A. INTRODUCTION
The term “enduring property” was introduced
in the 2004 federal budget (which became law in 2005) and
has a substantial impact on the calculation of the disbursement
quota of charities and the ability of charities to encroach
on ten-year gifts to meet its 3.5% disbursement quota.
Since the introduction of this term and other new rules
on the disbursement quota, there have been many questions
from the sector on the treatment of enduring property for
disbursement quota purposes. On April 20, 2009, Canada Revenue
Agency (“CRA”) released a document entitled “Treatment of
Enduring Property for Purposes of the Disbursement Quota”
(the “CRA Document”),
setting out answers to nine frequently asked questions on
this issue. Instead of repeating these nine questions and
answers, which are self-explanatory, this article explains
what an enduring property is and reviews principles that
apply to how enduring property is treated for disbursement
quota purposes,
as clarified by CRA’s questions and answers. Once the principles
are understood, they can be applied to different scenarios.
B. WHAT IS AN ENDURING PROPERTY?
The term “enduring property” is defined
in section 149.1(1) of the Income Tax Act (Canada)
(the “Act”). Enduring property includes four types of properties.
First, an enduring property includes
gifts received by a charity by way of bequest or inheritance
(including life insurance proceeds, RRSPs, and RRIFs by
direct beneficiary designation). Second, an enduring property
includes “ten-year gifts” received by a charity from a donor,
as explained further below. Third, an enduring property
includes a bequest/inheritance or a ten-year gift that has
been transferred from the charity that originally received
them to another charity. In other words, when a bequest/inheritance
or a ten-year gift is transferred from one charity to another,
the property would continue to be tracked as an enduring
property.
Fourth, an enduring property includes
gifts received by a charitable organization (but not a foundation)
from another registered charity, where (1) the majority
of directors and trustees of the donor charity deal at arm’s
length with the recipient charitable organization, (2) the
gift is subject to a trust or direction requiring that the
gift be utilized within five years, and (3) the gift must
be used to acquire tangible capital property to be used
directly in the recipient charity’s charitable activities
or administration, or to be used in a charitable activity
that could not reasonably be completed within one year after
having received the gift. This type of enduring property
is sometimes referred to as “five-year gifts.”
C. TEN-YEAR GIFTS
A ten-year gift is a gift that is subject
to a trust or direction imposed by the donor, requiring
the gift (or property substituted for the gift) be held
by the charity for a period of time that is at least ten
years from the date when the gift was made (the “hold period”).
If this charity transfers the ten-gift to another charity
during the hold period, the said trust or direction would
also be binding on the transferee charity. The Act also
allows the trust or direction to permit the original charity
or the transferee charity to expend the ten-year gift before
the end of the hold period to the extent of an amount determined
for the charity’s 3.5% disbursement quota. CRA repeatedly
stressed in a number of its responses in the CRA Document
that in order to qualify as a ten-year gift, the trust/direction
must restrict the encroachment up to the charity’s 3.5%
disbursement quota.
It is necessary for a charity to track
each ten-year gift separately in order to determine when
the hold periods in each case would expire. This is confirmed
by CRA’s answer to question 4 in the CRA Document. This
tracking is necessary in all situations, even though it
is possible that a charity’s endowment fund may consist
of various ten-year gifts donated at different points in
time and it is possible for donors to impose different hold
periods to each of these ten-year gifts. For example, a
donor, John Doe, donates $100,000 to a named John Doe Fund
in year 1 and instructs the charity to not to disburse the
gift for 20 years; then the donor’s son donates another
$5,000 to the John Doe Fund in year 3 and requires the charity
to hold the gift for 15 years. Both of these gifts are ten-year
gifts. However, the charity may not disburse the capital
of the first gift until year 21, but the charity may disburse
the capital of the second gift in year 18.
