Introduction
The Canada Revenue Agency (CRA) requires charities with significant investments, which are primarily held in private and public charitable foundations, to spend a defined minimum of their endowment each year for charitable causes. Tax law and associated interpretations and practices balance the sustainment of foundations' capital against the doling out of annual funds. The CRA uses a mechanism called the Disbursement Quota (DQ). Currently, 3.5% of the invested capital is the required minimum annual spending.
The balance is delicate. Give too much, and the foundation spends down to extinction. Spend too little, and urgent charitable needs go unmet while tax-sheltered funds grow. Operating charities facing hard times during Covid recommend increasing the DQ to 5%, 10% or more. The Canadian Federal Government noted these concerns in the February 2021 budget and asked for the public's input on how the DQ should apply in 2022.
The following are my opinions and recommendations:
The DQ
The DQ is a single tool that does two jobs. One job is to ensure spending of tax-sheltered foundation funds. I agree with this function, and as further support, would advocate raising the DQ to 6.5%. I have analyzed the long-term investment returns and find this level of spending is sustainable. [i] My findings are presented below.
The second job the DQ performs is to control capital accumulation. I find this function for DQ to be troublesome, so I recommend changes that could make an enormous difference over time. We begin by examining this second issue.
Capital Accumulation: DQ history
The Federal government introduced the DQ in the 1950s for two functions: to ensure charities firstly spent a good portion of donations on their charitable operations and secondly did not accumulate tax-sheltered capital.
Concerns existed then that a fraudulent operator could amass a fortune and dissolve the charity for personal gain. The government wisely added rules that any disbanding charity must donate remaining monies held only to qualified charity donees, thus eliminating personal gain opportunities.
After the government eliminated the dissolution concern, allowing tax-sheltered growth of funds seems less critical. Yet, in every revision to the DQ, the principle of avoiding capital accumulation has continued.
Capital Accumulation: DQ benefits
In a way, avoiding capital accumulation does make sense. Practically and politically, unlimited growth of capital in a tax-sheltered charity would be a problem. If the DQ did not exist and no payout was ever required, funds could grow indefinitely. Why would the government permit ever-larger pools of money to grow endlessly without any limits? Today's DQ is the mechanism that ensures tax-incented donations are deployed towards charitable activities on a timely basis.
But does the DQ's control over accumulation go too far? Could there be a middle ground for better long-term outcomes?
Capital Accumulation: DQ concerns
The DQ prevents uncontrolled growth, but in so doing, overreaches by eliminating all possibilities for beneficial controlled growth.
We live in a society based on capitalism. The DQ limits charities from extensive use of our society’s most essential financial tool: compound growth. Individuals and corporations (but not charities) can use compound growth to save money for every need: to go to college, buy a house, take a trip, raise a family, retire, start a company, grow a company and so on.
Imagine if the CRA mandated that individuals and businesses must spend 3.5% of savings annually. The savings could never grow to be enough to reach intended goals. Note that individuals can save up for any length of time, including saving their entire lives to bequeath to their heirs. No time limits are imposed on any spending by individuals or corporations.
Yes, individuals and businesses pay tax, but that is on income, not savings. Growth in savings generates income, and that too is taxed. But tax is never applied on the total savings, just the growth. The net result is individuals and businesses can accumulate capital based on compounded earnings.
Charities cannot create funding from organic growth in savings, as the DQ is the showstopper. The DQ, therefore, forces operational charities and foundations to focus solely on fundraising. No other solutions to grow are currently feasible.
Yet charities are like businesses and have pressing demands to increase services to meet persistent needs. Lack of funding is all too frequently the chief reason why valuable services cannot be rendered and why serious needs go unmet. Indeed, the lack of funds for operating charities is the underlying thrust driving this desire to raise the DQ annual spending in the first place!
Capital Accumulation: DQ for the future
Suppose charities were permitted to split their fundraising into two pools, the DQ Applies Pool (DQAP) and DQ Exempt Pool (DQEP), on condition the Revenue Minister pre-approve a time-based plan to transfer money from the DQEP to the DQAP. See Figure 1.
Figure 1
The current Income Tax Act permits a DQ Exemption with the Minister's pre-approval. Today's practice is for a charity to apply to the Revenue Minister for a DQ exemption ranging from three to ten years on funds raised over multi-year campaigns for a significant purpose, for example, a new hospital wing.
DQ spending of capital raised for a new hospital wing before raising enough money to start construction is counter-intuitive and counter-productive. So, in this case, the temporary, specific DQ exemption makes perfect sense. The expiry of the DQ exemption ensures spending begins after a reasonable time.
In the future, the above process should expand to permit charities to apply to the Revenue Minister with a similar major fundraising plan for the critical purpose of building a fund generator, as a form of social infrastructure. The charity would use compound growth within the DQEP to grow funds and then transfer portions of the funds to the DQAP at pre-approved intervals. The charity would apply to the Minister with a carefully defined Donation and Payout Plan.
