Oct 16, 2024
Introduction – Tax Exemptions for Charities
To promote philanthropic ventures, the Canadian income tax regime offers generous tax benefits for people and organizations engaging in charitable activities. First, under the Canadian Income Tax Act, an organization that maintains registered charity status is tax-exempt on any income it receives. An organization may qualify as a “registered charity” for income tax purposes on application to the Canada Revenue Agency (“CRA”) where, generally speaking, it: (i) is constituted and operates exclusively for charitable purposes (i.e. relief of poverty, advancement of education or religion, and any other charitable purposes regarded as charitable under law); (ii) it devotes all of its resources for its own charitable activities or to make “qualifying disbursements” to other qualifying donars and organizations (like other charities, municipalizes, and universities), subject to enumerated restrictions; and (iii) no amount of income is made payable to or available to members of the charity.
Further, a registered charity can issue donation receipts to its donors. An individual is entitled to claim a credit pursuant to section 118.1 of the Income Tax Act (or pursuant to section 110.1 for corporations) using a donation receipt, which entitles a donor to claim a non-refundable tax credit for a portion of that donation. Canadian charities principally rely on donation receipts to source funding from the general public; soliciting private funding is much harder to organize under Canada’s tax rules for charities. And while a charity might want to be classified as a non-profit organization instead, because non-profit organizations can more freely engage in commercial activities while maintaining tax-exempt status like a charity, the two statuses are mutually exclusive. That is to say, under Canada’s tax regime, an organization with a legally-recognized charitable purpose is barred from qualifying as a non-profit organization, and must instead become a registered charity to obtain tax-exempt status.
Private-sector enterprises are entitled to make charitable donations and claim charitable donation tax credits like any other taxpayer. A private-sector enterprise may very well have a valid reason for donating to charities beyond pure profit-making. With rising public interest in social enterprises, and other businesses that are not purely profit-driven, a business that seeks to differentiate itself from competitors might donate to a charity that advances the interests of its stakeholders. An enterprise may view making a charitable donation as a means to advertise itself and to promote its business interests. Depending on the facts, however, the tax consequences of a business making such a donation may change. If a donation is made for consideration or a benefit to the donor, or with insufficient donative intent, then it may not be a genuine gift and may disqualify the donor from claiming a donation tax credit. At the same time, a business might benefit more by claiming a donation as a business expense as opposed to claiming the donation tax credit, and may want the donation to be characterized that way intentionally. The rules and limitations that concern whether a business can treat a charitable donation as a business expense, as opposed to simply claiming a charitable tax credit, can be quite nuanced.
This article will briefly explore the tax law as it concerns whether and how Canadian businesses can treat charitable donations as a tax deductible expense. This article will begin by briefly exploring the law concerning whether and when a particular expense is deductible for a Canadian taxpayer operating a business. We will then briefly explore a sampling of Canadian case law that could justify or undermine treating a charitable donation as a deductible business expense. Our synopsis will then conclude with some pro tax tips from our top Toronto tax lawyers and some frequently-asked questions concerning deductibility of charitable donations for tax purposes, and possible options for charities to optimize their affairs to attract private investment.
What Makes an Expense “Deductible” Under Canadian Tax Law? Sections 9 and 18 of the Income Tax Act
Broadly speaking, subsection 9(1) of the Income Tax Act states that a taxpayer’s income from a business or property is that taxpayer’s “profit”. The term “profit” is inherently a net concept, and a taxpayer’s profit under subsection 9(1) has been found by Canadian courts to mean the difference between a taxpayer’s revenues and any expenses incurred to earn that income, with consideration to well-established business principles.
Section 18 of the Income Tax Act imposes statutory restrictions on the kinds of expenses that are deductible for calculating profit from a business or property. To be more precise, paragraph 18(1)(a) states that, in computing a taxpayer’s income from a business or property, “no deduction shall be made in respect of an outlay or expense except to the extent that it was made or incurred… for the purpose of gaining or producing income from the business or property.” This provision re-affirms explicitly that there is no deduction for an expense not incurred to earn income. Paragraph 18(1)(h) further restricts taxpayers from claiming a deduction for an expense incurred for “personal or living expenses” (other than a limited range of travel expenses incurred by a taxpayer while carrying on a business). While the concept of “profit” under subsection 9(1) inherently limits deductibility of expenses to those incurred to earn income, paragraphs 18(1)(a) and 18(1)(h) further refine the concept that an expense must have a genuine and defined business purpose in order to be deductible for tax purposes. The remaining paragraphs of section 18 provide more specific statutory restrictions, aimed specifically to prevent taxpayers from obtaining an unfair tax advantage.
