Are Canadian Nonprofits & Charities Allowed to Distribute Profits to Their Members?

When a charity in Canada decides to dissolve or wind up its operations, a crucial question arises: How should it distribute its assets without jeopardizing its tax-exempt status? The Canada Revenue Agency (CRA) recently issued a ruling that sheds light on this important topic. This article will break down the key points of this ruling, explain the implications for charities, and provide guidance on how to navigate these complex rules.

Understanding the Legal Framework for Charities in Canada

First, it's essential to clarify what type of organization we are discussing. In Canada, a charity is a tax-exempt entity as defined under paragraph 149(1)(l) of the Income Tax Act. Unlike a for-profit organization, a charity must operate exclusively for purposes other than profit. Additionally, no part of the organization's income should be paid out or made available for the personal benefit of any member, proprietor, or shareholder. An exception to this rule exists only for organizations that promote amateur athletics in Canada.

The CRA Ruling: What Prompted the Discussion?

The CRA's ruling was in response to a charity that had acquired shares of a private company at a nominal cost, which then significantly appreciated in value. The charity wanted to distribute these shares or the proceeds from their sale to some of its members before or during its dissolution. The central question was whether such a distribution would cause the charity to lose its tax-exempt status.

Distributing Capital Gains: What Are the Rules?

One critical aspect of the CRA's ruling revolves around the distribution of capital gains. Charities must be cautious when dealing with investments or assets, as using them for purposes unrelated to the organization's objectives can threaten their tax-exempt status. Holding onto investments, like shares, for an extended period might be seen as operating for profit, which is not allowed.

When it comes to distributing the proceeds from the sale of such investments, the CRA clarified an important point: capital gains, whether taxable or non-taxable, do not count as "income" under paragraph 149(1)(l). This distinction is crucial because income cannot be distributed to members without risking the charity's tax-exempt status. Therefore, a charity can distribute its capital or capital gains to members while retaining its tax-exempt status, provided it does not distribute any portion considered income.

Distributing Assets During Wind-Up: What Are the Limitations?

Even during the wind-up process, the rule against distributing income to members remains in effect. The only exception is for members that meet the specific criteria related to promoting amateur athletics in Canada. For all other members, the charity cannot distribute any income, regardless of their tax-exempt status or whether they are qualified donees.

This rule also applies to the distribution of assets during wind-up. If distributing these assets would result in any portion of the income being shared with members, the charity could lose its tax-exempt status.

Consequences of Losing Tax-Exempt Status

Losing tax-exempt status has significant consequences for a charity. According to the CRA, if a charity undertakes an action that disqualifies it from its tax-exempt status, a series of events is triggered immediately:

1. Deemed Disposition of Assets: The charity is deemed to have sold all its assets and reacquired them at fair market value while still tax-exempt.
2. Loss of Tax-Exempt Status: The charity then loses its tax-exempt status.
3. Reduction of Capital Dividend Account: Finally, any amount added to the capital dividend account due to the deemed disposition is reduced to zero, meaning it cannot be paid out to members.

Can Distributions Be Characterized as Gifts?

Some charities might consider characterizing distributions to members as "gifts" to circumvent the rules. However, the CRA's ruling clarifies that this approach is rarely viable. The CRA will closely scrutinize the circumstances surrounding the distribution, including the type of charity, the nature of the payment, its timing, and its purpose.

For incorporated charities, the CRA is likely to view such payments as shareholder benefits, given that members of non-share capital corporations are treated as shareholders for this purpose. If the charity is unincorporated, the nature of the payout will depend on its context. For example, during a wind-up, a payout could be considered compensation for the member's rights, resulting in a capital gain for the member.

However, even if the distribution is genuinely a gift, if it forms part of the charity's income, distributing it to members will still cause the organization to lose its tax-exempt status.

Navigating the rules around asset distribution and maintaining tax-exempt status can be complex for Canadian charities. The CRA's ruling offers valuable guidance but also highlights the risks involved if a charity is considering any payout to members, whether before or during a wind-up, it is essential to keep the statutory definition of a tax-exempt charity in mind and seek expert advice to ensure compliance with the law.

By understanding and following these rules, charities can avoid the significant tax consequences that come with losing their tax-exempt status, ensuring they continue to serve their communities effectively. This detailed guide is designed to help Canadian charities navigate the complex regulations surrounding asset distribution and tax-exempt status. It emphasizes the importance of careful planning and consultation with legal and tax professionals to ensure compliance with the law.

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