TAX ISSUES IN INTERNATIONAL PHILANTHROPY Ellen E. Halfon, Esq. Jones Day September 24, 2010 I. General Tax Hurdles for Direct Gifts/Grants to Foreign Charities A. Individuals federal income tax charitable deduction. Contributions by individuals to foreign charities will generally not qualify for federal charitable income tax deduction. IRC 170(c)(2) (contributions are deductible only to charitable organizations created or organized in the U.S.). This is true even if the foreign charity subjects itself to U.S. tax law by applying for and receiving recognition as an organization described in IRC 501(c)(3). Contributions to a domestic charity that uses some or all of contributions received to support charitable purposes in foreign countries, are permissible, however, so long as the domestic charity does not act as a mere conduit. See III, below. 1. Certain direct contributions permissible under tax treaties. The United States currently has tax treaties with Mexico, Canada and Israel the permits deductions for contributions to certain entities those countries; generally, such contributions must be made with income derived in the relevant foreign country. Under the U.S.-Canada treaty, however, deductible contributions can be made with U.S. source income to a Canadian college or university at which the U.S. citizen, resident or member of his/her family is or was enrolled. B. Individuals gift and estate tax charitable deduction. Gift and estate tax charitable deductions are generally allowed for direct gifts to foreign charities, provided they are to be used exclusively for charitable purposes. The deductibility of such gifts may, however, be impacted by estate/gift tax treaties with the country in question. As a practical matter, testamentary foreign gifts are more common than lifetime gifts to a foreign charity, since no corresponding income tax charitable deduction would be available for the lifetime gift. If an individual is in a carry forward charitable income tax deduction situation, however, or will not benefit from an income tax charitable deduction due to the AMT, a direct gift to a foreign charity might still be considered. 1. Gifts to foreign governments. Gifts to a foreign government for public purposes or without any limiting charitable purpose, are not eligible for charitable gift or estate tax deductions. The IRS has disallowed a charitable estate tax deduction even when a government has an internal policy that such gifts/bequests must be used solely for charitable purposes, under the theory that such policies might not be enforced. Thus, in order 1
to qualify for a charitable deduction, a lifetime or testamentary gift to a foreign government must specify the charitable purpose for which it is required to be used. See, e.g., TAM 8929001, TAM 8748001, Estate of Leona Engelman v. Comm r., 121 T.C. 54 (2003). 2. Charitable remainder trusts. Gifts to foreign charities cannot be accomplished through a charitable remainder trust even if a deduction would be permissible for a non-deferred gift for federal estate, gift or income tax purposes (e.g., if there is a treaty with the foreign country that would permit a charitable income tax deduction). This is because the charitable remainder trust rules require that a qualified charitable remainder beneficiary must be a charity described in 170(c), which includes only domestic charities. A CRT that names a foreign charity should not fail, however, so long as it has the required default provisions to provide for designation of a replacement charity. C. Corporations. The availability of charitable income tax deductions by domestic corporations for use overseas is more restricted. Under IRC 170(c)(2), a charitable contribution made by a domestic corporation that is intended for use overseas can be made only if made to a U.S. charity that is formed as a corporation rather than a trust. Thus, U.S. corporations can make charitable contributions for use overseas if made through an intermediary domestic charity that is a corporation. See III, below. D. Public Charities. U.S. public charities (e.g., organizations described in IRC 509(a)(1),(2), and in some cases 509(a) (3)) may conduct activities in foreign countries, and make grants to foreign charities, so long as it is they exercise sufficient control and discretion over the funds/activities. See III, below. 1. Donor advised funds of public charities. Grants to foreign charities can be made to a foreign charity by a donor advised fund (DAF), but only in the same manner as permitted for private foundations. IRC 4966 makes such grants subject to the taxable expenditure rules of IRC 4945. Excise taxes can be imposed on the DAF and on fund managers if expenditure responsibility is not exercised. See discussion of expenditure responsibility in II, below. E. Private foundations. A grants made by U.S. private foundations to any organization that is not a U.S. 501(3) organization described in IRC 509(a)(1), (2) or a Type I supporting organizations described in IRC 509(a)(3) (treated as a public charity) will be a taxable expenditure subject to excise tax under IRC 4945 unless the private foundation makes an equivalency determination or exercises expenditure responsibility. Grants to such organizations also need to qualify as qualifying distributions in order to count toward the private foundation s 5% minimum distribution requirements under IRC 4942. See II, below. 2
