Tax Planning for Cross-Border Philanthropy by U.S. Donors

By Jane Peebles, J.D., Freeman, Freeman & Smiley, LLP, Los Angeles, CA (member, Planned Giving Round Table of Southern California/Orange County Planned Giving Round Table)

(This article is also available as a pdf. Click here to view the pdf)

In recent years, there has been a dramatic increase in cross-border philanthropy. The world's population has become more mobile, the media expose us more and more intimately to developments around the world and the economy has become globalized. As a result, more U.S. citizens and residents are making donations to non-U.S. charities or to U.S. charities for use abroad. The tax rules applicable to such gifts differ in a number of important ways from the rules governing income, estate and gift tax deductions for contributions by U.S. persons to U.S. charities. Estate planners and allied professionals should develop some familiarity with these special rules so that they do not allow U.S. donors to stumble into unanticipated adverse tax consequences arising from charitable donations for use abroad.

Under the Internal Revenue Code (Code), a gift or estate tax deduction for a contribution by a U.S. donor to or for the benefit of a foreign charity is frequently available when no corresponding income tax deduction is allowed. Different rules apply to deductibility by individuals and by corporations. Even within the gift and estate tax context, the rules differ for outright gifts and gifts in trust and for gifts to foreign nongovernmental charitable entities and to foreign governmental entities. To complicate matters even more, certain treaties vary the rules in the Code. Moreover, the professional who counsels U.S. tax exempt organizations must be familiar with the rules applicable to grants abroad by different types of public charities and by private foundations.

This article reviews the basic U.S. tax rules that apply to cross-border charitable gifts and grants by U.S. individuals and corporations and by U.S. tax exempt organizations and is intended to provide a general overview for professionals who may be called upon to advise donors regarding the tax consequences of such contributions.

U.S. INDIVIDUAL DONORS
Income Tax Considerations. The Code does not allow U.S. persons any income tax deduction for direct contributions to foreign charities. Section 170(c) of the Code provides that an income tax deduction is permitted only if the donee organization was created or organized in the United States or any possession thereof, or under the law of the United States, any state, the District of Columbia or any U.S. possession. Therefore, if a U.S. individual donor wants a deduction against U.S. income for a gift to a foreign charity, the donation must be made to a U.S. tax exempt organization which operates abroad or can make grants abroad unless a special treaty exception applies. If the U.S. individual has taxable income arising in the jurisdiction of the foreign donee charity, an income tax deduction against that income may be permitted under the laws of the foreign jurisdiction or a tax treaty, and the availability of the deduction against non-U.S. income, coupled with a U.S. gift tax deduction, may be sufficient to motivate the donor to proceed with the gift.

As long as the donee organization was created or organized under the laws of the United States (generally, a U.S. corporation or a trust), the use of the charitable contribution abroad does not preclude the donor from claiming a U.S. income tax deduction for the donation. A gift by a U.S. donor to a U.S. charity for use abroad may be made through a "friends of" organization, community foundation or other U.S. public charity, or through a U.S. private foundation. In each case, the Treasury has specified rules and guidelines intended to ensure that the use of the funds remains within the discretion of the U.S. donee organization and that the funds are utilized to further its charitable purposes.

The easiest way for a U.S. person to obtain an income tax deduction for a charitable donation to be used abroad is to make it to a U.S. public charity that operates abroad through a foreign branch office or subsidiary. As long as the foreign branch or subsidiary is under the complete control of the U.S. charity, the U.S. charity is considered to be the true beneficiary, and an income tax deduction is permitted. The critical point is that the funds are to be used in a foreign country by a U.S. organization as opposed to being used by a foreign organization. A number of U.S. charities have broad-based direct programs abroad. Example include the Red Cross, CARE and Oxfam America. The U.S. donor may earmark contributions to such charities for a particular foreign program of such a U.S. charity as long as the earmarking is limited to programs subject to total control by the U.S. donee organization.

The IRS also recognizes "friends of" or "feeder" organizations, which are U.S. public charities formed to support a foreign charity or charities. A U.S. donor who wished to benefit a foreign hospital or university, for example, could make a donation to a U.S. organization formed to support that foreign entity. These organizations frequently have names such as "American Friends of Oxford University."

