The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.
By James E. Maule, Esq.
Villanova University School of Law, Villanova, PA
A recent decision, Foundation of Human Understanding v. U.S., No. 2009-5129 (Fed. Cir. 8/16/10), demonstrates the continuing difficulties encountered by tax administrators and judges schooled in pre-digital days and caught in a pre-digital mindset as the technological developments in the communications arena raise tax law issues. The case involves a Foundation incorporated in 1963, recognized as a tax-exempt entity by the IRS in 1965, and classified by the IRS as not a private foundation because it qualified as a publicly supported organization. The Foundation's claim that it was not a private foundation because it was a church was rejected by the IRS, a conclusion that had no bearing on the outcome.
Two decades later, in 1983, the Foundation again requested that it be treated as a church, the IRS denied the request, the Foundation sought a declaratory judgment by the Tax Court, and the Tax Court held it was a church. The Tax Court relied on five facts: the Foundation owned a building where it conducted services several times a week, it operated a school for children where it taught its doctrines, it owned another property where it held seminars, meetings, and other activities, it purchased a second building for church services, and it provided "regular religious services for established congregations." The Tax Court concluded that the Foundation's radio broadcasting and pamphlet printing activities did not support its claim of being a church, but considered these factors to be insignificant compared to the Foundation's other activities.
As the years progressed, the Foundation changed its operations. It moved its school into a separate corporation and operated it as a private non-denominational Christian school. It sold its church buildings. It continued to "disseminate its messages through broadcast and print media" and when the internet became popular, began to use it for the same purposes. In 2001, the IRS determined that the Foundation no longer qualified for church status. The Foundation sought a declaratory judgment in its favor, this time in the Court of Federal Claims, where it lost.
The Court of Federal Claims noted that there are two approaches to determining church status. One is a bundle of 14 criteria invented by the IRS, about which the court expressed concern because it "appears to favor some forms of religious expression over others," but the court examined the criteria and determined that the Foundation, though meeting some, had not proven that it "had a regular congregation or that it held regular services during the years at issue." The other approach, a so-called associational test developed by the courts, was the basis for the decision by the Court of Federal Claims. That test defines a church as an organization that includes a body of believers who assemble regularly for communal worship. Accordingly, the court concluded that because the Foundation did not provide regular religious services to an established congregation, and because the extent to which the Foundation brought people together to worship was incidental to its main function of spreading its message, it was not a church. The court rejected the Foundation's argument that a church exists if "there is a body of followers beyond the scope of a `family church' … [who] seek the teachings of the organization and express or acknowledge an affiliation with its religious tenets" because, according to the court, "every religious organization has members who express an affiliation with the organization's tenets." Ultimately, the court held that the Foundation failed to establish that "it held regular services with a regular congregation during the years at issue and because its `electronic ministry' did not satisfy the associational test."
On appeal, the Federal Circuit affirmed. After noting that neither Congress nor the IRS has done much to explain the meaning of the term church in §170, explaining that the definition of church is more limited than the definition for a religious organization, and agreeing that the 14 IRS criteria raise issues, the court decided to apply the associational test. It quoted other decisions that require "an associational role," "a body of believers or communicants that assembles regularly in order to worship," "a cohesive group of individuals who join together to accomplish the religious purpose of mutually held beliefs," and "an organization [that] bring[s] people together as the principal means of accomplishing its purpose." The court agreed with the trial court that holding occasional seminars in various locations did not constitute regular meetings, a regular congregation, or a regular assembly for worship, and that there was no proof that the seminars enabled participants to establish a community of worship. The court explained that while the associational test does not set a minimum frequency of gathering, it does require "gatherings that, by virtue of their nature and frequency, provide the opportunity for members to form a religious fellowship through communal worship."
The Federal Circuit also rejected the Foundation's argument that by listening to sermons broadcast over radio and the internet at set times, its members had established worship as a "virtual congregation." The court noted, "The fact that all the listeners simultaneously received the Foundation's message over the radio or the internet does not mean that those members associated with each other and worshiped communally." The court decided that even though the Foundation permitted members to call in and to have their comments shared with those who were listening, it did not permit members to interact and associate with each other in worship. The Foundation's reliance on a case holding that there can be a "church without walls" was rejected because in the cited case the church not only had a "street church" congregation, it also had a conventional bricks-and-mortar church building where worship services were held.
It is the rejection of the "virtual congregation" argument that poses problems. Even if, on a technical basis, the court's decision is correct because it rests on the Foundation's failure to meet its burden of proof, it merely postpones to another day a similar case where the organization brings in expert witnesses to explain how it is possible for people to interact without being physically proximate. Consider the various definitions provided for the associational test. One speaks of "an associational role," but does not require physical proximity. Experiences by millions of individuals with social networking sites demonstrates that people can associate, sometimes quite intimately, without being physically proximate. Or consider the definition of "a body of believers or communicants that assembles regularly in order to worship." Many denominations theologically propound the notion of "body of believers" as a bonding that transcends the physical limitations of a church building. Nothing in the definition requires that assembly cannot occur other than by physical proximity. Nor is there anything to suggest that worship requires interaction, particularly when one considers the many instances in which individuals arrive at a church, listen, and leave without speaking to anyone or at least without speaking to anyone concerning theological issues. For a court to decide that religious fellowship cannot be formed other than with physical proximity is for the court to intrude on the theological beliefs of the organization. In fact, religious fellowship can be established without physical proximity, and thus the court's application of the associational test, if not the test itself, poses the same concerns as does the 14-criteria test of the IRS. Something called the First Amendment overshadows both tests.
Yet there is something of even wider import brewing in this decision. The terms "regular services" and "regular congregation" have their counterpart in the definition of an educational institution. Section 170(b)(1)(A)(ii) defines educational organizations eligible for tax-deductible charitable contributions as those "which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on." Aside from jokes about irregular faculty, irregular curriculum, and irregular students, I ask those in the basic federal income tax course who are trying to learn the parameters of the scholarship exclusion, which incorporates the §170(b)(1)(A)(ii) definition, what happens to the on-line university? Are its students in attendance at the place where its educational activities are regularly carried on? Where is that place? Is it cyberspace? Is it the collective space formed by the aggregation of the various rooms scattered throughout the world where the students are sitting as they listen to, and in many instances respond to, the instructor and other students? Is physical proximity a prerequisite for "attendance at the place"?
The world has changed. People can interact without being in physical proximity in all sorts of ways that they could not accomplish before the advent of internet communications. Consider a class or a religious gathering taking place through video-conferencing. If the school or church relies solely on this technology, ought it be considered in some way "deficient" or "unqualified" as contrasted with their bricks-and-mortars predecessors? In many ways, reaching out, whether to students or congregants, in this manner opens the doors to people otherwise precluded, for mobility or other reasons, saves energy, eases pressure on the environment, and achieves a variety of other worthy goals.
True, the IRS and the courts can sit back and wait for Congress to amend the tax code to insert "whether or not in physical proximity" to bring the tax law into the 21st century. I am quite confident that this adjustment is thousands of pages deep in the pile of tax law changes that are on the Congressional desk. The words "regular," "place," "attendance," "assembly," and "association" are ambiguous in this context, and it is the obligation of the IRS and the courts to focus on these terms with 21st century eyes and minds. The next case will not be any less challenging. But it is "out there," waiting.
For more information, in BNA's Tax Management Portfolios, see Crimm, 484 T.M., Tax Issues of Religious Organizations , and Stophel and Gorsline, 482 T.M., Tax Issues of Educational Organizations , and in Tax Practice Series, see ¶6810, Determination of Private Foundation Status.
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