28 June 2010 External T.I. 2010-0358021E5 - 149(1)(l) Entity - Sale of Land

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: 1. Whether subsection 149(5) applies to the Corporation. 2. Whether the sale of a property will jeopardize the tax-exempt status of a 149(1)(l) entity. 3. Whether there is a distinction between the terms "pleasure" and "recreation" as those terms are used in paragraph 149(1)(l) and subsection 149(5). 4. What are the options available to the Corporation regarding the proceeds of the sale of the property? 5. What are the implications of those options?

Position: 1. Likely. 2. Generally, no. 3. Likely no. 4. See options discussed in letter. 5. See discussion in letter.

Reasons: See discussion in letter.

XXXXXXXXXX
									2010-035802
									Lori Merrigan
									(613) 957-8979
June 28, 2010

Dear XXXXXXXXXX :

Re: Sale of Land - Tax Implications to a 149(1)(l) Entity

This is in response to your correspondence of February 19, 2010, and April 14, 2010, inquiring about the tax implications to an entity described in paragraph 149(1)(l) of the Income Tax Act (the "Act") with respect to the sale of a piece of land. In this letter, unless otherwise expressly stated, all statutory references are to the provisions of the Act.

The situation outlined in your letter relates to a factual one, involving a specific taxpayer. Written confirmation of the tax implications inherent in particular transactions is given by this Directorate only where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, "Advance Income Tax Rulings". This Information Circular and other Canada Revenue Agency ("CRA") publications can be accessed on the internet at http://www.cra-arc.gc.ca. Should your situation involve a specific taxpayer and a completed transaction, you should submit all relevant facts and documentation to the appropriate Tax Services Office ("TSO") for their views. Although we cannot comment on your specific situation, we are able to provide the following general comments, which may be of assistance.

FACTS

The facts that we have received from you, and have assumed to be correct for purposes of our response are as follows:

• XXXXXXXXXX (the "Corporation") was incorporated with share capital between XXXXXXXXXX and XXXXXXXXXX .
• The objects of the Corporation are to purchase, maintain and manage property for use by its shareholders.
• The Corporation files an annual T2 return claiming a tax exemption under paragraph 149(1)(l).
• Originally, one piece of property was purchased by the Corporation. Each of the shareholders has built, and personally owns, a cottage on this original property (the "Original Property").
• In XXXXXXXXXX , a second, undeveloped adjacent piece of property (the "Vacant Property") was purchased by the Corporation, for use by the shareholders. No development has been undertaken on this property, but rather it has been held for the enjoyment of the shareholders.
• The only other assets held by the Corporation are a water tower, a common-use building and three docks, which are all available for use by the shareholders.
• Each year, the Corporation collects two types of membership fees from its shareholders:

  • Capital - Generally $XXXXXXXXXX is received from each shareholder to cover large expenditures, likely to be incurred in the future, such as road maintenance, dock repairs or even land acquisition. The funds are held in GIC investments only (there is no active investing).

  • Operating - The amount varies by year per shareholder and is intended to cover expenses such as individual cottage insurance, liability insurance of the Corporation, property taxes and communal phones. Any overages or shortages for the year are rolled into the next year, such that the following year's fees are adjusted to account for the overage or shortage.

• The Corporation is considering an offer to sell the Vacant Property to the XXXXXXXXXX (the "Purchaser"). The sale to the Purchaser would result in a capital gain for the Corporation.

QUESTIONS

You have asked us to consider the following questions:

1) Would subsection 149(5) apply in respect of the sale of a piece of land, such that the gain is taxable to the Corporation?

(i) Would a taxable capital gain jeopardize the tax-exempt status of the Corporation pursuant to paragraph 149(1)(l)?

(ii) Is there a distinction between the terms "pleasure" and "recreation" as those terms are used in paragraph 149(1)(l) and subsection 149(5)?

2) In the context of the options available to the Corporation regarding the proceeds from the sale of the property (the "Proceeds"):

(i) Does a payment of the Proceeds to the shareholders jeopardize the tax-exempt status of the Corporation under paragraph 149(1)(l)?

(ii) What would be the tax treatment of amounts paid to the shareholders from the Proceeds?

(iii) Can a 149(1)(l) entity use a capital dividend account to distribute the Proceeds to its shareholders? Since the 149(1)(l) entity is exempt from tax, does this mean that the entire capital gain from the sale of the Vacant Property would be added to the capital dividend account?

