The Disbursement Quota Rules and their Implications for Charities
Tucked away in 2010 Federal Budget were several proposed provisions which will radically impact the way that charities manage their donations. These provisions, which reform and substantially simplify the existing disbursement quota rules, should dramatically impact the conversations that gift planners (and all fundraisers) have with their prospective donors.
Thankfully, Canadians will be returning to those halcyon days when “DQ” meant a trip to the local Dairy Queen for some tasty soft serve. While the elimination of the most onerous disbursement quota provisions should be thunderously applauded, we need to understand what these changes truly mean when we sit down with our supporters and discuss their next gift.
Item #1: Elimination of the Charitable Expenditure Rule
The “80/20” rule for ordinary receipted donations will be eliminated. Charities will no longer be required to spend 80% of receipted donations on charitable activities by the end of the year following the issuance of the receipt.
This is good news for charities. Small and rural charities, especially those that received the bulk of their funding from tax-receipted donations as opposed to government grants or sponsorships, often had difficulty meeting the disbursement quota requirements.
Under the new regime, charities will no longer be required to closely monitor their receipted versus non-receipted donations. They will also be able to accumulate donations for the purpose of raising funds for longer-term projects (and may even be permitted to exclude these accumulated gifts from the 3.5% provision outlined below).
The 80/20 rule was originally introduced to curtail administrative spending by charities and ensure an appropriate portion was spent on charitable activities. Although this is repealed, charities are still required by law to “devote their resources to charitable activities”. Over the past few years, the Charities Directorate has engaged the charitable sector in a discussion about the level of expenses that are reasonable for charities to incur. The result was the introduction of new Fundraising Guidelines (which will not be discussed in this paper). While the Guidelines are new, and charities are just beginning to understand and interpret them, they are designed to ensure that charities continue to engage in charitable activities. The absence of the 80/20 rule does not mean charities can now arbitrarily and without sanction spend their funds on administration.
Key Point #2: Elimination of “Enduring Property”
Enduring property has been eliminated as well as the “ten-year” gift which excluded lifetime donations from the 80/20 formula if the capital was held for a minimum of ten years.
The rules around enduring property were incredibly burdensome for charities, especially the requirement that each ten-year gift be tracked individually. No longer will charities have to track the expiration of ten-year gifts for the purposes of a disbursement quota calculation or manage the fine line between ten-year and perpetual gifts. This will also allow charities to spend unrestricted gifts on their own timetable, reflecting the actual needs of their own programs and activities.
Of course, charities will likely still have to comply with the terms of their own endowments and the documents under which they were created.
Item #3: Elimination of “Capital Gains Pool”
The “capital gains pool” has been repealed. The capital gains pool was essentially a notional tracking of a charity’s realized capital gains. While it provided charities with somewhat more flexibility with respect to meeting their disbursement quota, it also provided administrators with an unending source of head-scratching.
Many charities did not implement the capital gains pool, due to their investment policy, record-keeping systems, and lack of understanding. The capital gains pool concept also imposed a set of administrative rules that was contrary to prudent investing. It dictated that capital gains be crystallized and the proceeds held outside the charity’s main investment portfolio to enable capital to be used for charitable purposes according to a complex formula. Many charities did not implement the capital gains pool, due to their investment policy, record-keeping systems, and fundamental lack of understanding. No wonder that I’d rather jump in the pollution-infested waters of the Erie Canal than wade into the murky ones of capital gains pool. Good riddance. The proposed new regime provides the flexibility without the complexity.
Item #4: Retention of the Capital Accumulation Rule
Charities must spend on charitable purposes an amount equal to at least 3.5% of eligible property owned in the 24-month period prior to the current year (that is, property not used directly in charitable activities or for administration). This is effectively unchanged from previous rules. However, charitable organizations with less than $100,000 (up from $25,000) in eligible property are exempt as are foundations with under $25,000 in such property.
Charities must continue to manage and track their eligible (sometimes referred to as “investable”) property. It is important to note that charities must take a rolling average of their property held in the 24-month period prior to the current year. This figure may different significantly from charity’s current eligible property due to market fluctuations, additional donations and grants.
I believe that the increase in the exemption for charitable organizations to $100,000 will lift the administration burden of the 3.5% rule for a significant number of charities. In fact, sector-based organizations like Imagine Canada will need to consider how to communicate this important change to their constituents.
It will be highly interesting to evaluate the impact of this change (and the elimination of enduring property rules) on a charity’s investment policy. The flexibility introduced by the proposed new rules should allow donor’s to disburse the capital from the gifts on a different schedule. What happens if a million-dollar donor asks the charity to use the donation over a five-year period (let’s say $200,000 per year) instead of using only the income over a longer term period. This request, along with others like it, should cause the charity to rethink its investment objectives (time horizon being an important component of investment objectives) and therefore its asset mix and investment policy. Charities may wish to consider the introduction of “spend-down” funds into their policy mix – a middle category between immediate use and endowment. Charities will also have more of an opportunity to build reserve funds or quasi-endowments, which are managed like endowments but with access to capital, as needed.
Finally, the new rules eliminate an inherent conflict between the governing rules of trustee investment legislation (typically found in provincial Trustee Acts) and the Income Tax Act. Trust legislation generally calls for charities to adhere to “prudent investor” standards which often result in a focus on total return investing (where the total return of the portfolio is the prime focus, rather than what generates these returns). The old DQ rules required a focus on income generation whereas the new regime will allow the charity to engage in total return investing without regard to the tracking of income and capital.
In fact, I would suggest that all charities carefully review their investment policies over the next few months.
Item #5: Strengthening of Anti-Avoidance Rules
The budget also introduced some other changes around inter-charity transfers, which will be ignored for the purpose of this article because these changes have virtually no impact on most donors.
Existing gift agreements may be reviewed in order to determine whether or not they can be amended to reflect the new rules. In cases where the gift arrangement can be amended and the original donor is still alive, it may be prudent to discuss with the original donor whether they would be interested in revisiting the current terms of the gift. Charities will also likely want to see the actual legislation before taking any drastic action on existing gifts.
It is critical for charitable personnel (including senior volunteers) to familiarize themselves with the new rules because of the potential of these new rules to affect not only how we administer the charity but how we discuss giving with our potential donors.