II. Direct Grants by Private Foundations. A. IRC 4942 Qualifying distributions. Under IRC 4942, a private foundation is required to distribute a minimum distributions annually of approximately 5% of the fair market value of its non-charitable use assets. Such grants must be qualifying distributions, meaning they must be used solely for charitable purposes. A foreign grant can qualify under IRC 4942 as a qualifying distribution if it is solely for charitable purposes and is made: 1. to a foreign organization that has received a favorable determination letter as a U.S. public charity (as a practical matter, this is seldom done, since contributions by U.S. taxpayers to a foreign charity with 501(c)(3) status still are not eligible for charitable income tax deductions). 2. to a foreign charity with respect to which the private foundation has made a good faith determination that the foreign charity is the equivalent of a U.S. public charity ( equivalency determination ). An equivalency determination requires: a. a legal opinion as to the equivalency of the foreign charity from the foundation s own counsel or from the foreign charity s counsel. b. an affidavit from the foreign charity that complies with Rev. Proc. 92-94. Under Rev. Proc. 92-94, if the affidavit is up to date, it can be relied upon by multiple U.S. foundations. See Treas. Reg. 53.4942(a)-3(a)(6). An equivalency determination can be costly and administratively burdensome, particularly for smaller charitable organizations. 3. a foreign governmental unit, provided the grant is for a specified charitable purposes (this should be memorialized in the grant letter). See IRC 4942(g)(1)(A), Treas. Reg. 53.4945-5(a)(4)(iii); and PLR 200408035. 4. to a foreign charity with respect to which the private foundation exercises expenditure responsibility. See Treas. Reg., 53.4945-5(b). Expenditure responsibility requires: (1) a pre-grant inquiry by which the private foundation exercises sufficient due diligence to determine that the foreign charity will use the grant solely for the charitable purposes intended (e.g., review of operational history, reputation and finances). (2) A signed written agreement with the grantee organization by which the grantee agrees to (i) maintain grant funds in a 3
separate account for the specified charitable purposes; (ii) repay to the private foundation any funds not used by the grantee for such purposes; (iii) submit annual reports to the private foundation describing how the funds have been used to fulfill such purposes (e.g., progress and milestones); (iv) maintain and provide the private foundation with access to books and records regarding the use of the funds. Often such agreements also prohibit regranting of funds to other foreign organizations or individuals. In addition, such agreements also often include language restricting use of funds for any purpose not permissible for an organization described in IRC 501(c)(3) (e.g., no substantial lobbying, no political expenditures, no private inurement or distribution), since such limitations are not always required for charitable status in other countries. (3) Reporting regarding the grant on the private foundation s Form 990-PF. 5. to a foreign entity that is not the equivalent of a U.S. charity (e.g., a noncharitable entity akin to a U.S. trade association or social club), where the expenditure responsibility requirements are met (e.g., the grantee agrees to segregate the funds in a separate account, use them only for designated charitable purposes, report to the private foundation regarding the use of the funds, and return any unused funds). If the grant is to a foreign charity that is the equivalent of a U.S. private foundation, then in order for grants to the foreign charity to count toward the private foundation s 5% minimum distribution requirement, in addition to exercising expenditure responsibility, the foreign grant must be distributed by the grantee for charitable purposes within 12 months following the close of the taxable year in which it was received and such distributions must be treated as being made out of corpus. See IRC 4942(g)(3) (these same rules apply to grants by private foundations to U.S. private foundations). B. IRC 4945 taxable expenditures. Under IRC 4945, a grant by a private foundation to a foreign charity will be a taxable expenditure subject to excise taxes unless the private foundation either makes an equivalency determination or exercises expenditure responsibility as described in II.A. above regarding qualifying distributions. In 2001, John Edie of The Council on Foundations requested and received from Treasury a general information letter (dated April 18, 2001) confirming that a private foundation is not required to first make a good faith determination regarding equivalency and may treat the grant from the outset as a grant to a non-public charity by exercising expenditure responsibility. The letter addressed treatment in such circumstances under IRC 4945 and 4942 (e.g., the letter stated that, in the case of a grant to a foreign grantee that the 4
