This month's blog is the first of two articles that discuss altering the Disbursement Quota (DQ) required for Canadian charities by the Income Tax Act.
The 'DQ' is a law that forces charities and foundations to spend at least 3.5% of their accumulated property that is not part of the everyday operations of the charity. So the charity must spend at least 3.5% of all its investments, like stocks and bonds, on charitable uses annually.
While that makes sense as we need charities to do their job, it means charities, unlike businesses and individuals, cannot use investment capital to grow the charity's capacity to serve. I argue this need for charities to spend money now needs to be balanced with the need to have stronger charities. These articles explore why and how we could achieve that better balance.
In suggesting changes to DQ, I can anticipate the groans.
We just went to great pains to update and greatly simplify the Disbursement Quota in 2010.
That is true, but compelling reasons exist for further tweaks, which I will outline over these two articles.
In this first article, we examine the background of the Disbursement Quota (DQ) required for Canadian charities by the Income Tax Act and reasons not to allow charities to accumulate capital. In next month's second article, we discuss the benefits of charities accumulating capital and possible means of implementation.
Historically the DQ was introduced in the 1950s for two functions: assure donors that charities spent a good portion on their charitable operations and ensure charities did not accumulate capital while sheltered from taxes.
Concerns existed then that fraudulent operators could amass a fortune and dissolve the charity for personal gain. The government wisely added new rules requiring any charity that disbands must donate monies held to qualified charity donees and thus eliminated personal gain opportunities.
After the government eliminated the dissolution concern, the question of tax-sheltered growth of funds seems less critical. Yet, in every revision to the DQ, the principle of avoiding capital accumulation has continued.
In 2010 the CRA greatly simplified the DQ computation. Calculating and tracking the DQ had become unwieldy and caused smaller charities to incur relatively high administration costs.
To illustrate, below are intentionally non-legible diagrams of the process to determine the DQ amount. A legible source document is here. The before 2010 procedure (on the left) vs. the after 2010 process show clearly the newer version is a significant simplification.
Understandably, donors deserve to be assured their gifts support a charity as intended. Contributions must not languish forever in an investment account. The DQ provides this assurance by requiring charities to spend a minimum of 3.5% of invested assets (those not employed in delivering the charitable service) each year.
While 3.5% may not seem like much or even enough, it is a minimum and applies only to a subset of the charity's assets. The level is especially appropriate for charitable foundations by allowing for perpetual donations to the supported charity each year despite market fluctuations or inflation.
Financial advisors use 3.5% of investments to provide a conservative pension that does not reduce the accumulated capital. If you have $2 million invested, you could have a $70 thousand pension and have the future equivalent of the $2 million when you die. In the same way, donations to foundations can be established to fund charity in perpetuity.
The issue of accumulation of capital
Outside of charities, in our capitalistic society, we are all encouraged to accumulate capital. At an early age, society teaches us about piggy banks and the importance of savings. We invest in our education for higher future earnings.
We are bombarded by retirement planning and savings advertising. We invest our savings to make money work for us and eventually to provide for our retirement. We have high esteem for those who (ethically) make large salaries and create wealth for themselves and others. We revere the champion donors who give millions from their accumulated wealth to charities. We respect corporations who use some of their profits to sponsor or donate significantly to charity.
And at the end of life, we honour those who donate some of their wealth to charity. We also know how hard it is to acquire wealth, and so usually, our last testament primarily gives to our immediate family.
Specifically, about capital accumulation, we tend to think positively. It is good and needed for success in life.
What is not understandable then is the aversion to the accumulation of capital by charities. Let's examine the pros and cons of a charity accumulating money, starting with the cons.
Cons: Reasons charities should NOT accumulate capital include:
We do not think of accumulating capital as a charitable objective.
We want to see charities spend as much as possible on their cause.
We dislike the idea of charities hoarding money when needs go unmet.
We expect charities that are benefiting from tax-shelters should focus on helping, not saving.
We are not confident that charities will spend wisely or benefit the operators.
We are concerned that charities could be vehicles for fraud or money laundering.
The above are all legitimate concerns, and at least partially are why the DQ exists. However, before looking at the pros for a charity to accumulate capital, consider first the ways charities raise money today:
Charities get funds from donors who control how much, when, and to which charity.
Charities get funds from fundraising activities, including annual donation campaigns, fundraising events, government grants, corporate donations, and sponsorships.
Charities get funds from legacy donations solicited to attract end-of-life estate gifts. These donations result from individuals accumulating capital and bestowing larger than usual sums to charities of interest.
Charities benefit from tax-saving charitable donation tax credits (CDTC) offered federally and provincially incentivizing larger donations, especially from higher tax bracket donors.
Charities benefit from tax-free earnings on investments by charities.
Note that board members are held responsible for choosing prudent investments.
Note that on the above list, charities are not adding to their capital base via investment returns. At best, their investment returns allow charities to maintain funds at about the same level after inflation. Charities grow in size by soliciting sizable endowments or running major capital campaigns, consuming significant resources in the process.
A somewhat recent trend in charitable donations is for donors to create a 'donor-advised fund.' A DAF is essentially a low-cost personal foundation run by an offering foundation (OF). Donors give instructions to the OF as to how much, where, and when to disburse. OFs advertise a benefit of DAFs can be to enable donors to give in perpetuity.
In 2018 the Canadian Federal Special Senate Committee on the Charitable Sector recommended exploring ways of ensuring donations do not languish in DAFs. Since the OF is currently required to provide the annual DQ funds only at an overall OF level, some individual DAF accounts can skip a year or more from donation to charity, thereby accumulating a small amount of capital. Some call for DAFs to have limited terms of ten years or to disburse at least 10% each year per DAF account in the US.
In next month's article, we turn to the benefits of charities amassing capital from investment returns.
Stay safe and cheers,
Cam Anderson
Coquitlam, BC, Canada
Email: Cam@FutureLegacies.ca
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