An income tax deduction for a charitable gift by a U.S. person for use abroad may also be available when the gift is made to a community foundation which, in turn, makes a foreign grant of the funds. Such a gift may be made to a "field of interest fund" or to a "donor advised fund" or it may be made by the community foundation from unrestricted funds, as long as the community foundation's governing documents and internal policies allow it to make grants abroad.

A cross-border charitable gift may also be made by means of a contribution to a U.S. private foundation which then makes grants to foreign charities. Stringent rules apply to such foreign grants, however, and the donor will want to be sure that the procedures of the private foundation meet IRS guidelines for assuring that the foundation has ultimate discretion over the use of the funds and adequate procedures in place to ensure the funds are used only for purposes recognized by U.S. taxing authorities as charitable purposes.

Certain income tax treaties contain more generous provisions regarding deductions for gifts by U.S. persons to foreign charities. Notably, the U.S. treaties with Canada, Israel and Mexico allow U.S. donors to deduct donations to charities in the contracting state against their foreign-source income from that jurisdiction. Under certain circumstances, the U.S.-Canada treaty even more generously allows a U.S. donor to claim a deduction against U.S. income for gifts to Canadian charities. For example, a U.S. person may claim a deduction against U.S. income for a direct gift to a Canadian university which the donor or a member of the donor's family attended.

Advisors who assist U.S. donors in structuring gifts through charitable remainder trusts should be aware that, even if a treaty provision would allow a U.S. donor to claim an income tax deduction for a direct gift to a charity organized under the laws of the treaty partner, such a charity should not be named as the charitable beneficiary of a charitable remainder trust. The Code specifies that each charitable beneficiary of a remainder trust must be a Section 170(c) organization. As a practical matter, the trust should not fail to qualify as a split-interest trust even if a foreign charity is inadvertently named as a beneficiary, since the trust instrument will contain a savings clause requiring that each charitable beneficiary be a Section 170(c) organization. However, since the trustee will be required to redirect the gift to one or more U.S. charities, it will not flow to the intended charitable recipient unless the trustee can locate a U.S. "friends of" organization or other U.S. charity through which to funnel the gift to the foreign charity.

Gift and Estate Tax Considerations. U.S. donors are generally permitted to claim gift tax deductions for lifetime gifts to foreign charities and estate tax deductions for testamentary gifts to foreign charities. Direct testamentary gifts to foreign charities are far more common than direct inter vivos gifts, however, since a concomitant U.S. income tax deduction is rarely available for such a lifetime gift.

A U.S. gift tax deduction will be allowed for a direct contribution to a foreign charity under Code Section 2522(a) if (a) the donee is organized for Section 170(c) purposes (i.e., religious, charitable, scientific, literary, educational, etc.); (b) no part of its net earnings inures to the benefit of any individual; and (c) it does not violate Code Section 4945 prohibitions against self-dealing and involvement in lobbying and political campaigns. Gifts to organizations in common law countries which are recognized as tax exempt in their own jurisdictions will generally qualify for the U.S. gift tax deduction since the laws of other common law jurisdictions are similar to U.S. laws governing tax exempt entities. Regardless of where the foreign charity is located, a gift tax deduction will be available if the foreign charity has obtained a determination of tax exempt status under Code Section 501(c)(3) from the IRS. Few foreign charities, however, go to the trouble of applying for IRS determination letters since U.S. individual donors are generally not entitled to U.S. income tax deductions even for gifts to foreign charities that have determination letters.

An estate tax deduction is similarly available for transfers of property by U.S. individuals to foreign charitable organizations provided the requirements of Code Section 2055(a), which are the same as those described above for Code Section 2522(a), are met.