Why Might a Business Want to Treat a Charitable Donation as an Expense?
The potential tax benefits of treating a charitable donation as an expense may be significant. Under the Income Tax Act, the amount of the donation tax credit that an individual or corporation can claim is capped. More specifically, the charitable donation tax credit is calculated as the total of: (1) 15% on the first $200 of charitable gifts; plus (2) 29% of gifts over $200, but under the highest marginal tax rate at the federal level (in 2023, $235,675); plus (3) 33% of gifts in excess of the highest marginal tax rate. As well, the donation tax credit is limited to 75% of the taxpayer’s net income for the year. In essence, the total amount donated to a charitable organization will never be fully deductible for a taxpayer.
Alternatively, the full amount of an expense incurred to earn income from a business or property is deductible, so long as that deduction is not limited by section 9 or section 18 above, or the limit on reasonableness of expenses under section 67. So depending on the circumstances, a business that donates a significant amount to a charitable organization in a given tax year might benefit far more for tax purposes by claiming those donations as a business expense as opposed to claiming the charitable tax credit.
The Potential Tax Risks for Treating a Charitable Donation as a Deductible Expense
The definition of a charitable gift for the purpose of the donation tax credit, and an expense for the purpose of incurring income from a business or property, are not residual definitions. In other words, just because a donation to a charity might not qualify as a charitable gift does not automatically mean it is a valid business expense.
This is a vitally important consideration for any business donating to charity. At common law, a charitable gift cannot be transactional. If a donation is made in exchange for a benefit, or even an expected benefit, that intent could very well disqualify it from being treated as a charitable donation. As a result, the donation tax credit would be unavailable. At the same time, a donation that does not actually meet the legal standard for a deductible expense would not be deductible for tax purposes. If a donation fails to meet both definitions, then the donor would have no recourse. So, any business donating to charity should carefully plan that donation to ensure that donation is consistent with the desired tax outcome.
When Might a Charitable Donation Qualify as a Deductible Expense?
Finding that an expense was incurred for purpose of earning income from a business is always a fact-specific analysis that requires considering the commercial realities of that taxpayer’s business. Finding an income-earning purpose may be quite obvious in some instances, such as when a business pays reasonable salaries to its employees. Deducting a business expense in connection with a donation to a non-profit organization or charitable cause remains an area of controversy in Canadian tax law, however. This is because a donation, by its very nature, is made for no consideration, and has generally provided nothing of commercial value to the donor.
One common starting point is characterizing the connection between the income-earning purpose behind a donation with the expected outcome of that donation. Canadian courts have developed a remoteness test to disqualify taxpayers from claiming expenses that have no clear connection to the commercial realities of a taxpayer’s business. Under Canadian common law, the connection between a taxpayer’s expense and anticipated income must be more than just tenuous or remote. In other words, if the expense is incurred with the hope of earning income, then it generally fails to exhibit an air of commercial reality.
For example, in Lyncorp International Ltd. v. The Queen, 2010 TCC 532, the taxpayer was a corporation that held shares in various companies. The appellant’s shareholder travelled by private jet to visit the companies in which the taxpayer corporation held an ownership interest. The shareholder’s hope was that by providing free services to the management of those companies, the dividends his corporation would receive from those companies would be increased. The taxpayer corporation deducted travel expenses in connection with the shareholder’s jet flights, which were denied by the Canada Revenue Agency (“CRA”). The Tax Court of Canada upheld the CRA’s decision, on the basis the relationship between the taxpayer corporation’s source of income and the expenses paid was too remote. More specifically, the taxpayer corporation received nothing by way of debt or equity for the services the shareholder rendered; those free services, with no connected obligation to repay, yielded only a hope of earning income. The Tax Court of Canada concluded that this could not accord with the commercial realities of operating a business or earning income. While this case is not directly connected with charitable donations, it demonstrates that Canadian courts will not hesitate to find that an expense is non-deductible where the purported benefits are not anchored by some predictable commercial benefit to the taxpayer.
