The Pros and Cons of the Legal Structures available to Social Entrepreneurs in Alberta

Written By Kristina Roberts, JD 2018

Disclaimer: The information provided in this blog article is NOT LEGAL ADVICE.  This information has been provided by a recent law school graduate, not a student-at-law registered with the Law Society of Alberta or a lawyer. If you need advice with respect to a specific legal matter, contact a lawyer. In Alberta, you can contact a lawyer by calling the Lawyer Referral Service at: 1-800-661-1095.

Historically, organizations designed to serve the community and organizations designed to maximize private profits have been kept separate from one another. This has led to some negative side effects, such as corporations that focus solely on short-term profits without considering their wider impact on society, and non-profit organizations that are under-resourced and cannot sustain themselves. Social enterprise business models present a promising middle-ground between these two sectors and have the potential to be self-sustaining and wealth generating entities, that also contribute to social and/or environmental progress. Of course, many of the current laws in Canada were designed for the traditional corporate and non-profit models, and therefore may restrict entrepreneurs from pursuing economic and social mandates simultaneously.

Since legislation varies from province to province, but tax status is governed federally, it has been especially confusing for charities and non-profits to determine the circumstances in which they will be allowed to engage in profit-generating activities. This blog outlines some of the legal structures that allow non-profits to engage in enterprising activities without compromising their favourable tax status; these are charities with “related businesses” and mixed entity structures. Another suitable legal structure for many social enterprises is the co-operative. In recent years, a couple of Canadian provinces have also designed “hybrid” legal structures, specifically for social enterprises, to help catalyze the growth of this promising sector. Below, the pros and cons of these legal structures are laid out.

Charities with Related Businesses

While the Canada Revenue Agency (CRA) generally prohibits non-profits from intentionally earning profits, there is an exception for charities that run “related businesses.” A “related business” is defined as either a business run by volunteers, or a business that is linked to the charity’s purpose and remains subordinate to that purpose. The CRA has specified that there are 4 types of linkages that can exist between charities and related businesses:

  • Businesses that either supplement charitable programs, or are necessary for the delivery or operation of these programs (e.g. a food outlet in a museum).
  • Businesses that are a by-product of a charity’s programs (e.g. selling the produce generated from an educational gardening program).
  • Businesses that exist to take advantage of the charity’s existing assets to gain income during periods when they are not being used for the charitable program (e.g. renting out a facility).
  • The sale of items that promote the charity or its objects (e.g. t-shirts that promote the charity’s purpose).

Pros

  • The business and the charity exist as a single entity
  • The organization will be tax exempt and will be able to issue tax receipts to donors
  • Profits from the business can be used to finance the activities of the charity.

Cons

  • Very restrictive definition of “related business”
  • The business must remain “subordinate” to the charity. This is determined by looking at the portion of the organization’s attention and resources dedicated to the business, the level of integration between the charity and the business, the motivation for decision making, and whether the relationship between the parties is fair. In general, the business must be a very minor part of the charity’s operations.
  • The ability of a related business to grow and thrive will be extremely stifled by the restrictions above. Since investors are unlikely to see a worthwhile return on their investment, obtaining outside financing for these types of businesses will be very difficult. Further, if a charity uses resources intended to fund charitable programs to finance the business activities instead, it risks losing its status.

Mixed Entity Structures

Instead of running a business as an in-house program of a charity, non-profit organizations and charities can set up businesses as arms-length subsidiaries. Typically, these arms-length businesses are structured as private, for-profit companies.

Pros

  • Flexibility in allocation of assets and risks between the entities
  • No restriction on the type of business that can be established
  • The CRA allows corporations to earn tax credits for charitable donations of up to 75% of their net income
  • Tax exemptions for the non-profit entity
  • Financing flexibility for the for-profit entity (e.g. access to impact investment).