granting private foundation has decided to treat as a noncharitable entity, so long as expenditure responsibility requirements are met and the entity has not applied for and received a U.S. determination letter, the IRS will not recharacterize the foreign grantee as a 501(c)(3) entity, and require application of the out of corpus rules described in II.A. above). C. Program-related investments in lieu of grants. Under IRC 4944, a private foundation may invest its resources in international projects that further the foundation s charitable purposes such an investment is called a program-related investments (PRI). A PRI must satisfy three criteria: 1. it must be made primarily to accomplish one or more charitable purposes of the foundation. 2. no significant purpose of the investment can be the production of income or appreciation of property. 3. no purpose of the investment can be to lobby, support or oppose candidates for public office, or to accomplish any political activities prohibited for private foundations. III. Examples of PRIs that could be made by a private foundation are investments in microfinancing projects, interest-free or below-market loans, loan guaranties or letters of credit. Expenditure responsibility must be exercised with respect to a PRI made to a foreign organization that is not a U.S. public charity equivalent, although the IRS has held that expenditure responsibility is not necessary where the PRI is made to a foreign government for a specific charitable purpose, because foreign governments are treated as public charities for purposes of the expenditure responsibility rules (see II.A.3. above). PLR 199943058, PLR20031053. For further examples of approved international PRIs, see PLR 200121078, PLR 200136026, PLR 200034037.. Use of Intermediary Organizations/Direct Foreign Grants by U.S. Public Charities A. Contributions or grants made to U.S. charities that conduct part or all of their charitable activities in a foreign country. The IRS has ruled that a 501(c)(3) entity may conduct part or all of its charitable activities in a foreign country. Rev. Rul. 71-460; see also, Rev. Rul. 68-117; Rev. Rul. 68-165. In addition, a section 501(c)(3) entity will not jeopardize its exemption even though it distributes funds to organizations that are not 501(c)(3) entities, including foreign charities. Rev. Rul. 68-489. In order that such activities do not jeopardize the U.S. charity s exempt status, however, the U.S. charity must retain control and discretion regarding the use of the funds and maintain records establishing that the disbursed funds were used solely for 501(c)(3) charitable purposes. These control requirements are relevant for preserving the deductibility by U.S. taxpayers for contributions to U.S. charities that disburse funds or conduct activities in foreign 5
countries, since (as noted above) absent a tax treaty, contributions to foreign charities are not deductible for charitable income tax purposes. B. Friends of organizations and other public charities disbursing funds to, or conducting activities in, foreign countries. A common form of 501(c)(3) entity is a friends of organization, which receives contributions in the U.S. but disburses funds to one or more named foreign charities. So long as the friends of organization exercises appropriate control over the contributed funds, and does not act as a mere conduit (which would cause the contribution to be deemed made to the foreign charity, rather than to the friends of organization), contributions to the organization are deductible. See Rev. Rul. 63-252. The factors that demonstrate control for friends of organizations provide guidance for any U.S. charity disbursing funds to, or carrying on activities, through foreign charities. In Rev. Rul. 66-79 (amplifying Rev. Rul. 63-252), the IRS held that the inclusion of the following language in the bylaws of a U.S. charity demonstrated that the charity had and exercised sufficient control as to the use of contributions that are disbursed to a foreign charity: 1. The making of grants and contributions and otherwise rendering financial assistance for the purposes expressed in the charter of the organization shall be within the exclusive power of the board of directors; 2. The board of directors shall review all requests for funds from other organizations that are not 501(c)(3) organizations, shall require that such requests specify the use to which the funds will be put, and if the board of directors approves the request, shall authorize payment of such funds to the approved grantee; 3. The board of directors shall require that the grantees furnish a periodic accounting to show that the funds were expended for the purposes which were approved by the board of directors; 4. The board of directors may, in its absolute discretion, refuse to make any grants or contributions or otherwise render financial assistance to or for any or all the purposes for which funds are requested; and 5. After the board of directors has approved a grant to another organization for a specific project or purpose, the corporation may solicit funds for the grant to the specifically approved project or purpose of the other organization; at all times, however, the board of directors shall at all times have the right to withdraw approval of the grant and use the funds for other charitable, scientific or educational purposes. The IRS again addressed this issue in Rev. Rul. 75-65, in the context of a U.S. charity that made grants to charities in a foreign country for the purpose of dealing with the problems of plants and wildlife ecology in that country. There, the IRS held that contributions to the U.S. charity were deductible because the 6
