Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: Did the corporation qualify for the tax exemption provided by paragraph 149(1)(l) of the Act for the years under review?
Position: It likely did not qualify.
Reasons: The Corporation may be operating for a profit purpose. Not clear if income is available for the personal benefit of members.
October 24, 2011
Compliance Programs Branch HEADQUARTERS
Specialty Audits Section Income Tax Rulings
Directorate
Attention: Rubin Dressler L. Zannese
(613) 957-2747
2011-040473
XXXXXXXXXX (the "Corporation")
We are writing in response to your request for our views as to whether the Corporation qualified for the tax exemption contained in paragraph 149(1)(l) of the Income Tax Act (the "Act") for the 2007 and 2008 taxation years. In particular, you asked us whether the large retained earnings reported by the Corporation indicates that the Corporation had a profit purpose during the years under review.
FACTS
Based on the information you have provided to us, our understanding of the facts is as follows:
- the Corporation was incorporated without share capital on XXXXXXXXXX , under XXXXXXXXXX ;
- the Corporation is a XXXXXXXXXX marketing association (a "MA") established by XXXXXXXXXX ("ACo");
- the members of the Corporation are XXXXXXXXXX (those who sell XXXXXXXXXX ACo products) located in the Corporation's geographical area;
- membership in the Corporation is voluntary;
- the Corporation does not charge membership fees;
- the object of the Corporation is to undertake the XXXXXXXXXX
- the Corporation's Articles of Incorporation require that the Corporation be carried on without "pecuniary gain to its members" and any profits be used to further its objectives;
- upon dissolution, any property of the Corporation remaining after the payment of all debts, is to be distributed to one or more registered charitable organizations as chosen by the members;
- the Corporation is party to an agreement with ACo (the "Agreement"). A blank copy of an earlier agreement was provided for our reference.
We note the following provisions:
- the XXXXXXXXXX and ACo agreed that it is mutually beneficial to promote the sales of XXXXXXXXXX through a program that will XXXXXXXXXX ;
- the added promotion is to be done through MAs which have been established by ACo based on marketing areas;
- the fund is established by ACo in accordance with the following terms and conditions:
- ACo will put aside funds each month based on the number of XXXXXXXXXX in that month;
- a portion of the funds will be remitted to the MAs, another portion will be remitted to each XXXXXXXXXX ;
- ACo will confirm the amounts paid on a monthly basis with the MAs;
- ACo will also contribute an amount to the MAs based on the amount of qualifying advertising they have previously undertaken;
- all expenditures from the MAs must be made with respect to one or more of the following:
- new XXXXXXXXXX advertising, XXXXXXXXXX ;
- XXXXXXXXXX advertising, XXXXXXXXXX ;
- point of sale items that enhance advertising programs;
- sponsorship of local special events including marketing activities related to XXXXXXXXXX shows;
- yellow page advertising; and
- consumer incentives that promote visits to a XXXXXXXXXX or encourage XXXXXXXXXX demonstrations provided that they are non-cash items and are limited to no more than XXXXXXXXXX ;
- only the first 2 bullets listed directly above qualify for contributions from ACo (i.e., only this advertising results in additional funds);
- the MAs are responsible for administering the funding received fairly and must conduct their promotional activities through one or more advertising agencies, subject to the approval of ACo;
- ACo is not required to contribute towards the administrative costs of operating the MAs. The funds for these expenses must come from "amounts contributed to the fund on behalf of the XXXXXXXXXX " (it is not clear to us what amount is paid on behalf of the XXXXXXXXXX and who is making this payment). The administrative expenses should not exceed 10% of annual expenditures;
- the MAs must submit a year-end statement of operations to ACo;
- a XXXXXXXXXX can still advertise on its own;
- ACo may withhold funds if the program is not being operated in accordance with the Agreement or if it is not in the best interests of ACo or the XXXXXXXXXX to continue with the program;
- the Agreement is in force until it is terminated; and
- upon termination of the Agreement, any funds in the MAs will be distributed in a manner determined by the MAs.
The Corporation's financial statements recorded the following amounts of cash, surplus and income:
- Year-end Balance of Cash and Deposits:
- 2008 - XXXXXXXXXX
- 2007 - XXXXXXXXXX
- 2006 - XXXXXXXXXX
- 2005 - XXXXXXXXXX
- 2008 - XXXXXXXXXX
- 2007 - XXXXXXXXXX
- 2006 - XXXXXXXXXX
- 2005 - XXXXXXXXXX
- 2008 - XXXXXXXXXX
- 2007 - XXXXXXXXXX
- 2006 - XXXXXXXXXX
- 2005 - XXXXXXXXXX
- The minutes of meetings held by the Corporation refer to a contingency fund for the purpose of covering spending over and above the approved media plan. There did not appear to be a method of calculating the amount that was to be retained in this fund. The balance of the contingency fund was approximately $XXXXXXXXXX at end of XXXXXXXXXX 2008. We understand that the contingency fund was not recorded separately from the retained earnings on the financial statements of the Corporation. It does not appear that the Corporation has ever needed to use the fund.
- The Corporation indicated that its plans for its retained earnings are either to transfer them to a new MA or, alternatively, if the contributions from ACo cease, to use this capital to continue advertising until the amount is depleted.