Cons

  • Mixed-entity structures can become complex and require a series of contractual arrangements.
  • Start-up enterprises may not have the resources and capacity to set up multiple entities.

Co-operatives

A co-operative (co-op) is owned by its members. Members may be consumers of the co-op’s products and services, or other stakeholders such as employees, producers, or community members.  Co-ops are democratically controlled, and are governed using a “one member, one vote” model. ­­­Co-ops typically operate at as close to a cost-recovery model as possible. Any surplus profit earned by the co-op belongs to its members, who then decide how to distribute it. Co-ops generally work towards the sustainable development of their communities.

Pros

  • Single entity
  • Flexible financing options e.g. for-profit co-ops are permitted to issue investment shares to non-members in order to raise capital
  • Less administrative burden than charities and other non-profit organizations that receive favourable tax treatment, if the co-op is structured as a for-profit entity
  • Allows for benefits to members and broader community.

Cons

  • Highly dependent on engagement of member base
  • Reduced control for individual entrepreneur.

Inspirational Structures

B.C. and Nova Scotia have taken the lead in Canada in developing hybrid legal structures designed specifically for social enterprises. These models will be elaborated on further in the sections below in order to provide inspiration to Alberta’s legislators and entrepreneurs alike.

British Columbia’s Community Contribution Companies (C3s)

The new B.C. regulations under the Business Corporations Act came into force in 2013.  One of the primary purposes of a C3, as stated in the articles of incorporation, must be a “community purpose” (e.g. the pursuit of health, social, environmental, cultural, or other community goals). C3s are permitted to access equity financing, however, a C3 may only distribute 40% of its assets and profits to shareholders. These restrictions were put in place in order to ensure that most of a C3’s profits would be dedicated toward pursuing the organization’s community purpose.

Pros

  • Single entity
  • Legal protection of community purpose (i.e. the community purpose will be embedded in the organization’s founding documents and will not be subject to the whims of changing leadership or economic conditions)
  • Broad definition of “community purpose” to allow for social innovation
  • Access to equity financing (impact investment)

Cons

  • No tax exemptions
  • No specific regulatory oversight
  • Lack of awareness of the model so may be difficult to attract financing and obtain legal services

Nova Scotia’s Community Interest Corporations (CICs)

The Community Interest Companies Act came into force in Nova Scotia in 2016. CICs share many of the same features as C3s. The primary difference between CICs in Nova Scotia and C3s in BC is that Nova Scotia has established a registrar specific to CICs, and Nova Scotia offers a tax credit to those who make investments in CICs.

Pros

  • Single entity
  • Legal protection of community purpose
  • Broad definition of “community purpose” to allow for social innovation
  • Access to equity financing (impact investment)
  • Specific regulatory oversight
  • 35% tax credit to impact investors

Cons

  • Lack of awareness of the model so may be difficult to attract financing and obtain legal services

Concluding Thoughts

Mixed-entity structures and co-ops are both viable alternatives to traditional corporate and non-profit structures for social entrepreneurs in Alberta. However, these structures are not suitable for everyone. Mixed-entity structures can be complex, and start-up enterprises may not have the resources and capacity to set up multiple entities. While co-ops offer many advantages, they require the existence of a highly engaged member base, which may not be a feature of every social entrepreneur’s business model.  In order to fill this void in Alberta, and stimulate the uptake of social entrepreneurship in this province, legislators could establish a new legal form (similar to what exists in B.C. and Nova Scotia) that allows an organization to sustain itself through enterprising activities, attract impact investment, and legally safeguard its socially beneficial purpose.

Stay Tuned

This blog article is the second in a series designed to provide information on legal structures to social entrepreneurs who are contemplating starting a new social venture.

This series is based on a directed research paper Kristina wrote titled “Legal Possibilities for Social Entrepreneurs in Alberta.” She was excited to have the opportunity to incorporate my passion for social enterprise into my legal studies, and to continue on my quest to discover how business can create a positive impact in society.