charity exercised control by making an initial field investigation regarding the purpose for which the grant would be used, entering into a written agreement with the foreign charity to ensure how the grant is used, and then making subsequent field investigations to confirm that use. C. Supporting organizations. 1. Supporting organization of foreign charity. A supporting organization described in IRC 509(a)(3) may be formed to support a foreign organization. Rev. Rul. 74-229. Thus, a friends of organization could, in theory, be created as a supporting organization (this might be desirable, for instance, if there were concern about passing the public support test). The challenge with using a supporting organizations for this purposes is the tension between the required close relationship of the supporting and supported organization, and the need for the domestic supporting organization to exercise sufficient control/discretion over grants (e.g., a Type I supporting organization controlled by the foreign charity would be problematic). Accordingly, friends of organizations are generally formed as stand alone 509(a)(1) public charities. 2. Foreign grantmaking/activities by supporting organizations. A supporting organization formed to support a domestic public charity can make foreign grants or conduct activities overseas, provided such grants/activities are in furtherance of the supported charity s exempt purposes (for instance, to facilitate a foreign program of the supported charity). The supporting must also exercise the same control and discretion required of any public charity making foreign grants. D. Grants to intermediary organizations by private foundations and donor advised funds (or even by other public charities). Intermediary organizations that exercise sufficient control over foreign grant-making or use of assets for charitable activities in foreign countries can provide a means for private foundations and donor advised funds (or even by other public charities) to support foreign charitable endeavors without the administrative burdens of making the grant directly (e.g., equivalency determinations, expenditure responsibility). E. Problems with earmarking. If the friends of or other intermediary organization does not exercise sufficient control and discretion over contributions or grants made to it and used overseas, the intermediary might be deemed to be acting as a mere conduit, and the contributions and grants will be deemed to have been made in fact to the recipient foreign entity, rather than the intermediary. This can jeopardize charitable income tax deductions for individuals and corporations, and might result in excise taxes being imposed on private foundations/donor advised funds (and their foundation managers) for failure to exercise expenditure responsibility regarding what would then be considered direct grants. Thus, while it is fine for contributions and grants to be earmarked for programs or grants that have been pre-approved by the 7
intermediary as part of its independent grantmaking/program approval process, if a gift or grant is specifically earmarked for distribution to another charity, or individual, and the intermediary has no discretion regarding such funds, the gift or grant will be considered to have passed through the intermediary. Examples that demonstrate appropriate discretion and control on the part of the intermediary organization: 1. A friends of organization should not just rubber stamp grants to the supported foreign charity; rather, the foreign charity should submit grant proposals with budgets that are evaluated by the friends of organization and approved in accordance with internal procedures. Grants should not just be made for general operating support, which effectively cedes control to the foreign charity, but for specific activities, programs and expenditures outlined in the grant proposal/annual budget submitted by the foreign charity to the friends of organization. 2. In order to avoid conduit treatment, contributions or grants should not be earmarked for use overseas in a manner that gives the intermediary no discretion or control to use the funds otherwise. If the intermediary has pre-approved a project of the foreign charity and then solicited funds for that purpose, gifts or grants earmarked for that project (since it was preapproved by the intermediary) should be treated as contributions to the intermediary. 3. A friends of organization should have a majority of directors who are U.S. citizens and do not act on behalf of the supported foreign charity. While U.S. citizenship of directors might not be required for state corporate law purposes, the IRS considers this a factor with respect to the control/discretion. See Rev. Rul. 66-79, but see also PLR 9129040. 