(iv) If the Proceeds are retained by the Corporation, does this jeopardize the tax-exempt status of the Corporation under paragraph 149(1)(l)?

The CRA's general views regarding 149(1)(l) entities are contained in Interpretation Bulletins IT-496R, "Non-Profit Organizations" and IT-83R3 "Non-profit Organizations - Taxation of Income from Property" which may be viewed at http://www.cra-arc.gc.ca. Among other criteria, to qualify as a tax-exempt entity described in paragraph 149(1)(l) of the Act, an organization must be both organized and operated exclusively for social welfare, civic improvement, pleasure or recreation or for any other purpose except profit.

Our discussion below is premised upon the existence of a properly constituted and operated 149(1)(l) entity, although it is important to note that we are not in a position to make this determination with respect to your inquiry.

DISCUSSION

Overview

In general terms, paragraph 149(1)(l) provides that the taxable income, including taxable capital gains, of a corporation is exempt from tax under Part I of the Act for a period throughout which a corporation meets all of the following requirements:

• it is a club, society or association;
• 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 organization is an association which has as its primary purpose and function the promotion of amateur athletics in Canada.

A taxpayer's income, which is computed under section 3, includes taxable capital gains. A taxpayer's taxable income is equal to the taxpayer's income for the year (plus the additions and minus the deductions permitted by Division C) pursuant to subsection 2(2). Accordingly, provided that subsection 149(5) does not apply (discussed below), and provided that the Corporation meets the conditions in paragraph 149(1)(l) outlined above, the Corporation will not be subject to tax on any taxable capital gains from the sale of the Vacant Property.

Question 1

Subsection 149(5) contains specific rules with respect to the property income earned by 149(1)(l) entities the main purpose of which is to provide dining, recreational or sporting facilities to their members. If subsection 149(5) applies to the Corporation, it will effectively be taxable on all capital gains, other than capital gains resulting from the disposition of property used exclusively for or directly in the course of providing the dining, sporting or recreational facilities to members, pursuant to subparagraph 149(5)(e)(ii).

Subsection 149(5) contemplates that 149(1)(l) entities may have capital gains. In our view, a 149(1)(l) entity may dispose of a capital property for an amount in excess of cost without jeopardizing its tax-exempt status under paragraph 149(1)(l). However, where the purchase and sale of properties is actively pursued as a source of income for an organization, the organization will be considered to be operating for a profit purpose.

In determining whether subsection 149(5) applies to the Corporation, you have asked whether there is a material difference between the terms "pleasure" and "recreation" as those terms are used in paragraph 149(1)(l) and subsection 149(5). You note that the term "pleasure" is used in paragraph 149(1)(l) and not in subsection 149(5), but the term "recreation" ("recreational") is used in both provisions. Specifically, you suggest that since the term "recreation" is used in both provisions, while the term "pleasure" is used only paragraph 149(1)(l), a distinction might be made between "recreation" and "pleasure". You suggest that the Corporation would be better described as providing facilities for "pleasure" rather than for "recreation", and as such would not be subject to subsection 149(5).

We do not agree that the absence of the term "pleasure" in paragraph 149(5) means that the term "recreational", as used in subsection 149(5), could not include "pleasure" type activities. Even if we agreed that a distinction exists between "pleasure" and "recreation" as those terms are used in paragraph 149(1)(l) we would still be required to give meaning to the use of the separate terms "sporting" and "recreational" in subsection 149(5). One possibility would be to interpret the term "recreational", in the context of a list that includes "sporting", to mean non-sporting, recreational activities, that is, pleasure activities. It is our understanding that these terms were not intentionally included in or excluded from these provisions to suggest material differences. Therefore, in our view, the term "recreational", as used in subsection 149(5), is sufficient to include pleasure activities such as typical activities at a cottage.

In any event, if the Corporation is subject to subsection 149(5), subparagraph 149(5)(e)(ii) provides that the capital gains resulting from the disposition of a property used exclusively for or directly in the course of providing the dining, sporting or recreational facilities to members are not taxable. Therefore, if the Vacant Property is used exclusively for providing recreational facilities to the members, the gains realized from the sale of that property would likely not be taxable to the Corporation.

