What do charities, non-profits, and co-operatives need to consider before seeking investment for their ventures? Should you be operating your social enterprise within these structures?
Below is a quick overview of the legal structures most often used by enterprising non-profits, and their potential limits. For a more detailed backgrounder of Canadian legal structures for social enterprise, click here.
Unless a charity is operating a social enterprise using 90% volunteers, there are strict limits on the type of enterprise that can be operated
If the volunteer test is not met, then the charity must demonstrate that the enterprise is linked and subordinate to the charity. The definitions of ‘linkage’ are specific. ‘Linkage’ to the organization’s charitable purpose means that the business must meet one of the following tests. It must:
- Be a usual and necessary concomitant of charitable programs (e.g. a hospital parking lot, a university bookstore, a museum gift shop); or
- Be an offshoot of a charitable program (e.g. a church that records and sells choir recordings); or
- Represent a use of excess capacity (e.g. charging for parking lot use during hours of closure, or renting out event tents when not being used by the charity); or
- Involve the sale of items that promote the charity and its objects (e.g. calendars, T-shirts, etc.).
Linkage is not demonstrated by the fact that the profits from the enterprise flow back to the parent charity.
Unrelated businesses need to hive off their operations into a corporation.
If the charity’s social enterprise meets neither the volunteer nor the linkage / subordination test, then it is considered to be an ‘unrelated business’ and should be operating its enterprises within a separate taxable corporation. This means that a separate Board of Directors must be struck, and the enterprise is run in absolute separation from the charity. The enterprise cannot in this case benefit in any way from the charity: if, for example, it is using charity staff or space, then the corporation must pay the charity fair market value for these benefits.
At the end of the year, the corporation can donate up to 75% of its net profits to the charity, and only pays income tax on the profits that remain. Especially because corporate income taxes reflect the lowest income tax rates in Canada, and because only 25% of net profits are taxed, the tax expense should not be interpreted as a barrier to forming a corporation as a means of protecting charitable status.
Social Finance Available to Charities
When considering access to social finance, a charity can access debt financing including mortgages, lines of credit, operating lines; plus quasi-equity investments. It cannot however, sell investment shares, nor can it distribute any portion of its income to members.
If it has hived its social enterprise off into a separate taxable corporation, it can sell investment shares, as any corporation can.
Because it is a separate legal entity however, the corporation cannot benefit from donations and grants accessed by the parent charity. It would, however, have access to the grant supports available to mainstream businesses, such as employment / training subsidies, and innovation grants.
It surprises many to learn that non-profits are not permitted to intentionally generate profits, regardless of whether the profit is spent by the organization on administration or community works during the same year.
Five recent Canada Revenue Agency rulings, and two pieces of case law (decisions of the court) support this position. One of the rulings states that non-profit entities can only make profit ‘by mistake’ or to save for the construction or purchase of a building for community use (as opposed to administration). The same ruling specifically prohibits non-profits from undertaking contracts with ‘mark-ups’ (i.e. what the sector commonly refers to as 'admin fees').
CRA estimates that 75% of non-profits in Canada are currently offside.
Non-profits derive their tax exempt status from a specific section of the federal Income Tax Act. Section 149.1(l) is the section of importance. It gives a tax exemption to:
"a club, society or association that, in the opinion of the Minister, was not a charity within the meaning assigned by subsection 149.1(1) and that was organized and operated exclusively for social welfare, civic improvement, pleasure or recreation or for any other purpose except profit, no part of the income of which was payable to, or was otherwise available for the personal benefit of, any proprietor, member or shareholder thereof unless the proprietor, member or shareholder was a club, society or association the primary purpose and function of which was the promotion of amateur athletics in Canada…"
The statement that the organization cannot have profit as a purpose is the key piece here. Many organizations assert that profit is not a ‘purpose’ of their organization, but rather a means to the end of supporting worthy endeavours. The Canada Revenue Agency does not currently accept this explanation.
Connection between CRA and provincial Society Acts
Interestingly, many provincial Society Acts do permit enterprising activities. BC is among them, and Bill-65, Ontario Non-Profit Corporations Act contradicts the federal (Canada Revenue Agency) Income Tax Act. Because the Income Tax Act trumps provincial Society Acts, the Canada Revenue Agency stance has significant importance.
