Private Foundations: Exceeding the 20 Percent Limit

A private foundation that owns more than 20 percent of a class of shares of a corporation's stock faces a penalty of 5 percent of the FMV of those excess shares (10 percent for a repeat offence), and the CRA may revoke its charitable registration. This limit can be exceeded unintentionally, perhaps by accepting a share donation or through the actions of a corporation in which the foundation owns shares (for example, selective redemptions). Corrective actions may be problematic or ineffective (for example, exchanging shares for debt).

The excess corporate holdings percentage (ECHP) is the percentage of a class of shares held by a private foundation at the end of its taxation year that exceeds the 20 percent limit. A net increase in ECHP is allocated to the private foundation's divestment obligation percentage (DOP) between its current and fifth subsequent taxation year, depending on how the shares were acquired. A penalty is assessed for any year in which the private foundation has a positive DOP.

Gifting the shares to a public foundation or a charitable organization might solve the problem, since those types of entities are not subject to the excess corporate holdings regime. However, the entities would have to consider the impact that the shares may have on their activities and disbursement quotas, particularly where the shares are not liquid or retractable. The problem could also be avoided by converting the private foundation into a public foundation.

Another possibility is requesting a reallocation of the DOP to a subsequent taxation year (up to 10 years) under subsection 149.2(6). This reallocation is possible only if the minister believes that it would be just and equitable.

A further potential solution is to sell the shares for cash. However, selling the shares back to the issuing corporation may not be possible if the corporation does not have sufficient liquidity. Finding a third-party purchaser for the shares may not be possible or desirable, and selling the shares for less than FMV to a non-qualified donee may constitute a breach of trust under common law.

Where the issuing corporation does not have the liquidity to pay cash for the shares, another idea that seems attractive at first glance is for the corporation to redeem the shares, with the compensation being a promissory note. However, subsection 188.1(3.2) states that if a private foundation enters into a transaction to avoid a DOP by substituting shares for "an interest (or for civil law, a right), in a corporation other than shares," then for this purpose such interest is deemed to have been converted back into shares at their FMV. Is debt considered an "interest," or is that term restricted to a form of equity participation, such as a stock option or warrant? In a technical interpretation provided to the author (dated December 12, 2018), which should at some point become public, the CRA takes the former interpretation. Thus, this exchange would not reduce the DOP, and the ECHP problem would still exist.

A side point: Suppose the ECHP problem arises because an individual donates shares of his or her private company to a private foundation. In that case, some planning might be required to ensure that the foundation can issue a donation receipt, because a non-qualifying security includes shares of a corporation not dealing at arm's length with the donor (subsection 118.1(18)).

Simon Cheung
Gardiner Roberts LLP, Toronto

Canadian Tax Focus
Volume 9, Number 2, May 2019
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