Question 2

As stated previously, one of the requirements that must be met in order for the Corporation to be considered a 149(1)(l) entity is that it cannot not distribute or otherwise make available for the personal benefit of a member or shareholder any of its income.
For purposes of determining the amount of income of a 149(1)(l) entity payable or made available to members, income is defined in subsection 149(2) not to include any capital gains realized by the entity. Therefore, the Corporation should be able to make payments to its shareholders without jeopardizing its status under paragraph 149(1)(l) as long as those payments are from a capital gain realized from the sale of capital property owned by the Corporation.

Payments to the shareholders of a 149(1)(l) entity that is a corporation may take several forms:

(a) Refund of Member Fees - If shareholders are required to pay dues each year and a surplus exists at the end of the year, a 149(1)(l) entity may refund each shareholder an amount after the end of the year out of the surplus. This may be considered a refund of fees and would not constitute a taxable event. The financial statements of the corporation, together with the facts surrounding the distribution must support the characterization of the amounts as a refund of fees. For example, in a year where the corporation provides services or facilities to its members, some or all of the fees must be attributed to providing those services or facilities. Unless there are clear accounting records, or the corporation is inactive, the CRA will not accept that an amount paid to shareholders of a corporate 149(1)(l) entity is a refund of fees.

(b) Return of Capital - The payments may be characterized as a return of capital in accordance with subsection 84(4) and subparagraph 53(2)(a)(ii). If an amount is a return of capital, then the amount received up to the paid-up capital of the share would be received tax-free.

(c) Dividend - Any proceeds of disposition paid to the shareholders over and above the paid-up capital described above would likely be characterized as dividends, where the payment is a pro rata distribution to all shareholders. The payments would be taxed as regular dividends in the hands of the shareholders.

(d) Shareholder Benefit - Payments to the shareholders may be included in income and taxed as a shareholder benefit, in accordance with subsection 15(1), if it is determined that the payment is a benefit to particular shareholders or groups of shareholders, rather than a general return of capital or a pro rata distribution to all shareholders (i.e., dividends).

(e) Capital Dividend - A private corporation may elect, under subsection 83(2), in prescribed manner and form, to pay its shareholders a dividend out of its capital dividend account. No part of a capital dividend is included in computing the Part I income of a shareholder resident in Canada and no amount is deducted in computing the adjusted cost base of a shareholder's shares for such a dividend, provided that the election is made for the full amount of the dividend.

With respect to (e) above, a 149(1)(l) entity may qualify to have a capital dividend account if it is a private corporation. Under subsection 89(1), a capital dividend account consists of, among other things, the excess of the corporation's capital gain over the corporation's "taxable capital gain". A taxpayer's "taxable capital gain" from the disposition of any property is defined in paragraph 38(a) to be one half of the taxpayer's capital gain from the disposition of that property. Therefore, whether the entity is exempt from tax or not, the taxable capital gain is one half of the capital gain and the amount eligible to be added to the capital dividend account will never be greater than one half of the capital gain. This means that the tax-free amount available to the shareholders of a corporation (including a corporate 149(1)(l) entity), through the capital dividend account, will generally be limited to one half of the capital gain. This means that, in the situation outlined in your correspondence, one half of the Proceeds less the adjusted cost base of the property may be available to the shareholders as capital dividends, although a number of criteria would have to be met. The other half would generally be taxable to the shareholders.

Alternatively, the Corporation could choose to retain some or all of the Proceeds in order to further its objects. In our view, the Corporation would reasonably require some time to incorporate this surplus into its not-for-profit operations. However, if after a reasonable period of time it is apparent that the Corporation's surplus is not being expended on capital improvements, reduced costs of its services or other reasonable not-for-profit operational accommodations, the tax-exempt status of the Corporation as a 149(1)(l) entity could be jeopardized.

Nothing in this letter should be construed as implying that we are confirming that any of the taxable income of the Corporation is, or has been, exempt from tax under Part I of the Act pursuant to paragraph 149(1)(l) at any particular time. In this regard we note that the question of whether the Corporation does, in fact, operate exclusively for any purpose other than profit, with no part of its income payable to or otherwise available for the personal benefit of any member, is a question of fact which must be determined on an ongoing basis. This determination falls within the responsibility of the CRA's Compliance Programs Branch, and can generally only be made by the taxpayer's local TSO after the fact.

We trust that these comments will be of assistance.

Yours truly,

Eliza Erskine
Manager
Non-Profit Organizations and Aboriginal Issues Section
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch