The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney, Washington, DC
A tax-exempt organization may distribute funds to a nonexempt organization, such as a foreign charity, and retain tax-exempt status provided that the exempt organization retains control and discretion as to the use of the funds, that records establish that the funds were used for §501(c)(3) purposes, and that the distributions are limited to specific projects that are in furtherance of its own exempt purposes.1
Similarly, on the deduction side, contributions to a domestic charity "created or organized in the United States …" for use overseas may be deductible provided that certain requirements are met. Pursuant to this rule, it is sufficient, for purposes of §170, that the organization to which a contribution is made be created in a U.S. jurisdiction. The organization's primary activity, however, may consist of the conduct of a charitable activity, such as a school, overseas.
However, a contribution intended for foreign use made to an otherwise qualified U.S. charity will nevertheless be nondeductible if the donor "earmarks" its gift for a particular foreign donee, or if de facto earmarking arises due to statements made by the U.S. charity in its fundraising solicitations. In such cases, the IRS views the foreign charity as the real donee, and the U.S. charity as a mere conduit. The IRS has ruled, however, that contributions to a domestic charity that are solicited for a specific project of a foreign charitable organization are deductible under §170 if the domestic charity has reviewed and approved the project as being in furtherance of its own exempt purposes, and the domestic charity has control and discretion as to the use of the contributions.
The IRS's position vis a vis contributions solicited for overseas projects conducted by foreign charitable organizations has evolved in a series of published revenue rulings as follows:
Rev. Rul. 63-2522 discusses the deductibility of contributions by individuals to a charity organized in the United States which thereafter transmitted some or all of its funds to a foreign charitable organization. Example 4 of that ruling concerns a domestic charitable organization which made grants to a foreign organization for purposes which the domestic organization has reviewed and approved as in furtherance of its purposes. Contributions to the domestic organization were not earmarked in any manner for the foreign organization, and the use of the contributions was subject to control by the domestic organization. Therefore, the Service ruled that the domestic organization was considered to be the recipient of such contributions within the meaning of § 170(c)(2) of the Code.
In Rev. Rul. 66-79,3the IRS ruled that contributions to a domestic charity described in §170(c)(2) that were solicited for a specific project of a foreign charitable organization, were deductible under § 170, if the domestic charity had reviewed and approved the project as being in furtherance of its own exempt purposes, and had control and discretion as to the use of the contributions. Therefore, under this ruling, contributions received by the domestic organization from such solicitations were regarded as for the use of the domestic organization, and not for the use of the foreign organization receiving the grant from the domestic organization.
In Rev. Rul. 75-65,4 a domestic charitable organization was formed, under §501(c)(3), to deal with the problem of conserving plant and wildlife ecology in a foreign country. The domestic organization maintained control and responsibility over the use of any funds granted to private foreign organizations by first making a field investigation of the purpose to which the funds would be put, and then by entering into a written agreement with the recipient organization, and making continuous field investigations to see that the money was expended in accordance with the agreement. Under these circumstances, the IRS ruled that gifts and contributions made to the domestic charitable organization were deductible by individual donors under §170.
In a number of private rulings,5 the IRS has elaborated on the types of procedures which should be initiated by the domestic organization making grants to a foreign charity in order to ensure that the domestic organization retains control and discretion over the use of the contributions received by it. These include:
1. The board of directors of the domestic organization should review the purposes of the recipient organization or organizations and determine that they conform to §170(c)(2), i.e., that they are analogous to United States nonprofit charitable organizations. Specific projects and related solicitation programs also should be reviewed and approved by the board of directors of the organization.
2. The domestic organization should enter into an agreement with the foreign recipient organization on the use of the donated funds. In this agreement, projects in which the funds are to be expended should be specified in detail.
3. The domestic organization should require an accounting, or a sufficiently detailed line item financial report, from the foreign recipient organization, to enable the domestic organization to account for the use of the donated funds. Physical inspection of the projects, by personnel of the domestic organization, is helpful in demonstrating to the IRS that the domestic organization retains control over the use of the funds.
4. The domestic organization should retain the exclusive power to refuse any conditional or earmarked grants made to it. The domestic organization should not legally bind itself to expend contributed funds for the use of foreign organizations or projects, but may indicate its intention to expend the funds for such purposes to the extent consistent with its own goals. This does not mean that the domestic organization may not solicit funds for specific projects in foreign jurisdictions, but that it must retain discretion to use the funds for other exempt purposes of the organization should it determine that this use would be more appropriate.
It thus is advisable for any domestic charitable organization - including both public charities and private foundations - wishing to assure the deductibility of donations made by its contributors and intended for foreign use to include these safeguards in the bylaws governing its activities.
PLR 201438032, released on September 19, 2014, illustrates how the foregoing principles operate in practice in a situation in which a tax-exempt public charity ("Charity") formed and funded, with contributions from U.S. persons, a foreign subsidiary to conduct operations in a foreign country.
Charity's purpose is to support foreign-born orphan children with food, clothing, housing, education, medical treatment, psychological treatment, and other similar support. Charity operates programs in the United States and internationally, including by building an orphanage in "Foreign Country." Toward that end, Charity has formed a subsidiary entity ("Subsidiary") in Foreign Country. Subsidiary is a nonprofit foundation and has no operations in the United States, and there is no indication in the PLR that Subsidiary ever sought tax-exempt status in the United States.
Subsidiary's governing "statutes" provide Charity with total control over all aspects of Subsidiary and its activities. Subsidiary is granted the power to act as proxy for Charity, and to act under its direction. These statutes provide Charity with control of Subsidiary's most important governing bodies and governing offices, which are, in effect, appointed by Charity and, in some cases, overlap with, Charity's directors and officers. An independent "fiscal auditor" immediately reports to Charity if any fiscal irregularities or issues arise.
Subsidiary is not allowed to substantially engage in political propaganda, or otherwise attempt to influence legislation, or participate or intervene in any political campaign on behalf of any candidate for public office. Subsidiary is also prohibited from allowing any of its funds to inure to the benefit of any of its directors, trustees, officers, private shareholders or members, or to individuals.
Charity also has the unilateral power to expel a member of Subsidiary. Charity is entitled to receive minutes of each meeting of Subsidiary's governing body and is entitled to a copy of the entire minute book of Subsidiary upon request. Charity can decide at any time to dissolve and liquidate Subsidiary and proceeds from the liquidation (after payment of all liabilities) will be paid over to Charity.
To fund Subsidiary, Charity intends to transfer portions of donations Charity receives to Subsidiary. Charity has passed certain resolutions establishing an advisory committee of Charity's board, which provides initial review and assessment of Subsidiary's funding needs, whether those needs arise as a result of a request by Subsidiary or as a result of an independent decision by Charity to further its projects in Foreign Country through Subsidiary.
The resolutions require that: (1) funds must be kept by Subsidiary in a separate account; (2) Subsidiary must keep separate financial records regarding use of the funds; (3) Charity's board maintains control over the use of the funds; (4) Subsidiary may only use the funds for Charity's charitable purposes and as directed by Charity's board; (5) Subsidiary may not use the funds for any political campaign, propaganda, advocacy for legislation, or private inurement; (6) Subsidiary must be current in providing accounting and audit information to Charity; (7) Subsidiary remains controlled by Charity and its members; and (8) Subsidiary is in compliance with its governing documents.
Charity also represents that Charity does not adhere to any "earmarks" or restrictions placed on donations by donors. Funds are solicited for general use by Charity in Charity's various projects. Charity is not required in its charter, governing documents, or by any other source, to transfer contributed funds to Subsidiary. Charity's board maintains independent control of the management of all donations under its general corporate authority, and each transfer of funds to Subsidiary is vetted.
On the foregoing facts, and after applying the published rulings cited above (and others), the IRS ruled that:
1. The formation and funding of Subsidiary will not adversely affect Charity's §501(c)(3) tax-exempt status; and
2. Donations made to Charity that are used to fund Subsidiary's activities in Foreign Country will be deductible by donors under §170(a).
In particular, the IRS noted that the use of funds transferred in the formation and operation of Subsidiary is under Charity's sole control and discretion. Charity reviews, assesses, and approves Subsidiary's funding needs. Charity requires periodic accountings and audit information from Subsidiary, and Charity has the discretion to refuse to make contributions to Subsidiary. The funds that are transferred by Charity to Subsidiary are used in furtherance of Charity's charitable purposes. Therefore, Charity is not acting as a mere conduit but instead is considered the true recipient of the funds because Charity exercises full control and discretion over the use of contributions, including those transferred to Subsidiary in order to further Charity's charitable purposes.
This ruling provides a good roadmap for public charities who are considering operations in a foreign country, either directly or through another organization. We note that private foundations that wish to contribute funds to overseas charities or governments must jump through further hoops in order to comply with the requirements of §4942 (qualifying distributions) and §4945 (taxable expenditures).6
For more information, in the Tax Management Portfolios, see Webster, 450 T.M., Tax-Exempt Organizations: Organizational Requirements, Webster, 451 T.M., Tax-Exempt Organizations: Operational Requirements, Schenkelberg and Gross, 880 T.M., Private Foundations — Distributions (Section 4942), and in Tax Practice Series, see ¶6880, Taxes on Failure to Distribute Income.
1 Rev. Rul. 71-460, 1971-2 C.B. 231.
2 1963-2 C.B. 101.
3 1966-1 C.B. 48.
4 1975-1 C.B. 79.
5See, e.g., PLR 8346038 (contributions to domestic charity to restore the birthplace of A in a foreign country are deductible where not earmarked or otherwise legally required to be used for the restoration project); PLR 8142167 (contributions to domestic charitable organization which makes donations to foreign monastery are deductible where board approval precedes donations); PLR 8124124 (contributions to domestic charity which makes grants to foreign theological seminaries are deductible where domestic organization's bylaws assure control over funds); PLR 8043026; PLR 8034139; PLR 7943102; GCM 37444 (Mar. 7, 1978) (amounts contributed to domestic charity not deductible where it maintains no formal operating system whereby control or supervision over foreign projects is exercised); and GCM 35319 (Apr. 27, 1973).
6See, e.g., Rev. Proc. 92-94, 1992-2 C.B. 507. We note a peculiar proviso contained in the final paragraph of the PLR, to the effect that "this ruling does not reach any conclusion as to the qualifying distribution status of Charity's proposed transfer under §4942(g)(3)." Section 4942 applies only to private foundations and private operating foundations. PLR 201438032 specifically states that Charity is a public charity described in §170(b)(1)(A)(vi).
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