4. An intermediary domestic charity should maintain records showing the process by which gifts/grants are received and processed, as well as how distributions are made to support the conclusion that the intermediary is not a mere conduit. F. Intermediary used for charitable contributions from domestic corporations. As noted above, domestic corporations are only eligible for charitable income tax deductions for contributions that will be used overseas if the recipient domestic charity is formed as a corporations (but not as a trust). IRC 170(c) and Rev. Rul. 69-80. A friends of or other intermediary domestic charity that plans to solicit charitable contributions from corporations should therefore be formed as a corporation. G. Designated funds at intermediary. A donor/grantor can establish a designated fund at an intermediary, such as a donor advised fund or a field of interest fund at an intermediary charity. A fund could even be established to support a particular foreign charity, provided that the intermediary has pre-approved that 8
charity under its own discretionary procedures, rather than merely accepting an earmarked fund. In each case, however, the intermediary must continue to exercise control/discretion and, in the case of a donor advised fund, must also exercise expenditure responsibility. For this reason, most commercially sponsored charitable funds (e.g., Fidelity) do not permit grants to foreign charities. H. Use of intermediary avoids administrative burdens associated with complying with anti-terrorism financing rules. Following September 11, initiatives to prevent the use of charitable funds to finance terrorism were implemented (these are discussed in IV below). By making grants to an intermediary charity that has procedures in place to comply with these rules, a grantmaking charity can avoid the administrative burden of following these rules itself. IV. Anti Terrorism Financing Rules A. General. In addition to the tax requirements described above, criminal and civil penalties can be imposed if charitable contributions to foreign charities are used to support or engage in terrorism. B. Executive Order 13324. Executive Order 13224 prohibits transactions with individuals and organizations deemed by the Executive Branch to be associated with terrorism and allows the government to freeze all assets controlled by or in the possession of these entities and those who support them. Prohibited types of transactions include financial, material or technological support and financial services, as well as humanitarian assistance. If a charity violates the order, it assets can not only be blocked, but its tax exempt status can be revoked; the charity may also be subject to criminal and civil penalties. Executive Order 13224 does not require knowledge or intent; thus, a charity can violate the order even if it does not know it is providing support to persons listed as Specially Designated Global Terrorists or SDGT s. The list of SDGT s is updated by Treasury regularly and can be accessed on the U.S. Treasury Office of Foreign Assets Control ( OFAC ) website (http://www.ustreas.gov/offices/enforcement/ofac/). C. USA Patriot Act. The USA PATRIOT Act (many temporary provisions of which were made permanent in 2006) also imposes fines and other penalties (including imprisonment) for providing material support or resources with the knowledge or intention that they are to be used in terrorist acts or by foreign terrorist organizations. Material support or resources is broadly defined under the Act and includes most tangible and intangible property, as well as financial and other assistance. IRC 501(p) also provides a number of consequences for a charity that is identified as a terrorist organization or supporter of terrorism, including automatic suspension of 501(c)(3) status of a U.S. charity designated as a terrorist organization. The IRS lists such suspended organizations on its website. 9
D. Anti-Terrorist Financing Guidelines, Voluntary Best Practices for U.S. Based Charities (issued by the Treasury Department on September 29, 2006 (the Guidelines; originally issued in November 2002 and revised in December 2005). The Guidelines released by Treasury provide a risk-based approach for charities to ensure that their assets are not being used to support terrorism. The Guidelines are voluntary and acknowledge that not all aspects of the Guidelines apply to every charity. Steps that are listed for charities making grants of funds that may be used in foreign countries (not all of which need be followed in each case) include the following: 1. gathering detailed information about the grantee; 2. conducting a reasonable search of public records to ensure that the grantee is not suspected of activity related to terrorism; 3. checking the master list of Treasury s OFAC (on the U.S. Treasury website, see above), to make sure that neither the grantee, nor any of grantee s key employees, directors, and other senior management appear on the list; 4. conducting a reasonable search of publicly available records to ensure that the charity's own key employees are not reasonably suspected of activity related to terrorism; and 5. requiring grantees to certify that they do not deal with anyone subject to OFAC