organization was registered in error. However, consistent with current practices where status is annulled under administrative law, a revocation tax will not be applied and official receipts issued prior to the annulment will be honoured.
Measures relating to revocation and annulment will apply to notices issued by the Minister of National Revenue after the later of December 31, 2004 and 30 days after these proposals receive Royal Assent.
New objection and appeal procedures
Under current rules, where a registered charity or applicant for registration disagrees with a decision of the CRA, the next step is to appeal the decision to the Federal Court of Appeal. Under the budget proposals, greater access to the appeals process will be given to charities and applicants in two respects. First, an impartial internal CRA objection process for matters affecting charities will be established (as discussed below). In addition, appeals of taxes and intermediate penalties are to be made to the Tax Court of Canada rather than the Federal Court of Appeal. However, appeals of registration, revocation and annulment decisions will continue to be directed to the Federal Court of Appeal.
Objection process to be introduced
Under current rules, charities and applicants do not have access to the objection process that is available to taxpayers in general. Consequently, it is proposed that the current objection process will be extended to include situations where:
- An application for registration has been denied;
- A charity's status has been revoked or annulled;
- Designations are made by the CRA as to whether a registered charity is a private or public foundation or it is one that is directly involved with charitable programs and services; or
- Any tax or penalty has been imposed.
The usual rules for objections will apply:
- A Notice of Objection will have to be filed within 90 days from the issuance by the CRA of the notice of assessment that is the subject of the objection;
- The results of the review will be required to be communicated to the organization in writing; and
- Affected parties must use the objection process before an appeal may be made to court.
New public disclosure rules
Although the Canadian public currently has access to a variety of information about registered charities, the information available will be broadened under the budget proposals. In addition to the proposals discussed below, the CRA will develop a public awareness program whereby more information will be distributed to the public and the charitable organization sector. In addition, the CRA will give charities a stronger voice in setting future charity administration through the new Charities Advisory Committee. The committee will be composed of sector representatives who will provide advice and recommendations to the CRA.
More information to be made available
Effective for information submitted to the government after 2004, the CRA will be authorized to release the following additional information to the public:
- Financial statements that are filed with the charity's annual information returns;
- Letters sent by the CRA to a charity relating to the grounds for annulment of the charity's registration;
- The CRA's decisions regarding a notice of objection filed by a registered charity;
- Any information filed in support of an application for special status or an exemption under the tax rules, as well as any responses from the CRA on the application (for example, requests for permission to accumulate assets); and
- The identification of a registered charity on which a sanction has been imposed, the type of sanction imposed, and the letter sent to the charity relating to the grounds for the sanction.
Information on denials of registration
Each year, many prospective charitable organizations are denied status as a registered charity. Consequently, as a service to the charitable sector and the public, the CRA will make more information available on denied requests while protecting the identity of those who applied. In particular, the following information will be provided in respect of a denied registration:
- The governing documents of the organization, including the organization's statement of purpose;
- Information disclosed by the organization in the course of making the application;
- A copy of the notice of denial in respect of the organization; and
- A copy of the decision, if any, of the CRA's Appeals Branch regarding a notice of objection, if filed by the organization.
Donation receipt disclosure
Charities are currently required to include certain specific information on official receipts such as details about the charity and the donor, the eligible amount in respect of the gift and the date of the gift. The government has proposed that the name and website address of the CRA must appear on the receipt, presumably so donors have access to information on charitable donations. This requirement will apply for donation receipts issued after 2004.
New disbursement quota rules
Under current rules, a charity is required to disburse a portion of donations received for charitable purposes - referred to as the disbursement quota rules. An overview of these rules is provided in the chart below.
Overview of Current Disbursement Quota Rules |
A registered charity must annually disburse an amount by expending amounts on the delivery of its own charitable programs and services, or by transferring funds to other registered charities/qualified donees. The current disbursement quotas are as follows:
For charitable organizations:
¨ 80% of tax-receipted donations (other than endowments) received by it in the previous year.
