What Every High-Net-Worth Donor Should Know Before Launching a Private Foundation

By DeWayne Osborn, CPA, CGA, CFP; Published in CPABC in Focus
Published: June/Summer 2014

Legislation and Philanthropy

Since the release of the federal budget of March 19, 2007, three significant pieces of legislation have had a dramatic impact on the philanthropic sector in Canada, and on high-net-worth (HNW) donors in particular. The purpose of this article is to review the legislation that is currently in force. (A fourth piece of legislation proposed in the 2014 federal budget, which should have a similar impact if ratified, is a topic for future discussion.)

Before getting into the legislation, it’s worth mentioning a general trend that Canadian charities are being forced to deal with as the population ages. Today’s donors are demanding more accountability and more control over their donations to (or “investments in”) charities, and are becoming less and less tolerant of public charities not allocating their funds as they’d like. Seeking more flexibility and control over the disbursement of funds, many donors have turned to the idea of creating private foundations. So much so that the number of private foundations in Canada has increased by 10% in the last five years, while the number of public foundations has increased by only 0.92%. In fact, for the first time in my 14 years working in this sector, private foundations outnumber public foundations (5,334 vs. 5,024, respectively[1]).

Legislative changes – the good and the bad

Extending the zero capital gains inclusion rate

Prior to 2007, donors were severely limited in the types of property they could put into their newly created private foundations. These restrictions were relaxed somewhat in the 2007 federal budget, when the Department of Finance (Finance) extended the zero capital gains inclusion rate for gifts of listed securities to private foundations (prior to that date, the provision only applied to gifts of listed securities to public charities). This means that gifts of securities defined as stocks, bonds, warrants, and rights listed on prescribed stock exchanges; mutual funds; and segregated funds made to private foundations no longer generate a capital gain inclusion to the donor. This provision applies to gifts from corporations and individuals; hence, if the gift is made from the donor’s personal corporation, 100% of the capital gain can be credited to the capital dividend account and paid out as a tax-free capital dividend. In short, donors now have more flexibility in the types of property they can gift to their new private foundations.

Simplifying the disbursement quota

The second piece of significant legislation that affected HNW donors positively was proposed in the March 4, 2010 federal budget. Finance dramatically simplified the administration of charities by simplifying the amount charities have to spend each year on charitable activities—this amount is referred to as the “disbursement quota.”[2]

Prior to March 4, 2010, foundations had to calculate their disbursement quotas based on two amounts: 80% of the previous year’s tax-receipted gifts, and 3.5% of the 24-month average fair market value of all property owned by the foundation but not used for charitable activities and/or administration. Using a simple example, if a foundation issued tax receipts of $500,000 in 2008 and had 24-month average investments not used for charitable activities of $1 million, its 2009 disbursement quota would be $435,000 (80% X $500,000 + 3.5% X $1 million).

For fiscal year-ends after March 4, 2010, however, that same foundation would have to spend $35,000 on its charitable activities. Thus, HNW donors have increased flexibility in determining the amount and timing of their gifts and the disbursements for their activities.

Targeting the ownership of privately held shares

Unfortunately, not all of the legislative changes affecting HNW donors who are considering launching their own private foundations have been positive. In the March 19, 2007 federal budget, Finance also introduced the Excess Corporate Holdings Regime for Private Foundations[3], a piece of legislation singularly targeted at private foundations and their ownership of shares—in particular, privately held shares.[4]

A word of caution: Finance will not tolerate any strategy, tactic, series of transactions, or any other action it deems to be an attempt to avoid this legislation. Therefore, unless there is a specific and immediate plan to redeem the shares caught by this legislation, I strongly suggest that donors not use this type of property in private foundations.

If at any time during its fiscal period, a private foundation (registered after March 19, 2007) owns 2% or less of the issued and outstanding shares of any share class, there are no concerns, as the legislation refers to this level of ownership as “Safe Harbour.” However, once the foundation owns more than 2% of any share class of a corporation, other provisions of the legislation are triggered.

For example, if a private foundation owns more than 2% of the listed and outstanding shares at any time during the fiscal period, it must report to the CRA the percentage of shares that it and any relevant person with material interests hold. Generally speaking, a “relevant” person is someone not at arm’s length with the foundation (for example, the donor and his or her family). “Material interest” is defined as ownership of more than 0.5% of the shares of the class or ownership of shares that have a fair market value in excess of $100,000.

Provided the foundation and all relevant persons together own less than 20% of the corporation’s share class, the legislation refers to this level of ownership as “Monitoring.” In the Monitoring range, the foundation is required to report annually to the CRA the percentage of shares that it and any relevant person with material interests hold, as well as its own and any relevant person’s material transactions for each share class. A material transaction (or series of transactions) is one that exceeds the lesser of $100,000 or 0.5% of the total fair market value of all the issued and outstanding shares of the class.

If, at the foundation’s fiscal year-end, the foundation and all relevant persons considered together own more than 20% of any share class of a corporation, the foundation is considered to be in the “Divestment range.” In this range, the foundation is required to reduce its divestment obligation to 20% or less within specific time frames or it will face substantial penalties and/or revocation of its charitable status[5]. Time frames range from the same fiscal period for shares purchased by the foundation to two years for shares gifted inter vivos, to five years for shares gifted via a bequest.

HNW donors who are considering forming private foundations should be advised of the issues of using private company shares very early in the discussion process. And while the administration of private foundations has never been easier, donors must also be reminded that once property is donated, it cannot be retrieved. Furthermore, donors should be advised that regulations governing the operation of private foundations prohibit many of the activities they may be accustomed to doing on a regular basis (such as moving money in and out of a foundation for purposes other than charitable activities).

Final thoughts

For charitably inclined HNW individuals, the private foundation offers the maximum level of flexibility and control over philanthropic activities. With the exception of privately held shares, virtually any property can now be gifted into a private foundation in a tax-effective manner. Once the property is in the foundation, the HNW individual and/or their family then have the flexibility to pick and choose the projects they wish to fund thanks to the dramatically relaxed disbursement quota. All it takes is some careful planning to stay onside with the evolving legislation.

DeWayne Osborn is the general manager, chief compliance officer, and in-house expert on charitable and planned giving with Lawton Partners in Winnipeg, Manitoba.

Footnotes

  1. https://www.canada.ca/en/revenue-agency/services/charities-giving/charities-listings.html.
  2. The failure of a private foundation to meet its disbursement quota obligations can lead to the revocation of charitable status.
  3. Refer to the Canada Revenue Agency publication T2082 - Excess Corporate Holdings Regime for Private Foundations or Section 149.2 in the Income Tax Act of Canada.
  4. It is highly unlikely that a person would donate sufficient levels of publicly listed securities to cause a problem; however, if they did do so, these securities would be caught under the legislation.
  5. A first-offence penalty equals 5% of the fair market value of the share class multiplied by the foundation’s divestment obligation. This penalty increases to 10% for a second occurrence within five years. Finally, a penalty equal to 10% of fair market value of the share class multiplied by the foundation’s divestment obligation is imposed if the foundation fails to file the report to the CRA properly.