Possible elements of a DQ Exempt Donation and Payout Plan
A defined Donation and Payout Plan would control the amounts contributed, inform and limit the donor, and mandate payout amounts from the DQEP to the DQAP at specified dates. This plan eliminates uncontrolled growth.
Charities and donors not wishing to engage in the program would be under no obligation to do so.
The two differences in this proposal from existing DQ exemption requests are:
the length of time is much longer to permit significant capital growth and
the proposal extends the purpose for DQ exemptions allowed from today’s builds of hospital wings etc., to permit the building of a fund generator to augment and regenerate foundation coffers repetitively.
Example: DQ Exempt Donation and Payout Plan
This example is an illustration of ways to balance requirements. Many possible variations are possible with the primary goal to balance donations for today with seed money for the future.
Example Results:
Table 1
Impact of DQ Exempt Donation and Payout Plan
Donations: Controlled DQ Exempt contributions:
Government and charities share control of donations into the DQEP in three ways:
Limiting the length of years for donations to DQEP
Limiting the total amount per year to a percent of the charity's prior year annual receipts, and
Setting per donation contributions limits
Limiting the annual amounts available to donate creates scarcity and incents donors. This scarcity may encourage donors to give more during the DQEP campaign than they might otherwise, potentially surpassing the loss of DQ during the first ten years.
Tax deductions should apply for one hundred percent of all donations. All subsequent growth is tax-credit-free and will significantly reduce tax credits the government incurs in future.
Payouts: controlled growth for DQAP
The impact of creating a DQEP is that a tax-receipted donation is only partially contributing to its DQ via the DQAP portion for the first ten years. The DQAP receives the total donation value of DQ at year ten, and that same DQ grows with each subsequent twenty-five-year addition.
During typical markets, the investments are expected to double in about ten years. Actual results may be higher or lower. Whatever remains in the DQEP after year ten is the seed money for the fund generator. The year ten provision limits how long the charity must wait to have the total amount collected in a given year fully included in the DQAP.
This first ten-year period is similar to the exemption period allowed today for a major capital campaign. Except, in this case, the investment earnings during the first ten years remain in the DQEP to fund future growth and contributions are balanced with a high percentage immediately going into the DQAP.
The funds grow to a sizeable amount during the next phase from year ten to one-hundred and sixty. The payout portion is limited to twenty-five percent, so the bulk of the funds continue building up the fund.
Per Table 1 example results, we can see that by year one-hundred and sixty that a ten percent donation grows to almost seven hundred and thirty times larger.
Fundraising can cost fifteen[ii] percent of funds raised. Charities will pay no fundraising costs on transfers into the DQAP, and therefore save millions. For example, on a $7.3 million annual fundraising campaign costing 15%, the fundraising saved is $1.1 million.
Government considerations
Governments save tremendously on transfers from DQEP to DQAP by avoiding donation tax receipts. For example, for a $7 million fundraise, the tax credits avoided at 40%[iii] could exceed $2.8 million.
Accepting this new proposal for Donation and Payout plans requires no new wording in the Income Tax Act, relying instead on a change in interpretation guidelines issued by the CRA and the revenue minister.
Public reaction
Allowing the funds inside the DQEP to become a fund generator will appeal to those who want to see improvements in charitable funding. Positioning fund generators as infrastructure will create a sense of pride and ownership, fostering a protective attitude similar to Canadian's love of our health care system. Norway has an enviable sovereign fund that is protected by public pride and opinion from tampering.
Donors who give to public foundations could envision their contributions growing from seed funds to mature fund generators, repeatedly giving to charity amounts far beyond their current reach. This growth function democratizes charitable funding as donors big and small can equally make significant donations.
Those donors who can afford to set up private foundations could request to establish a fund generator immediately to regenerate their wealth to benefit their charitable goals.
Operating charities will not appreciate the intrusion of a ten-year wait period to establish seed funds but will see the advantages when the growth and repeat payouts begin. These charities also may take issue with the funds growing to a considerable extent if foundations' spending does not increase. But with predictable payouts regularly coming into the DQAP, foundations spending would increase beyond current levels.
Benefits of a charity accumulating capital
In the future, with support from a solid fund generator, charities could:
Offer more programs to meet the charitable need holistically
Be in control of finances for programs
Provide staff job security, team continuity, saving hiring and training costs
Help other charities
Save significantly on fundraising costs
Reduce reliance on government grants and tax deductions
This proposal recommends the creation of a publicly owned fund generator. This fund generator is an infrastructural element our society now sorely lacks.
Raising the DQ
What DQ percentage could the government require that foundations give each year that balances spending and growth? Perhaps the government should raise the DQ to 5% (a level the DQ has been before) or even go higher. The answer lies in balancing the two objectives, support and growth, over the possible gyrations of the investment markets.