When an inter vivos or testamentary gift is made to a foreign government or governmental unit, a U.S. gift or estate tax deduction will be available only if the gift must be used for charitable, rather than public, purposes. A written gift agreement for a lifetime gift, or the Will or living trust providing for the testamentary gift, should specify that the gift must be used solely for charitable purposes. An unrestricted bequest to a foreign government is not deductible under Section 2055(a) even if that government has adopted an internal policy or local law requiring all such bequests to be used solely for charitable purposes . The rationale seems to be that the foreign jurisdiction may fail to enforce its own laws or policies or may, through internal policy decisions, redirect the bequest to public purposes even after its initial allocation for charitable purposes. If the U.S. governing instrument providing for the gift or bequest fails to mandate use for charitable purposes, the IRS will not respect a probate court order imposing that limitation if the order conflicts with local law in the foreign jurisdiction. 

U.S. Corporate Grants for Use Abroad. A further special restriction applies to corporate contributions. Under IRC Section 170(c), corporate contributions intended for use outside of the United States are not deductible unless the donee is a U.S. corporation. For this reason, U.S. charities with international operations are generally organized as corporations rather than as trusts or unincorporated associations. Although there is no logical reason for this distinction, a U.S. corporation may make a deductible donation for use abroad only if the donee "friends of" organization, community foundation, other U.S. public charity or private foundation is organized in corporate form.

RULES APPLICABLE TO U.S. CHARITIES MAKING GRANTS ABROAD
"Friends of" Organizations. The IRS rules governing so called "friends of" organizations, established to support foreign charities, are designed to ensure that the U.S. feeder organization is the true donee and not merely a conduit for sending funds abroad. The U.S. intermediary organization must review and approve each proposed foreign grant as being in furtherance of its own charitable purposes. Donations to the U.S. intermediary may not be earmarked by the donor for a specific foreign charity. The U.S. intermediary donee must exercise sufficient control over the use of the funds to be considered the true recipient of the gift. In order to satisfy this requirement, the U.S. feeder should (a) review the purposes of the foreign donee charity to determine that they are within the ambit of Code Section 170(c), (b) review and approve specific foreign projects and related solicitation programs, (c) enter into a written agreement with the foreign donee specifying in detail the projects for which the grant will be used, (d) require accountings from the foreign donee each year until the grant has been fully expended so the U.S. feeder can account for the use of the funds and (e) retain exclusive power to refuse any conditional or earmarked donations and avoid obligating itself to expend contributions for the use of foreign charities or projects. While the "friends of" organization may solicit funds for specific projects abroad, it must retain discretion to use the funds for other exempt purposes it determines are more appropriate. A U.S. donor may nevertheless make a donation to a U.S. feeder with reasonable certainty that the funds will reach the intended foreign organization or project.

Other U.S. Public Charities. The IRS imposes few formal restrictions on grants abroad by other types of U.S. public charities. However, boards of public charities have a fiduciary duty to ensure that the funds under their control are used solely for charitable purposes. For this reason, any public charity making grants abroad would be wise to review the governing instruments of the intended foreign grantee as well as local governing law, enter into a written agreement with the grantee that documents the grantee's commitments and obtain annual accountings from the grantee until the grant has been fully expended. Although the U.S. public charity is not required to make a determination that the foreign grantee is the equivalent of a Code Section 501(c)(3) organization, it will be in a stronger position on audit if it has done so and documented its file accordingly.

Community foundations may be subject to geographic restrictions in their governing documents requiring that grants be made only to support local organizations and projects. Even if the governing documents permit grants abroad, a community foundation making a foreign grant from unrestricted funds should follow the general guidelines for such grants by public charities described above.

If the foreign grant will not come from unrestricted funds, other issues may arise. If the donor to a "field of interest" fund has specified a particular charitable focus but has left total discretion to the community foundation to determine the ultimate grantee, the community foundation may make grants to a foreign charity from the fund without any additional problems. Donors to "donor advised funds" are able to make only nonbinding recommendations as to the use of the funds, so grants to foreign charities from donor advised funds do not by themselves cause problems. However, if the community foundation permits grants abroad from donor advised funds but not from unrestricted funds, the IRS may argue that the "advised fund" is in fact subject to donor control.

Private Foundations. Private foundations making grants abroad will want to determine whether the foreign grant counts as a "qualifying distribution" for purposes of the Code Section 4942 minimum distribution rules and to avoid running afoul of the Code Section 4945 prohibition against grants to organizations other than public charities unless the grantor exercises "expenditure responsibility."