D. 80% AND 3.5% DISBURSEMENT QUOTA
An enduring property is generally excluded
from the 80% disbursement quota (under A of the formula
for calculating disbursement quota)
in the year it is received. This means that the charity
would not be required to expend 80% of the enduring property
in the following year. However, the enduring property would
be included in calculating the charity’s disbursement quota
(under A.1 of the formula for calculating disbursement quota)
in the year in which it is spent or transferred to a qualified
donee. In this regard, CRA clarified in its response to
question 7 in the CRA Document that enduring property expended
in a taxation year will impact the charity’s disbursement
quota requirement in the same taxation year in which
the property is expended, but it would not create an 80%
disbursement quota requirement in the following year.
Specifically, this means that upon the
expenditure of an enduring property, the expenditure will
create a disbursement quota obligation on the charity so
that it is required to expend 80% of the enduring property
in the year of the expenditure (not the following year)
under A.1(a)(i) of the disbursement quota formula. The disbursement
quota obligation so created would be met by the expenditure
itself in that same year.
If, instead of expending an enduring
property on the charity’s charitable programs, the enduring
property is transferred to a qualified donee (e.g. another
registered charity), then the transfer would create a 100%
disbursement quota in the year under A.1(a)(ii) of the disbursement
quota formula, which would also be met by the transfer itself.
With respect to the transferee charity, the receipt of the
enduring property would not create a disbursement quota
obligation on the charity because enduring property is not
included in B in the disbursement quota formula. However,
the enduring property would create a disbursement quota
obligation when it was subsequently expended or transferred
to a qualified donee.
When an enduring property is not used
directly in the charity’s charitable activities or administration
(where a ten-year gift is invested by the charity during
the hold period), it would need to be included in the charity’s
3.5% disbursement quota calculation.
E. ENCROACHMENT OF TEN-YEAR GIFTS AND CAPITAL GAINS POOL
1.
Donor permission for encroachment and capital
gains pool
It is possible
for a ten-year gift to be subject to a trust or direction
to permit the original recipient charity (or a subsequent
transferee charity) to expend the ten-year gift before the
end of the specified hold period to the extent of an amount
determined for the charity’s 3.5% disbursement quota. In
other words, where a ten-year gift is not subject to a donor’s
trust or direction permitting encroachment, it would not
be permissible to encroach on the ten-year gift at all.
This is confirmed in CRA’s response to question 2 in the
CRA Document.
As long as
the encroachment on a charity’s ten-year gifts does not
exceed what is in the charity’s “capital gains pool,” the
Act permits the entire amount encroached to be applied towards
meeting the charity’s 3.5% disbursement quota. The capital
gains pool is a notional account of all realized capital
gains derived from the disposition of a charity’s enduring
property. This is effected by allowing a charity to reduce
the 80% disbursement quota obligation in A.1 of the disbursement
quota (as explained above) by an amount claimed by the charity
that does not exceed the lesser of 3.5% disbursement quota
and the charity’s capital gains pool.
Since a donor’s
trust/direction may allow a charity to encroach on a ten-year
gift up to 3.5% of the disbursement quota, it is conceptually
possible that the encroachment on a ten-year gift for the
purpose of meeting its 3.5% disbursement quota may in fact
exceed what is in the charity’s capital gains pool. However,
in that situation, the encroachment that is beyond the capital
gains pool (the “excess amount”) would be included in A.1
of the disbursement quota and therefore create a disbursement
quota obligation on the charity. The charity would thus
be required to expend 80% of the excess amount in the year
under A.1(a)(i) of the disbursement quota formula, which
disbursement quota obligation so created would be met by
the expenditure itself in that same year. This would only
leave 20% of the excess amount available towards meeting
the 3.5% disbursement quota.
Capital gains
from the disposition of all enduring property can
be included in the capital gains pool, including bequest
and inheritance, ten-year gifts and five-year gifts, as
explained above. However, the Act states that capital gains
from a disposition of a bequest or inheritance received
by the charity before 1994 cannot be included.