¨ 80% of the proceeds from the disposition of endowments in the current year.
For charitable foundations:
¨ 4.5% of the fair market value of its capital assets (generally investments) that are not used directly in charitable activities or administration.
¨ For private charitable foundations, 100% of amounts received by it from other registered charities.
¨ For public foundations, 80% of amounts received by it from other registered charities. |
Several proposed changes to these rules were announced and are summarized below:
Disbursement quota rate on capital assets reduced
Currently, public and private foundations are required to disburse 4.5% of the average value of capital assets over the previous 24 months. The principle is that this rule will require the foundation to disburse investment income that was either earned, or could have been earned, on charitable activities. Given that most foundations have not been able to earn such a return in recent years due to low interest rates, they have had to dispose of investment assets to meet this quota. To help foundations reduce capital encroachments, it is proposed that the 4.5% quota rate will be reduced to 3.5% for taxation years beginning after March 22, 2004. In addition, the quota rate will be reviewed periodically to ensure it is reasonable.
Disbursement quota - realized capital gains
Where a foundation invests in assets providing capital appreciation rather than interest or dividends, problems can arise where investments are sold to meet the current 4.5% disbursement quota. Specifically, an expenditure of the proceeds is subject to the 80% disbursement quota rule, meaning that only 20% of the proceeds can effectively be used to meet the 4.5% quota rule.
To help foundations investing in appreciating assets, the 80% disbursement requirement applying to the expenditure of proceeds from these dispositions will be reduced to the lesser of 80% of the capital gains realized on these dispositions and 3.5% of the value of all property not used directly in charitable activities or administration. This proposal will apply to taxation years beginning after March 22, 2004.
Charitable organizations subject to 3.5% disbursement quota
When the current rules were set, recognition was given to the fact that most capital gifts were made to public and private foundations. Consequently, only these foundations were subject to the 4.5% quota (which will be reduced to 3.5%).
However, given that charitable organizations are receiving capital gifts with greater frequency, there is currently a bias against foundations receiving these gifts. Accordingly, it is proposed that charitable organizations will be subject to the 3.5% quota. For organizations registered after March 22, 2004, the proposal will apply immediately. In the case of organizations registered before March 23, 2004, this proposal will apply to taxations years beginning after 2008.
Transfers between charities
Under current rules, both charitable organizations and charitable foundations may receive funds transferred from other charities and count these transfers against their disbursement quota. In the case of recipient foundations, they must expend the transferred amount as part of their disbursement quota requirement (80% for public foundations and 100% for private foundations). However, where the recipient is a charitable organization, the transfer is not taken into account in calculating its disbursement quota.
To again make the rules consistent for all charities, transfers received by charitable organizations will be subject to their 80% disbursement quota.
This rule will not apply to "10-year" gifts (gifts subject to a condition that the gift be held by the charity for a period of 10 years or more). Where a 10-year gift is transferred to another charity, it will be treated as though the gift was made to the transferee charity by the original donor. Both transfer changes will apply to taxation years beginning after March 22, 2004.
Charities named as insurance or retirement plan beneficiaries
For gifts made after 1998, the tax rules for donors were changed so that where a charity is named as beneficiary of an RRSP, RRIF or insurance policy, the amount transferred after death would be treated as a bequest made by the taxpayer. This strategy is useful as the plan or policy proceeds will not be subject to probate tax.
However, from the point of view of a charity, these gifts do pose a problem, as there is a concern that the amount was not "a gift of capital received by way of bequest or inheritance" (as such gifts are subject to the 3.5% quota). Also, it would not be possible to impose restrictions to make the amount a 10-year gift. Therefore, such a gift appears to be subject to the disbursement quota rules for regular gifts.
To provide relief to charities receiving gifts through direct designations, it is proposed that these gifts will automatically be considered to be capital gifts by way of bequest or inheritance, and therefore, will only be subject to the 3.5% disbursement quota.