A grant by a U.S. private foundation to a foreign organization that has received an IRS determination letter that it is a public charity is always a qualifying distribution for purposes of the 5 percent minimum distribution rule. If the foreign donee does not have such a determination letter, the Treasury Regulations indicate that the private foundation should first try to make a "good faith determination" that the donee is the equivalent of a U.S. public charity. If this determination can be made, the foreign grant will be a qualifying distribution even if the grantor does not exercise expenditure responsibility.

In making a good faith determination, the private foundation may rely on an opinion from its counsel or the grantee's counsel or an affidavit of the grantee. However, if this method is used, each potential U.S. grantor private foundation must obtain its own lawyer equivalency letter or grantee affidavit, and the cost is prohibitive for smaller foundations. In Revenue Procedure 92-94 , the IRS approved a form of affidavit of the foreign grantee that may be relied upon by multiple U.S. grantors as long as it contains current information.

If the proposed foreign donee organization cannot be determined to be the equivalent of a U.S. public charity, then grantor private foundation must exercise expenditure responsibility over the grant, and the "out of corpus" rules must be satisfied in order for the grant to be a qualifying distribution.

Exercising expenditure responsibility entails making a pre-grant inquiry to allow the grantor to make a reasonable determination that the proposed grantee can fulfill the charitable purpose of the grant. An officer or director of the foreign grantee must also sign a written grant agreement specifying the charitable purpose of the grant and committing the grantee to (a) repay any funds not used for the grant's purpose; (b) submit annual reports detailing how the funds have been used, compliance with the grant agreement and the grantee's progress in achieving the purpose for which the grant was made; (c) maintain books and records which are made reasonably available to the grantor; and (d) refrain from using any of the funds for lobbying, direct or indirect influence on any public election or voter registration drive, or any activity for a noncharitable purpose, to the extent such use of the funds would be taxable to a private foundation. The agreement will typically also prohibit the grantee from re-granting the funds to other organizations or individuals since that triggers additional complicated rules. If the foreign grantee is not the equivalent of a U.S. private foundation (i.e., it is a trade union or for profit organization), it must maintain the grant funds in a separate fund dedicated to charitable purposes. 

In 2001, The Council on Foundations secured from the Department of the Treasury a general information letter, which may be relied upon by all U.S. private foundations, confirming that foundations need not attempt a good faith equivalency determination before turning to expenditure responsibility if the private foundation determines, based on preliminary information available to it, that it will be highly impractical or impossible to make the good faith determination. The general information letter, dated April 18, 2001, states clearly that a U.S. private foundation making grants abroad may always jump directly to expenditure responsibility and skip over the attempt at a good faith equivalency determination. This is a welcome development because attempts at equivalency determinations are frequently unsuccessful. If the grantor sees that this will be the case, it can save the expense of making the attempt.

Grants to foreign governmental units do not require either an equivalency determination or expenditure responsibility. The Treasury Regulations provide that a foreign organization will be treated as a public charity if it is a "foreign government, or any agency or instrumentality thereof ... even if it is not described in IRC Section 501(c)(3) ." However, any grant to such a governmental unit must be for charitable, not public purposes. The U.S. grantor organization's file should contain: (a) documentation establishing that the grantee is a foreign government or governmental unit, and (b) a copy of its grant letter specifying the charitable purpose of the grant.

If the foreign charity grantee is the equivalent of a U.S. private foundation, the U.S. foundation's grant to it must also meet the "out of corpus" requirement. A grant from one private foundation to another will not meet the definition of a qualifying distribution for purposes of application of the 5 percent minimum payout rules to the grantor unless the grantee satisfies the "out of corpus" rule. The "out of corpus" rule requires that any grant from one private foundation to another must be spent by the grantee within 12 months after the close of the taxable year in which it received the funds. One private foundation cannot make grants to endow another. The grantee must take the grant funds "out of corpus" and spend them within the required amount of time. This policy is designed to ensure that such private foundation grants will be used for the public benefit and not merely used to build the recipient organization's investment portfolio.