If a non-profit is deemed to be operating offside
If a non-profit is found to be operating outside of its permitted purposes (e.g. intentionally generating profits for uses other than capital expenditures, or building a modest reserve), then it loses its tax exemption. It would then owe corporate income tax on its year-end profits. Further, the organization would be interpreted by CRA as having falsely claimed non-profit status in any past years that apply, and would be taxed on the net profits shown at the end of each fiscal year since formation.
It would still, for structural purposes, be a ‘non-profit’, so could still access grants that are normally available to the sector.
Social Finance Available to Non-profits
When considering access to social finance, a non-profit can access debt financing including mortgages, lines of credit, and operating lines; plus quasi-equity investments. It cannot however, sell investment shares because it is by its nature a non-share corporation; nor can it distribute any portion of its income to its members.
Co-operatives can be viewed as well-established hybrids that successfully combine commercial and community mechanisms and interests.
Co-ops are vitally important to Canada’s economy and communities. There are over 9,000 co-operatives serving over 17 million members in virtually every field of endeavour. The Canadian Co-operative Association summarizes the key differences between business corporations and co-operatives this way:
Co-operatives are guided by these key principles:
- Voluntary and open membership;
- Democratic member control;
- Member economic participation;
- Autonomy and independence;
- Education, training, and information;
- Co-operation among co-operatives; and
- Concern for community.
Co-operatives can be created for a wide range of purposes and activities – from purely commercial to charitable. While primarily driven to achieve member benefit, co-operatives can make community benefit their first priority, or they can combine member and community benefit as they choose. They can also maintain that on dissolution or wind up, remaining assets must be transferred to a charity or other community organization.
The co-operative structure is an excellent organizational form for a wide range of enterprises and situations.
Perhaps its greatest strengths are:
- a) economic democracy – one member one vote, not one share one vote; and
- b) the potential to counter Canada’s seemingly endless incremental loss of ownership of commercial and industrial assets to non-Canadian corporate interests.
Co-operatives provide a legal structure ideal for communities wishing to regain control of local economies and achieve economic self-determination. Examples are the purchase of a saw mill or manufacturing facility closed by a distant corporate head office.
Co-operatives are not appropriate for every situation
Co-operatives require a critical mass of members, who may be producers, workers, retailers, service providers, consumers, investors, or a combination of these (i.e. a multi-stakeholder co-operative). That critical mass of membership may be large, as with a retail co-operative or a credit union. Or it may be relatively small – for example, a handful of health care professionals who form a co-operative to deliver home care to seniors.
Within this critical mass of members, there must be a core group of committed and able members willing to do the hard work needed to make the co-operative enterprise work. In situations in which there is a critical mass of members and a core of committed and able members, a co-operative structure can be an excellent choice. Without that critical mass and core, a co-operative structure is not an option.
Most co-operatives pay income tax
Most co-operatives file annual corporate information returns, remitting income tax at corporate tax rates. Some may qualify for the non-profit exemption (section 149(1)(l) of the Income Tax Act), but they must be devoid of intentional profit on all activities – see the section on non-profits. This means that social enterprises operated within a co-operative structure are almost always taxed on their profits.
Social finance available to co-operatives
Co-operatives can raise capital for community projects by issuing shares to members or outside investors. They can also access some grants (but not as many as charities can), and can access debt financing including mortgages, lines of credit, operating lines; plus quasi-equity investments.
Social enterprises can adopt the legal form of business corporations established under existing incorporation legislation.
Indeed, this is the structure recommended by the Canada Revenue Agency for registered charities that have engaged in or are considering an ‘unrelated’ business activity (see the section on charities.
The essential objective recognized by corporate law and theory is the maximization of shareholder value. It is possible for business corporations to adopt other objectives, such as community or environmental benefit, and for corporate shareholders to enshrine these objectives or values in formal incorporation documents.
The BC government is currently undertaking research into the feasibility of embedding special enabling features within the BC Business Corporations Act that could be adopted by social enterprises to enshrine certain characteristics (e.g. stakeholder primacy, interest / dividend caps, an asset lock) within the existing corporate structure.
Social finance available to business corporations
Business corporations can access the widest range of repayable social finance tools, as they have been more or less designed with optimal investment opportunities in mind.
Non-repayable grants available to corporations are generally intended to support employment creation, innovation, and access to global markets.
THE WHAT, WHY, WHO, AND MOST IMPORTANTLY, THE HOW OF SOCIAL FINANCE IN CANADA.
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The contents of Your Guide to Social Finance is general in nature, current only as of the date of publication and is provided for informational purposes only. It is not intended to provide professional investment or financing advice. Please consult a certified professional before making any decision regarding your investments and financing.