sanctions, known to support terrorism, or to have violated OFAC sanctions. The key with respect to the Guidelines are that they are voluntary, and permit a charity to use a risk-based approach to determine the level of due diligence required in any case. It is generally considered appropriate, however, for a U.S. charity, at a minimum, to check the OFAC list as part of its normal pre-grant due diligence, including the names of the grantee s key staff and board members. The charity should therefore check for the names of any direct recipient of the funds and the names of the recipient s key staff and board members. Many organizations are already familiar with checking the OFAC list as part of their employee screening process. The charity should also keep records of its grant procedures and risk assessments regarding grantees. Also, it is generally considered good practice to include language in a grant letter, to be signed by the grantee, by which the grantee certifies that the granted funds will be used solely for the charitable purposes granted and not to support terrorism of any kind, and that that the grantee does not employ or deal with any entities or individuals subject to OFAC sanctions, known to support terrorism or to have violated OFAC sanctions. 10
V. Annual Reporting (Form 990/Form 990-PF) A. Public charities. Reporting on Annual Return (Form 990). Form 990 for tax years commencing in 2008 includes additional reporting requirements for charities conducting activities outside the U.S. If a public charity has aggregate expenses from grantmaking or program services activities in excess of $10,000 in a taxable year, it will be required to answer yes to Question 14b of Part IV of the Form 990, and to complete Schedule F of Form 990 (copies of the relevant page of the Form 990 and Schedule F are attached). B. Private Foundations. The Form 990-PF includes specific reporting requirements for private foundations that exercise expenditure responsibility or make PRIs. Responses to questions on the Form 990-PF regarding qualifying distributions and taxable expenditures may require further analysis and reporting where the private foundation makes foreign grants or PRIs. VI. Other Developments A. June 10, 2009 Report by the Advisory Committee on Tax Exempt and Government Entities (ACT). IRS appointed ACT has made specific recommendations intended to simplify cross-border philanthropy. Specific recommendations include: 1. Facilitating the formation of one or more Equivalency Determination Information Repositories (EDIRs), the purpose of which is to make equivalency determinations in accordance with Rev. Proc. 92-94, and maintain such determinations for use by multiple charities, thus providing centralized and reliable equivalency information for the benefit of funders. EDIRs could be formed with fields of interest (e.g., health and wellness, immunology, technology) (an idea that has been promoted since Rev. Proc. 92-94 was issued). 2. Characterization of support from certain foreign organizations as unrestricted public support. ACT has recommended guidance from the IRS and Treasury to make it clear that support received by a domestic public charity from foreign governments, international organizations designated by executive order (e.g., UNICEF, World Bank), and foreign charities with respect to which an equivalency determination has been made should not be restricted either under the 2% limitation for 509(a)(1) organizations or the 1% limitation for 509(a)(2) organizations. This would ensure that domestic charities could receive such support without concern they will be tipped into private foundation status. 3. Simplification of expenditure responsibility requirements to provide safe harbor reporting periods for grants of capital assets or grants used to acquire capital assets. 11
The 2009 ACT report can be found at http://www.irs.gov/pub/irstege/tege_act_rpt8.pdf B. Use of international funds for grantmaking. A number of international funds, some with U.S. affiliates, accept contributions/grants for distribution to other foreign charities (e.g., Charities Aid Foundation (UK), Transgiving Europe). Even if there is not a U.S. affiliate to which grants can be made, U.S. charities can use such funds to facilitate international grantmaking because due diligence, equivalency determination, or expenditure responsibility would only have to be exercised with respect to one entity. Grant letters to such an international fund should be crafted to comply with all rules applicable to the grantor for international grants, including any necessary restrictions on re-granting. VII. Case Studies and Questions (if time permits) Disclosure Pursuant to Department of Treasury Circular 230 Unless expressly stated otherwise in this communication, (1) nothing contained in this communication was intended or written to be used by any taxpayer, can be used by any taxpayer or may be relied upon or used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer under provisions of the Internal Revenue Code of 1986, as amended, (2) this communication was not written to support the promotion or marketing of the transactions or matters addressed herein, and (3) any taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. 12