Furthermore, the grantee foundation must provide records to the grantor foundation showing that: (a) the grantee met its minimum payout requirement before it received the grant, and (b) the grantee satisfied its minimum payout requirement for the year in which the grant was received in addition to spending the grant. Since most foreign charities are unfamiliar with the minimum payout rules and do not maintain the records necessary to compute it, satisfying the "out of corpus" requirement frequently will not be possible. In such a case, the grantor may adopt one of the following approaches: If the U.S. grantor private foundation's actual charitable distributions for other grants during the year far exceed its minimum payout requirement, it can exercise expenditure responsibility over the grant to the foreign private foundation equivalent and simply not count the grant in meeting the minimum payout requirement. This would allow it to avoid the "out of corpus" rule entirely with respect to the grant. In the alternative, if the grant to the foreign charity is earmarked for the purchase of capital equipment, and if the purchases are completed within 12 months after the close of the taxable year in which the foreign charity receives the funds, the "out of corpus" rule will be satisfied.

CONCLUSION
The current rules governing charitable donations for use abroad are quite complex. While there is hope that more treaties will contain liberalized deduction provisions in the future, advisors must be aware of the current rules, and structure such gifts appropriately, if U.S. donors are to obtain the desired tax benefits.

©2003 Jane Peebles, J.D. Article used with permission.

Jane Peebles is a partner in the law firm of Freeman, Freeman & Smiley, LLP. Jane received her B.A. and M.A. from the City College of New York and her J.D. from N.Y.U. School of Law. A frequent lecturer on sophisticated estate and charitable planning, she has addressed the Heckerling Estate Planning Institute, USC Tax Institute, International Bar Association (in London, Amsterdam and Mexico) American Bar Association, and National Committee on Planned Giving, as well as numerous estate planning councils, planned giving roundtables, nonprofit organizations and other professional groups throughout the United States. Jane practices in the areas of domestic and international estate and charitable planning, counseling high net worth individuals, family owned businesses, nonprofit organizations and philanthropists.

Jane is a Fellow of The American College of Trust and Estate Counsel and has been certified by the California State Bar Association as a specialist in Estate Planning, Trust and Probate Law. She teaches Tax Benefits of Charitable Giving and International Charitable Gift Planning for the American Institute for Philanthropic Studies at Cal State Long Beach (1995-present). She is a member of the American, International, California (Executive Board, Estate and Gift Tax Committee), Los Angeles (Exempt Organizations Committee), and Colorado Bar Associations; Planned Giving Roundtable of Orange County; Planned Giving Roundtable of Southern California; National Committee on Planned Giving; and Council on Foundations. Jane is a director and founder of The Women’s Leadership Council and is the International Advisor to the Estate Planning Committee of The California Society of Certified Public Accountants.

Publications: “Emerging Legal Issues in International Philanthropy,” Perspectives on Foundation Management: Innovation and Responsibility at Home and Abroad, John Wiley & Sons (2002); “Estate Plan Design and Drafting After the EGTRRA,” Major Tax Planning, University of Southern California, Matthew Bender (2002); “Hot Topics in Charitable Giving,” Major Tax Planning, University of Southern California, Matthew Bender (2000); “Creative Uses of Charitable Lead Trusts, Major Tax Planning, University of Southern California, Matthew Bender (1999); “Cross Border Gifts,” Journal of Gift Planning (2nd Quarter 1999); “Charitable Gifts of Retirement Plan Assets,” Planned Giving Design Center Website (April 1999); The Handbook of International Philanthropy, Bonus Books (Chicago, 1998); "Tax Planning for Cross-Border Philanthropy by U.S. Donors," Trusts & Estates Magazine (May 1998), "Here There Be Dragons: Navigating the Waters of Cross-Border Philanthropy," Thirty-First Annual University of Miami Philip E. Heckerling Institute on Estate Planning, Matthew Bender (1997); "Socially Responsible Investment and the Private Trust," Probate & Property Magazine (July/August 1992) (co-author); and "A Primer on U.S. Estate and Gift Taxation of Aliens,” Major Tax Planning, University of Southern California, Matthew Bender (1991) (co-author).