Friday, 1 February 2013

Can a Charitable Foundation with a Single Trustee be designated as a Public Foundation?

Recently published in the Canadian Tax Journal and reproduced with permission here.

The Federal Court of Appeal recently released its decision in Sheldon Inwentash and Lynn Factor Charitable Foundation v. Canada. At issue in the case were the requirements for a charitable foundation to qualify as a “public foundation” for the purposes of the Income Tax Act.

The Effect of the Designation
There are several differences between a private charitable foundation and a public foundation. The main difference from a non-tax perspective is that a private foundation is typically funded by related individuals while a public foundation is typically funded by unrelated parties.

From a tax perspective, there are several additional differences. One important difference is that the Act strictly prohibits a private foundation from carrying on any business. A public foundation, on the other hand, may carry on a business related to the charitable objects of the foundation.

Another notable difference from a tax perspective is that a private foundation, unlike a public foundation, cannot issue donation receipts for non-qualifying securities unless and until such securities are disposed of within 60 months of the date on which the donation was made. A non-qualifying security for these purposes is a security, obligation, or share of a non-arm’s-length corporation. In other words, where a shareholder of a related corporation gifts his or her shares to a private foundation, the donor is unable to take an immediate tax benefit from this transaction, and if the foundation does not  dispose of the  qualifying shares within  the  statutory  time frame, the tax advantage to the donor will be lost.

The Facts
In Sheldon Inwentash, an inter vivos trust was settled by Mr. Inwentash and capitalized by him, his spouse (Lynn Factor), and /or entities controlled by them. While the trust qualified as a charitable foundation and a registered charity under the Act, the min- ister designated the trust as a private foundation, as opposed to a public foundation, in large part on the basis that the trust had only one trustee.

Pursuant to paragraph 172(3)(a.i), the trust appealed the designation directly to the Federal Court of Appeal.

The Current Statutory Ambiguity
The court considered the intent of Parliament with respect to whether a charitable foundation with a single trustee could be designated as a public foundation. The Act does not explicitly address this issue. However, section 149.1 does define the term “public foundation” to mean, essentially, a charitable foundation of which
1. more than 50 percent of the directors, trustees, officers, or like officials deal with each other at arm’s length, and
2. not more than 50 percent  of the capital contributed  was paid by a related group.

Neither  the definition nor any other provision of the Act specifies whether a public foundation  must have a minimum number  of directors, trustees, etc., in order to meet the first requirement.
A charitable  foundation  that  is not a public foundation  is considered  to be a “private foundation,” as defined in section 149.1.

The Court’s Decision
Textual Interpretation
The appellant’s main argument was that, while the trust had only one trustee, on the basis of the wording of the definition of “public foundation,” this did not constitute a violation of the arm’s-length requirement.

The court disagreed. The court held that the intention of Parliament was to ensure that public foundations have more than one trustee. There were three reasons for this. First, it is implicit in the reference in section 149.1 to “more than 50% of the . . . trustees” that there be more than one. Second, section 149.1 states that all of the trustees and other like officials should be dealing with “each other”; if the trustees are required to “deal with each other,” there must be more than one. Third, if the trustees must deal with each other at arm’s length, there is a requirement of multiple trustees. One cannot be at arm’s length from oneself. The court therefore held that there must be more than one trustee.

During the oral argument, counsel for the appellant suggested that the court should read out or not apply certain words in the definition when there was only one trustee. Yet the legislature is presumed not to speak in vain. Every word in the statute is generally considered to be in the statute for a reason [Ruth Sullivan,  Sullivan on the Construction of Statutes, 5th ed. (Markham, ON: LexisNexis Canada, 2008), at 530.].  This, the court held, was a reason not to accept the statutory interpretation put forward by the appellant.

It appears that Dawson JA was prepared to decide the case on this textual interpretation, but she chose to extend her analysis:
In my view, by the use of this language Parliament has precisely and unequivocally evidenced its intent that public foundations must have more than one trustee (or director, officer or like official). This means that the ordinary meaning of the words used should play the dominant role in the interpretation of the definition. For completeness, however, I will review the statutory context and purpose of the definition.

Context and Purpose
The court held that the statutory context and the purpose of the “public foundation” definition clearly indicated that, in choosing different treatment of public and private foundations, the federal government was concerned about potential abuse through self-dealing transactions.[1]

Charitable foundations can be used to mask self-dealing transactions and avoid taxes for the principals behind the foundation. The court provided two examples of such transactions:
 1. having the charity rent premises from the donor at high rent; and
2. investing in low-yield debt or equity of the donor’s business.

The court reviewed a publication from the Department of Finance and concluded that by creating public and private foundations, Parliament was balancing a desire to promote philanthropy with a concurrent desire to limit the potential for avoidance schemes.[2] A requirement for multiple trustees/managers[3] is one way to ensure that one party cannot control the work of the foundation at issue, and thus to reduce the likelihood of self-dealing transactions. If many people are involved in filling management positions and in giving money, there will likely be multiple layers of oversight of the activities of the charitable foundation.  This makes it more difficult for any individual or group to arrange the affairs of the foundation so as to benefit that individual or group, rather than the charitable purposes for which the foundation was created. If these safeguards against the possibility of self-dealing are in place, the designation of “public foundation” will give greater latitude to the charity. Conversely, if the setup and operation of the charitable foundation is unlikely to prevent self-dealing by its founders, or by other individuals or groups, the law provides specific restrictions  (as noted above) that are designed to remove the tax benefits that may otherwise have been part of the reason for creating the foundation in the first place. Therefore, the law creates an incentive for oversight and commitment to charitable purposes, rather than an opportunity for self-dealing.