A charity
would also need to be careful with the type of encroachment
permitted by the donor’s trust and direction in order to
ensure that the permission would not jeopardize the donated
property being qualified as a ten-year gift. The trust/direction
must limit the encroachment to meeting the charity’s 3.5%
disbursement quota. In situations where the trust/direction
permits a charity to encroach on capital to cover its administration
fees and investment management fees, this is permissible
provided that the trust/direction restricts the encroachment
for such fees up to the charity’s 3.5% disbursement quota.
However, if the permitted encroachment is not limited to
such a cap, CRA’s response to question 6 in the CRA Document
indicates that the gift would not qualify as a ten-year
gift in the first place. In other words, in order to qualify
as a ten-year gift, the trust/direction must restrict the
encroachment up to the charity’s 3.5% disbursement quota.
Furthermore, CRA clarified in question 6 that any encroachment
on capital will factor into the disbursement quota calculation
and that amounts spent on administration and investment
management fees are not charitable expenditures and cannot
be used to satisfy the disbursement quota.
The Act is
silent in relation to the encroachment of bequests and inheritance
because such issues would be governed by the terms of the
testamentary instruments creating such gifts.
2.
Charity’s discretion to encroach
A charity
can decide when and whether to encroach on
its ten-year gifts in order to meet its 3.5% disbursement
quota, and if there is an encroachment, how much
to encroach.
CRA’s response to question 5 in the CRA Document clarified
that even where a charity has disbursement excess, the charity
has the discretion to encroach on the ten-year gifts in
meeting its 3.5% disbursement quota, provided that the terms
of the ten-year gift permits encroachment.
3.
Realized capital gains and notional account
It is important
to note that the capital gains pool consists only of capital
gains realized on the disposition of enduring property.
Unrealized capital gains are not included. Since only realized
capital gains are included in the capital gains pool, in
some circumstances it may be beneficial for a charity to
dispose of its investment assets at a time when the market
is high in order to maximize the amount of realized capital
gains in the pool available for future encroachment when
required.
The capital
gains pool is a notional account of all realized
capital gains derived from the disposition of enduring property.
As such, just because amounts are tracked in the notional
account of the capital gains pool, this does not necessarily
mean that funds are available for disbursement, especially
in situations where there is a loss in the value of an enduring
property as a result of a down turn in the market.
4.
Tracking of capital gains pool and declaration
in T3010
Charities
should declare its capital gains pool in its annual T3010
Information Return. The Explanatory Notes to Bill C-33 indicate
that that “annual calculation of additions to and deductions
from the capital gains pool is voluntary; however, it may
be of benefit to a charity to make this calculation if it
expects to ever claim a reduction of its disbursement quota
in respect of the expenditure of enduring property.” In
other words, regardless of whether a charity expects to
utilize its capital gains pool in the year, it should make
its annual calculation and declare such amount on an annual
basis on its T3010 Information Return in order to be able
to utilize its capital gains pool if and when it wishes
to do so in the future.
In CRA’s
response to question 3 in the CRA Document, CRA indicated
that if a charity does not track its capital gains pools,
it will inhibit its ability to encroach on enduring property.
CRA explained that tracking the capital gains pool allows
a charity to reduce its 80% disbursement quota obligation
under A.1 of the disbursement quota formula (i.e., enduring
property spent or transferred to a qualified donee in a
taxation year). Therefore, if a charity does not track its
capital gains pools, it will be unable to determine the
amount of the reduction that it is entitled to. As such,
while the annual calculation of the capital gains pool is
voluntary, CRA recommended that charities declare their
capital gains realized on the disposition of enduring property
so that they would be able to calculate and claim a reduction
in the disbursement quota in a subsequent taxation year.
5.
The need to distinguish between income and
capital
It is possible
that some fund agreements do not distinguish the earnings
on the endowment portfolios between interest, dividends,
and realized and unrealized capital gains, but instead considers
all of them as current earnings, while the capital refers
to the dollar value of the original gift. CRA’s response
to question 1 in the CRA Document indicated that in such
situations, such gifts may not qualify as ten-year gifts.