Given that a donation, by definition, is made without an expectation of any return or consideration, it falls to the facts of each case to determine whether the income-earning benefit was more than remote. Take, for example, the curious case of Olympia Floor & Wall Tile (Quebec) Ltd. v. Minister of National Revenue, 1970 CanLII 1691. In this case, the taxpayer was a corporation that made significant donations to a registered charity. In exchange for those donations, the managers of the charity ensured the taxpayer received significant kick-backs by favouring the taxpayer corporation as a supplier for the charity. The business the taxpayer received from the charity represent over a quarter of its commercial sales. The taxpayer deducted its donations to the charity as a business expense, which was upheld by the Tax Court of Canada. The Tax Court of Canada found the donations were analogous to advertising expenses, and that the contributions however improper were necessary to maintain its sales. On that basis, those donations were reasonably necessary for the taxpayer’s business to continue operating.
Similarly, in Impenco Ltd. v. Minister of National Revenue, 1988 CanLII 10054, the taxpayer was a corporation operating a successful manufacturing company in Canada. In 1984, the taxpayer’s business began stagnating. In an attempt to revive its business, the taxpayer’s management made strategic donations to local charities, with the intent of advertising its business and maintain its customer base. The taxpayer claimed those donations as a deductible expense. The CRA assessed the taxpayer on the basis the donations were actually a charitable gift, and only allowed the taxpayer a much smaller deduction equal to the donation tax credit amount claimable at the time. The Tax Court of Canada found the donations were valid business expenses, and not a charitable gift, because the evidence showed the taxpayer had a real and provable strategic purpose for advertising its business that motivated those donations. While the taxpayer could not prove the donations actually resulted in an increase in sales, the Tax Court of Canada accepted the taxpayer’s intent to earn income from the donations was the only relevant factor. As a result, the donations were characterizable as fully-deductible business expenses.
Pro Tax Tip: Consider Using a Dedicated Subsidiary to Attract Private Investments
Broadly speaking, a charity is required to devote all of its resources to charitable activities. This heavily restricts the fundraising activities a charity can directly engage in. A charity is also permitted to engage in a “reasonable” level of business-related activity. According to the CRA in Charity Guidance CPS-019 (“What is a Related Business?”), a permissible “related” business will include (i) one that is not related to the charity’s purpose but is substantially run by unpaid volunteers, or (ii) one that is linked and subordinate to a charity’s purpose. Failing to satisfy these conditions is not a mistake to make. A charity that is non-compliant with the rules can have its charitable status revoked by the CRA. When charitable status is revoked, the charity is required to transfer is property to another arm’s-length charity, or be subject to a hefty revocation tax on the fair-market-value of its property.
A charity that wants to attract private investment for its charitable work, but minimize risk to losing its charitable status, could set up a separate taxable corporation to carry on those activities. A charity can generally hold a majority of shares in a taxable corporation without offending the Canadian tax law or CRA policy, but only so long as the subsidiary does not rely on the charity to operate its business or manage its affairs. The subsidiary can then operate its business and seek private investment, and flow income it earns to a parent charity via tax-free intercorporate dividends or as a distribution of profits as donations to the parent. For private investors, the tax implications will be the same as any other private investment, opening up substantially more opportunities for the charity to benefit. Structuring the taxable subsidiary’s governance and ensuring it always acts at arm’s-length from its parent charity will be crucial for the success of the structure. The success of this structure demands the involvement of experienced Canadian tax lawyers, to ensure the proposed structure will not compromise the parent’s tax-exempt status, or result in any other adverse tax consequences for involved parties.
FAQs:
What does “profit” mean for purposes of the Canadian Income Tax Act?
Subsection 9(1) of the Income Tax Act imposes a net-profit mechanism for calculating that taxable income from a business or property. A taxpayer’s “profit” under subsection 9(1) has been found by Canadian courts to mean the difference between a taxpayer’s revenues, and any expenses incurred to earn income, with consideration to well-established business principles. Section 18 of the Income Tax Act imposes further statutory restrictions on the kinds of expenses incurred by a taxpayer that are deductible for calculating profit.
Can a donation to a charity or non-profit organization be a deductible expense for Canadian tax purposes?
Broadly speaking, Canadian courts have been reluctant to accept that a business expense can be claimed in connection with a donation to a non-profit organization or a charitable cause, because a donation made for no consideration has generally provided nothing of commercial value to the donor. The courts have, on occasion, found that charitable donations could be deducted because those donations were analogous to advertising expenses and were reasonably necessary expenses for a taxpayer’s business to operate. Finding that an expense was incurred for purpose of earning income from a business remains a fact-specific analysis, however, with consideration to the commercial realities of that taxpayer’s business.
Disclaimer: This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