As a technical change, where a capital gift by way of bequest is received, the regular disbursement quota rules will apply where the gift is spent in the year of receipt. Both changes will apply for taxation years beginning after March 22, 2004.
Conclusion
Although many of the proposals are beneficial to charities, some of the changes will force charities to make major changes in the way they operate. Consequently, charities should start planning now for the application of these proposals. Your BDO advisor is ready to help.
This bulletin is a publication of BDO Dunwoody LLP on developments in the area of taxation. This material is general in nature and should not be relied upon to replace the requirement for specific professional advice. The information in this bulletin is current as of March 23, 2004.
© 2004 BDO Dunwoody LLP
Appendix: Registered Charities: Intermediate Taxes and Penalties |
| |
Tax or Penalty
(Unless registration of the charity is revoked) |
| Infraction |
First infraction |
Repeat infraction (Repeated acts or omissions will increase the probability of revocation) |
| Late filing of annual information return |
$500 penalty |
$500 penalty |
| Issuing of receipts with incomplete information |
5% penalty on the eligible amount stated on the receipt |
10% penalty on the eligible amount stated on the receipt |
| Failure to comply with certain verification and enforcement sections of the Income Tax Act, e.g. keeping proper books and records |
Suspension of tax-receipting privileges |
Suspension of tax-receipting privileges
|
| Charitable organization or public foundation carrying on an unrelated business |
5% tax on gross unrelated business revenue earned in a taxation year |
100% tax on gross unrelated business revenue earned in a taxation year and suspension of tax-receipting privileges |
Private foundation carrying on any business
|
5% tax on gross business revenue earned in a taxation year
|
100% tax on gross business revenue earned in a taxation year, and suspension of tax-receipting privileges |
| Foundation acquires control of a corporation |
5% tax on dividends paid to the charity by the corporation |
100% tax on dividends paid to the charity by the corporation |
| Undue personal benefit provided by a charity to any person. For example, a transfer to a person who does not deal at arm’s length with the charity or who is the beneficiary of a transfer because of a special relationship with a donor or a charity |
105% tax on the amount of undue benefit |
110% tax on the amount of undue benefit and suspension of tax-receipting privileges |
| A gift that is restricted under subsections 149.1(2), (3) or (4) of the Income Tax Act |
105% tax on the amount of the gift |
110% tax on the amount of the gift |
| Issuing receipts in a taxation year for eligible amounts that in total do not exceed $20,000 if there is no gift or if the receipt contains false information |
125% tax on the eligible amount stated on the receipt |
125% tax on the eligible amount stated on the receipt |
| Issuing receipts in a taxation year for eligible amounts that in total exceed $20,000, if there is no gift or if the receipt or if the receipt contains false information |
Suspension of tax-receipting privileges and 125% tax on the eligible amount stated on the receipt |
Suspension of tax-receipting privileges and 125% tax on the eligible amount stated on the receipt
|
| Delaying expenditure of amounts on charitable activities through the transfer of funds to another registered charity |
The charities involved are jointly and severally, or solidarily, liable for the amounts so transferred plus a 10% tax on those amounts |
The charities involved are jointly and severally, or solidarily, liable for the amounts so transferred plus a 10% tax on those amounts |
Notes:
These intermediate sanctions will not prevent application of the current provisions, which allow the Minister of National Revenue to revoke the registration of a charity in respect of any of the above infractions. For example, failure to file an information return may result in revocation of registered status upon a first infraction.
This chart does not include infractions for which no tax or penalty would be assessed, yet which would lead to revocation, e.g. ceasing to conduct charitable activities.
Taxes and penalties will be assessed in aggregate for a taxation year.
A repeat infraction is an action in a taxation year that gives rise to a tax or penalty in respect of which an assessment was previously raised for a preceding taxation year.
Rules of general application may also apply in addition to the sanctions referred to above, e.g. the failure to keep proper books and records is an offence punishable by a fine or imprisonment.
Source: Federal Department of Finance: 2004 Budget Papers