CRA explained that both 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 the holding period. Therefore, where
the fund agreements allow a charity to expend these capital
gains (both realized and unrealized) prior to the end of
the ten‑year period, the gift may not qualify as a
ten-year gift in the first place, unless such expenditures
do not exceed the charity’s 3.5% disbursement quota.
The continuing
focus on distinguishing between what is capital and what
is income is interesting in the context of charities and
disbursement quota calculations. This distinction is well
known to trust lawyers and trustees who need to ascertain
the respective rights and entitlements of income beneficiaries
on the one hand and capital beneficiaries on the other hand.
However, the distinction between income and capital is difficult
for charities to understand and is often ignored. New investment
vehicles, such as mutual funds, which provide blended income
and capital payments do not lend themselves easily to determining
what is income and what is capital and as such, the tracking
of the capital gains pool by charities may prove to be challenging
for charities.
6.
Encroachment and collapsing a ten-year gift
Prior to
Bill C-33, CRA took the position that if all or any portion
of the capital of a ten-year gift, or property substituted
for it, is expended in a year prior to the expiration of
the hold period imposed by the donor, then the entire
ten-year gift may be collapsed and therefore subject
to the 80% disbursement quota and create a 80% disbursement
requirement in the following year. The 2004 federal budget
explained that, since an annual disbursement quota is applied
to funds held by charities, sometimes a charity may prefer
to (or may be compelled to) meet its obligation to satisfy
the disbursement quota by realizing capital gains rather
than and in addition to disbursing investment income earned
from these funds, especially where the return on the investment
is weighted heavily in favour of capital gains or in a low-interest
environment. However, “if the charity does so, … it must
also then meet an 80 per cent disbursement obligation to
the extent that the proceeds of disposition are expended
by the charity.”
This difficulty is caused by the fact that the then 4.5%
disbursement quota (now reduced to 3.5%) and the 80% disbursement
quota applicable to the portion of a ten-year gift expended
in any year are cumulative disbursement quota obligations.
Under the old rules, when an amount that has been subject
of a ten-year gift is encroached on to satisfy the 4.5%
disbursement quota, it is also bought into the 80% disbursement
quota calculation.
The difficulty
caused by the wording in the Act was addressed in Bill C-33.
In this regard, question 9 in the CRA Document is in relation
to situations where a charity encroaches on a ten‑year
gift, whether the entire ten‑year gift would be required
to be included in A.1 of the formula for the charity’s disbursement
quota for the year, or only the portion of the gift that
was expended in the year that must be included in the calculation.
CRA indicated that if the terms of the fund agreements permit
the charity to expend a portion of the property gifted in
excess of its 3.5% disbursement quota, the gift would not
qualify as enduring property in the first place and 80%
of the gift would be required to be included the charity’s
80% disbursement quota and create an 80% disbursement requirement
in the taxation year subsequent to the year in which the
gift was made. However, where a portion of an enduring property
is expended, only 80% of the amount spent and 100% of amount
transferred to qualified donees would be 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. Similarly, the remainder of the gift would
not be included in the charity’s A.1 in the formula for
the charity’s disbursement quota until is expended or transferred
to a qualified donee.
7.
Filing T3010
Lastly, CRA’s
response to question 8 in the CRA Document addressed the
issue of whether a charity should apply for relief or just
continue filing the T3010 if it is unable to meet its disbursement
quota in 2009 because of the financial crisis. CRA’s response
reminded that a charity has the obligation to file its T3010
annual information return and it may lose its charitable
registration if the form is not filed on time. However,
CRA also reminded that a charity may apply for relief under
subsection 149.1(5) of the Act if it is unable to meet its
disbursement quota due to unforeseen circumstances that
are beyond its control.
F. CONCLUSION
Although the concept of enduring property,
capital gains pool, and encroachment of ten-year gifts have
been in operation since its introduction in 2005, there
are still many questions regarding how the terms apply in
practice. This underscores the complexities of the disbursement
quota formula that was introduced in 2005. In spite of CRA’s
attempts to clarify the application of these rules, it is
the author’s concern that many charities may still be left
in an uncertain and vulnerable position.