I have built a predictive model to calculate potential outcomes at various annual DQ rates to inform the choice to answer this question. My model simulates random market movements at each DQ rate over one hundred years.
The model calculates two central values:
the fund's average annual level (the spending) and
the end value (the growth) over one hundred years of random market gyrations.
Knowing these values at various DQ levels allows us to compare the expected results over many years and select an ideal DQ. The ideal DQ for purposes of this study would ensure the charity gets the maximum possible support annually without diminishing the fund's ability to continue to payout at that same DQ rate in perpetuity.
View details of the model's assumptions, calculations and results here.
The simulation results
The results shown in the tables below are probabilities, not guarantees. Outcomes in percentages reflect today's dollars as the effect of two percent inflation has been subtracted from the assumed growth rate. The proportionality of the results does not change with or without inflation.
Table 2 addresses whether a fund can deliver now and continuously at various DQ rates without the fund's significant risk getting smaller. We can see the most likely effects by looking at the median value (where 50% of results are higher and 50% lower).
Table 2 shows for various DQ levels the Median Average and Median End values over one hundred iterations of one hundred years each:
Table 2
The results above for DQ lower than 6.5% show a strong and significantly growing fund. Even moving to a DQ of 7%, the median values enable a foundation to give 7% annually without experiencing a decline.
But the fund with a DQ of 7% would be diminished in capability half the time when results are lower than the median value. How much a higher DQ reduces the fund is addressed by the following table:
Table 3
Table 3 explains the risks of fund reductions. For example Table 3 shows that the risk for an ongoing DQ at 6% is that 8% of the time results in lower average fund values than the starting value. For about 11 % of simulations, the end value will be lower than the starting value. However, this means that the results would be higher in 92% and 89% of simulations.
The furthest right column shows that at a DQ of 6%, the Average End Value with lower-end value declined 28%. Remember, this only occurs 11% of the time. Mitigation over the one hundred years would be a fundraising campaign of 28% or 0.28% each year.
At a DQ above 6%, results are increasingly higher chances of reduced average and end values.
By keeping the DQ at 3.5%, the simulator shows zero risks over one-hundred simulations of the fund's value going down or that the average fund value was less than the starting value. Even with no new donations! The average end value result was to grow 6.19 times the starting value.
Fundraising impact
The effect of fundraising (at least for public foundations) should not be overlooked. According to a Globe and Mail study published in March 2018, the charities with the most considerable assets averaged 0.7% in the year of assets in gifted receipts. I suggest we could assume 0.7% as a proxy for the level of the public foundation's annual fundraisings.
Applying that assumed annual impact reduces the DQ by 0.7%. For example, choosing to set the rate at 6.5% with a 0.7% fundraising effort per year might move our results closer to 5.8% after taking fundraising into account. Appealing to donors is essential for a foundation's longer-term health, so the DQ level of 6.5% appears sustainable.
DQ level proposals
Moving to a DQ of 6.5% for foundations annually and 6% for foundations with no gifted receipts over the prior 24 months would allow much higher annual charitable giving while assuring the foundations remain strong. The impact of moving from 3.5% to 6.5% contributes 85% more per year for those foundations today at 3.5%.
The GIVE5 website reports that Charity Intelligence estimates a 5% commitment from all foundations would add $700 million in funding to charities. This DQ rise of 1.5% is a one-time event (1.5% is the difference of 5% less 3.5%).
Moving to a permanent 6.5% DQ would increase funding by 3.0%. Projecting from the Charity Intelligence data, this would mean adding $1.2 billion a year. That's another $30 billion over the next 25 years in much-needed funding.
Conclusion
A strong plan to add fund generators to our social infrastructure supports raising the DQ levels well beyond 3.5%, even beyond 6.5% levels. The government will be able to balance possible endowment decline with funding growth.
Such a change holds great potential to transform the Canadian society of the future. Our descendants will appreciate our forethought in creating funds for the next generations to use to their benefit and pass on. We owe a duty to our society to implement the many ideas in this proposal to create an ever better collective future.
Photo by Dan Almeida on Unsplash
Footnotes:
[i] Some creative and perhaps considerable legal work may be required in the cases where foundations are not currently permitted to sell their endowment capital and thus are only permitted to donate interest and dividend income. Current interest rates are inadequate to meet higher DQ rates, yet equity prices continue to escalate to new highs. Selling equity is necessary to address the imbalance. [ii] Per Costs of Fundraising Costs (affinityresources.com) the average US charity spent $1 to raise 5.40 which is 18.5%. As a rough estimate then and to be conservative, a 15% factor is used.
[iii] The site Claiming charitable tax credits in Canada in 2020 – RC Forward estimates for larger donations above the first $200 that a savings of between 40 and 53% apply. We assume 40% to be conservative.