A parallel concept to the distinction in the Act between a “public” and a “private” charitable foundation can be found in corporate law. In that context, the same nomenclature is often used in popular discourse to describe the distinction between corporations subject to public securities regulation and other corporations. Generally, there are different rules governing the control of public corporations. For example, under the Canada Business Corporations Act (“CBCA”), “distributing  corporations”  (which generally would all be “public” corporations) are expressly required to have at least three directors, at least two of whom must not be either officers or employees of the corporation.

The point of this requirement is to ensure that management[4] is accountable to persons who are not dependent on the corporation for their livelihood.[5]  In a “public” or “distributing” corporation, a solicitation of funds from the public is made.[6]  At the same time, the involvement of most shareholders in the corporation is minimal and intermittent, through shareholder meetings.18  Yet shareholders are the residual beneficiaries of the activities of the corporation.19 Thus, certain safeguards are put in place to ensure that the members of management do not enrich themselves at the expense of the shareholders.20  In the simplest terms, the use of outside directors (who are neither part of management nor employed by the corporation) is designed to discourage self-serving behaviour. In the same way, public foundations are subject to a less restrictive regulatory regime under the Income Tax Act than that applied to private foundations, presumably on the basis that the involvement of arm’s-length directors and funding from third parties will prevent any self-dealing that would allow unwarranted tax benefits.

The Interpretation Act Argument
The appellant argued that section 33(2) of the federal Interpretation Act applied. That provision states that “words in the plural include the singular.” The court rejected this argument, relying on section 3(1) of the Interpretation Act, which states as follows:
 (1) Every provision of this Act applies, unless a contrary intention appears, to every enactment, whether enacted before or after the commencement of this Act [emphasis added].
The court held that the use of the terms “more than 50%,” “deal with each other,” and “at arm’s length” in the definition of “public foundation” clearly indicated a contrary intention to the application of section 33(2) of the Interpretation Act.

SheldoInwentasis an example of a case where the court reached the right result on the facts before it, using a textual, contextual, and purposive interpretation. However, in the end, it is not likely a decision that will present a major obstacle to taxpayers, since it should be easy for a foundation to appoint two arm’s-length trustees. Rather, it is the second branch of the “public foundation” definition (whether as currently drafted or as proposed in technical amendments released on July 16, 2010)[7] that will present the bigger obstacle. While this second branch was at issue in Sheldon Inwentash, the court decided that it need not address it, given its finding on the first branch.

[1] CBCA section 120 provides a series of procedural and substantive requirements to validate a self-dealing transaction. Absent compliance with this provision, under both the statute (CBCA section 120(8)) and the common law (Aberdeen Railway Co. v. Blaikie Bros., [1843-60] All ER 249 (HL)), the transaction will be invalidated by the court.
[2] The court cited Canada, Department of Finance, Discussion Paper: The Tax Treatment of Charities (Ottawa: Department of Finance, 1975). In addition to the issues identified by the court, the discussion paper contained the following comments (at 9, paragraphs 20-21): “The creation of such [private] charities may have significant tax consequences. Most importantly, the charity is exempt from all taxes on its income, subject to the distribution rules which normally require that 90 per cent of the annual income be paid out each year. Other tax consequences follow from the fact that subsequent contributions to the charity are tax-deductible within prescribed limits and that bequests are, in some provinces, free of succession duties. It has become evident in recent years that a few taxpayers have been abusing the opportunity to establish private charities. The most common abuse has been in arranging investments and expenses to ensure that the charity has little income and pays out a relatively small sum annually in comparison to its capital. This may be done by having the charity invest in low-yield debt or equity of the donor’s business, by renting premises from the donor at high rent, by paying family members high salaries for relatively little work or by lending money to family members at low rates of interest.”
[3] In our view, the words “directors, trustees, officers or like officials” in the definition of “public foundation” in section 149.1 is meant to cover all categories of management personnel. Regardless of the title given to the person (director, officer, trustee), or the legal form used (corporation, trust, or other legal form of a charitable foundation), if the person is reasonably part of the management team of the foundation, he or she is subject to the rules that are designed to reduce the likelihood of self-dealing with the foundation. For further discussion, see the text following note 5 below.
[4] “Management” in this case refers to the collectivity of directors and officers of the corporation who manage its strategic directions as well as its day-to-day affairs. See J. Anthony VanDuzer, The Law of Partnerships and Corporations, 3d ed. ( Toronto: Irwin Law, 2010), at 15 and 254-55. Section 102(1) of the CBCA requires that directors either manage or supervise the management of the business and affairs of the corporation. Practically, it is far more common for directors to do the latter while leaving day-to-day management concerns to the officers of the corporation. The board of directors often meets a limited number of times throughout the year to review the affairs of the corporation and make large-scale strategic decisions: VanDuzer, supra, at 255. Therefore, depending on how the power is divided, both officers and directors effectively have management power.
[5] Officers and employees are generally expected to devote most (if not all) of their professional efforts to the business and affairs of the corporation, and it is their actions that often determine corporate success. The appointment of non-executive directors, as required by CBCA section 102(2), is therefore intended to provide an important check on the power of officers and other employees. For a fuller discussion of the role of non-executive directors in governance in both theory and practice, see, for example, Derek Higgs, Review of the Role and Effectiveness of Non-Executive Directors (London: Department of Trade and Industry, January 2003).
[6] Jeffrey G. MacIntosh and Christopher C. Nicholls, Securities Law ( Toronto: Irwin Law, 2002), at 139 and 254.
[7] Canada, Department of Finance, Legislative  Proposals To Amend the Income Tax Act and Related Legislation To Effect Technical Changes and To Provide for Bijural Expression in That Act (Ottawa: Department of Finance, July 16, 2010), part 1, subclause 109(1).

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