What Happens When a Non-Profit loses its Status?

By Arthur B.C. Drache - July 2010

               Most readers are fairly well versed in what happens when a registered charity loses its status, that is, when it is revoked. In a simplified nutshell the organization must transfer all its assets (according to a statutory formula) to another registered charity which is at arm's length.

                But for a non-profit organization governed by subsection 149(1)(l) of the income tax act[1][1] the rules are much less clear. The situation is exacerbated because non-profit status is self-assessed and only after an audit might the CRA decide that the organization did not qualify. It might well be that many, many years have passed since status was claimed which raises a host of questions given that conceptually taxes might be owing for decades past. Arguably limitation provisions would not apply since the claim of tax-exempt status would have been based on wrongful reporting during the entire period.

                The CRA in an opinion letter dealt with the issues after an inquiry. We feel that the detailed response is so useful, even though it was dealing with a specific case that it is worth reproducing virtually the whole letter.

                "1.    What are the tax consequences of losing a 149(1)(l) exemption?

                In general terms, paragraph 149(1)(l) of the Act provides that the taxable income of an organization that is a club, society or association 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 not a charity;

·         it is organized  and operated exclusively for social welfare, civic improvement, pleasure, recreation or any other purpose except profit; and

·         it does not distribute or otherwise make available for the personal benefit of a member or shareholder any of its income, unless the member or shareholder is an  association which has as its primary purpose and function the promotion of amateur athletics in Canada. 

                If an organization does not meet one of the criteria listed above at any particular time, then the organization ceases to qualify for the exemption provided by this provision.  Subsection 149(10) of the Act will apply at the time the organization ceases to be a 149(1)(l) entity and provides that the organization's taxation year ended immediately before that time.  It is important to note that subsection 149(10) only applies if the organization is a corporation. 

                If subsection 149(10) of the Act applies, a new taxation year begins for the organization and the organization is deemed not to have established a fiscal period before this time.  Further, the organization is deemed to dispose of all of its assets immediately before the time the organization ceases to be a 149(1)(l) entity  for fair market value and immediately reacquire them for the same amount.  The result is that any gain that accrued on the assets during the time the organization qualified as a 149(1)(l) entity will generally be exempt from tax.   However, paragraph 149(5) of the Act contains specific rules with respect to the property income earned by 149(1)(l) entities the main purpose of which was to provide dining, recreational or sporting facilities to their members.  If subsection 149(5) applies to an organization, the organization will be taxable on all capital gains, other than capital gains resulting from the disposition of property used exclusively for or directly in the providing of the dining, sporting or recreational facilities to members.

                For purposes of calculating taxable income for the organization's first taxable taxation year, the organization is deemed to have deducted under sections 20, 138 and 140 of the Act the maximum allowable amounts that could have been claimed or deducted as a reserve under those sections.  As well, for purposes of sections 37, 65 to 66.4, 66.7, 111 and 126 of the Act, and subsections 127(5) to (26) and section 127.3 of the Act, the organization is deemed to be a new corporation, and its first taxation year begins at this time.  This means, for example, that the organization cannot claim a loss carry-forward as allowed by section 111 of the Act that the corporation accrued during the time it was a 149(1)(l) entity.

2.    What steps must be taken to change a 149(1)(l) entity from a tax-exempt state to a taxable state?

                An organization that qualifies for the exemption from tax provided by paragraph 149(1)(l) automatically changes its status when it ceases to meet the requirements of that paragraph.  Moreover, unlike for a registered charity, for a 149(1)(l) entity there is no loss of registration (such entities do not register under the Act), no formal notification process that must be followed and no revocation tax. 

3.    For how many years can we assess?

                We spoke with the Administrative Law Section in Income Tax Rulings, which is the group that deals with issues involving assessments and collections of outstanding taxes.  They advised that since  (the organization) was likely never a 149(1)(l) entity, section 152 of the Act would apply.  Paragraph 152(3.1)(b) of the Act provides the general rule which is that a reassessment can be issued within 3 years from when the return was filed.  However, if an organization has made a misrepresentation on the return, then subparagraph 152(4)(a)(i) applies, in which case, it is open for the Crown to assess the taxpayer at any time, for any period of time."

                This last position is perfectly logical and would allow an open-ended backward assessment. Our experience, we should say is that if the error had taken place over a long period, even decades, some negotiation of tax due. If the directors of a non-profit have serious concerns about whether its status has changed or whether it ever qualified in the first place, run, don't walk, to your lawyer and accountant. The tax problems may be immense.