General
In general terms, paragraph 149(1)(l) of the Act provides that the taxable income of an organization is exempt from tax under Part I of the Act for a period throughout which the organization meets all of the following conditions:
- it is a club, society or association;
- it is not a charity;
- it is organized and operated exclusively for social welfare, civic improvement, pleasure, recreation or any other purpose except profit; and
- its income is not available for the personal benefit of a member or shareholder.
We understand that your concerns are that the Corporation was not operating exclusively for a purpose other than profit and that income was available for the personal benefit of its members.
Profit Purpose
A review of the incorporating documents of the Corporation indicates that it is organized exclusively for a purpose other than profit (advertising on behalf of its members without profit). However, we agree with the auditor that the Corporation appears not to have been operated exclusively for a purpose other than profit.
Under the Agreement, the Corporation obtains its revenue from ACo. Part of the revenue is based on the number of XXXXXXXXXX each month to the XXXXXXXXXX who are members of the Corporation. The other revenue from ACo depends on the amount of advertising expenses incurred by the Corporation. Once the Corporation spends a certain amount on advertising, ACo contributes an additional sum to the Corporation. Thus, the more advertising undertaken by the Corporation, the more revenue the Corporation earns. It does not appear that the latter revenue stream is in any way connected to the costs incurred by the Corporation to fulfill its objectives. This funding mechanism almost inevitably ensures that the Corporation will have revenue in excess of expenses, so that net income will accumulate in the Corporation.
XXXXXXXXXX
An organization claiming a paragraph 149(1)(l) exemption can earn a profit, as long as the profit is incidental and arises from activities directly connected to its not-for-profit objectives. The net income reported by the Corporation resulted from activities undertaken to support its not-for-profit objectives (advertising on behalf of members). However, it appears that
(i) the net income was consistent and material, suggesting a profit purpose; and
(ii) there is no plan or need to spend the net income (and no indication of any need for a large operating reserve), suggesting that the net income is being allowed to accumulate for the purpose of earning investment income or for the purpose of creating a capital amount out of an amount that ACo may be claiming as an expense (or both).
Further to the above comments, we refer you to paragraphs 8 and 9 of Interpretation Bulletin IT-496, "Non-Profit Organizations":
"8. An association may earn income in excess of its expenditures provided the requirements of the Act are met. The excess may result from the activity for which it was organized or from some other activity. However, if a material part of the excess is accumulated each year and the balance of accumulated excess at any time is greater than the association's reasonable needs to carry on its non-profit activities (see paragraph 9), profit will be considered to be one of the purposes for which the association was operated. This will be particularly so where assets representing the accumulated excess are used for purposes unrelated to its objects such as the following:
(a) long-term investments to produce property income;
(b) enlarging or expanding facilities used for normal commercial operations; or
(c) loans to members, shareholders or non-exempt persons.
"This may also be the case where the accumulated excess is invested in a term deposit or guaranteed investment certificate that is regularly renewed within a year and from year to year, whether or not the principal is adjusted from time to time.
"9. The amount of accumulated excess income considered reasonable in relation to the needs of an association to carry on its non-profit activities and goals is a question of fact to be determined with regard to the association's particular circumstances, including such things as future anticipated expenditures and the amount and pattern of receipts from various sources (e.g., fund raising, membership fees, training course fees). For example, it is conceivable that there would be situations where an accumulation equal to one year's reasonably anticipated expenditures on its non-profit activities may not be considered excessive, while in another situation, an accumulation equal to the reasonably anticipated expenditures for a much shorter period would be considered more than adequate. Where the present balance of accumulated excess is considered excessive or an annual excess is regularly accumulated that is greater than an associations needs to carry on its non-profit activities (see paragraph 8), it may indicate that the association's aims are two-fold: to earn profits and to carry out its non-profit purposes. In such a case, the operated exclusively requirement in paragraph 149(1)(l) would not be met."
In our view, the large amount of retained earnings suggests that the Corporation has not operated exclusively for any purpose except profit. XXXXXXXXXX . The amount accumulated does not appear to represent a reasonable operating reserve. The Corporation has accumulated a large fund from which it can earn investment income. Essentially, the Corporation consistently receives more revenue than it need to fulfill its objectives due to the funding mechanism contained in the Agreement.
Income to Members
It is not clear whether the Corporation satisfied the condition that no income be available for the personal benefit of members. There are many professional and trade groups that belong to associations set up for their benefit. However, in most of these cases, the members pay a fee for membership and in return receive services from the association. This case may be different, as the income of the Corporation appears to come from ACo, not its members. It is not clear whether the amounts contributed by ACo are amounts that have been redirected at the instruction of the members. ACo contributes both an amount based on XXXXXXXXXX to the XXXXXXXXXX and an amount based on past advertising done by the Corporation. If the amounts contributed by ACo cannot be regarded as income from members, then there is a technical concern that the Corporation's income is available for the personal benefit of members when it advertises on their behalf. You may wish to advise the Corporation of this issue.
Please contact us if we may be of further assistance.
Yours truly,
Eliza Erskine
Manager
Non-Profit Organizations and Aboriginal Issues
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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