Recently the IRS has released an adverse determination letter dealing with discretion and control over grants to foreign organizations by an "American Friends of ..." organization. What is interesting, but certainly not new, is the US requirements for "discretion and control" by "American Friends of" which are similar, but not identical to the Canadian requirements for "direction and control" that are discussed in the CRA Guidance CG-002, Canadian Registered Charities Carrying Out Activities Outside Canada. The IRS essentially argued that the 501(c)(3) was acting as a conduit and revoked its status.
Some of the highlights of the discussion about "discretion and control" are listed here:
Rev. Rul. 71-460, 1971-2 C.B. 231, provides that a domestic organization that conducts some or all of its activities outside the United States is not precluded from qualifying for exempt status under section 501(c)(3).
Revenue Ruling 63-252 1963-2 C.B. 101 holds that for a contribution to a domestic organization to be deducible under section 170 a grant that is sent to a foreign entity must be reviewed and approved by the domestic organization. This ensures that the grant is not earmarked and subject to the control of the domestic organization. Revenue Ruling 66-79 1966-1C.B.48 clarifies Revenue Ruling 63-252. Rev. Ruling 66-79, 1966-1 C.B. 48, provides rules for determining whether a domestic charitable organization has and exercises sufficient control as to the use of contributions for the purposes of section 170(c). Contributions to a foreign charity generally are not deductible. While a domestic charity can use the contributions abroad, it cannot merely transfer them to a foreign charity. Revenue Ruling 66-79 describes the following factors that indicate that the domestic organization has discretion and control over the use of monies sent abroad.
The bylaws of the corporation provide, in part, that:
(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) in furtherance of the organization's purposes, the board of directors shall have power to make grants to any organization organized and operated exclusively for charitable, scientific or educational purposes within the meaning of section 501(c)(3) of the Code;
(3) the board of directors shall review all requests for funds from other 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;
(4) 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; and
(5) 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.
This revenue ruling concluded that contributions to this organization are deductible because gifts received were used for the domestic organization's charitable purpose and the domestic organization maintained control and discretion over the use of the funds. Rev. Rul. 68-489, 1968-2 C.B. 210, provides that an exempt organization under section 501(c)(3) does not jeopardize its exempt status by distributing funds to organizations not themselves exempt under section 501(c)(3), provided the exempt organization:
1) retains control and discretion as to the use of the funds;
2) maintains records establishing that the funds were used for section 501(c)(3) purposes; and
3) limits distributions to specific projects that are in furtherance of its own exempt purposes.
Revenue Ruling 56-304 1956-2 C.B. 306 holds that an organization described in section 501(c)(3) may make distributions of their funds to individuals, provided such distributions are made on a true charitable basis. Organizations that make distributions to individuals should maintain adequate records and case histories to show the name and address of each recipient of aid; the amount distributed to each; the purpose for which the aid was given; the manner in which the recipient was selected and the relationship, if any, between the recipient and (1) members, officers, or trustees of the organization, (2) a grantor or substantial contributor to the organization or a member of the family of either, and (3) a corporation controlled by a grantor or substantial contributor, in order that any or all distributions made to individuals can be substantiated upon request by the Internal Revenue Service.
In order for contributions to be deductible, the domestic charitable organization must ensure that grants made to a foreign organization or monies paid to an individual have been reviewed and approved in advance to ensure that the exempt purpose of the domestic charity is furthered.
Revenue Rulings 63-252 and 66-79 dealing with deductibility of contributions, hold that if payments are made to a foreign organization that have not been reviewed and approved in advance by the Board of the domestic organization then contributions to the domestic organization are not deductible because the domestic organization is acting as a conduit for the foreign organization and the domestic organization cannot establish that the funds were not earmarked for the foreign organization.
A foreign organization should be viewed as a non-exempt organization since that entity has not established that it meets the requirements of tax exempt status under section 501(c)(3). Based on Revenue Ruling 68-489 an exempt purpose can be established if a grant made to a non-exempt organization is subject to the discretion and control of the exempt charitable organization. The organization described in the revenue ruling accomplished this by limiting its grant to a specific project that it reviewed in advance and by maintaining records to establish that an exempt purpose is served.
Foreign organizations should be treated as non-exempt entities since they have not established that they meet the requirements for exemption under section 501(c)(3) and the rationale in Revenue Ruling 68-489 should be applied.
For the years under examination substantially all of the organization's disbursements were reportedly made to or for the benefit of CO-l. These payments were not for specific projects, but for the general operating expenses of C0-1. The organization did not maintain records to establish that:
(1) The making of grants was within the exclusive power of the board of directors;
(2) The board of directors reviewed all requests for funds and required that the recipient organization specify the use to which the funds will be put;
(3) The board of directors required 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; and
(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.
The organization has not established that it maintained contemporaneous written substantiation to verify that it maintained discretion and control of its
funds to comply with the contribution deductibility rules outlined in Revenue Rulings 63-252 and 66-79. The organization did not establish that it funded
specific projects reviewed in advance. Instead the organization acted as a conduit for C0-1, in effect making C0-1 the actual donee organization.
Some of the specific issues raised include:
A review of the bank statements showed a very high frequency of large deposits and subsequent withdrawals of the same amounts within a matter of days. The C0-2 statements showed significant transfer of funds but did not identify the beneficiary. The CO3 statements showed substantial transfers of funds that named the beneficiary as'______'. Although the bank statements for C0-3 and C0-3 identified the beneficiary of the wire transfers, the Service was unable to determine whether the wire transfers represented to have been made in support of foreign entity were used for section 501(c)(3) purposes because of inadequate recordkeeping by the organization.
Failure to respond to requests for information that would verify exempt purpose of payments
The Service issued Information Document Requests (IDR) dated February 28, 20XX for each year under examination. The IDR included specific requests for missing checks, wire transfer receipts, bank statements, documents to substantiate reimbursements to the Director, records to substantiate that funds were used for section 501(c)(3) purposes, records to substantiate loans made directly by individuals to Country and clarification on particular transactions. The organization did not respond to our request for information.
There is also an interesting discussion on how payments directly to certain individuals that in part serve to assist with avoiding the tax system in a foreign country could be problematic:
The representative stated that some payments to individuals were for salaries and to reimburse a director of organization for advances he made to C0-1. The organization did not substantiate that the payments made to the teachers were to subsidize C0-1 's salary expense. Over the four year examination. period the "salary expense" was $_______. But assuming that the representative's oral testimony is accurate and this was indeed a valid salary expense, having the organization make these payments instead of C0-1 serves to frustrate the administration of the Country income tax laws by having these monies escape reporting requirements. This is a substantial nonexempt purpose.
The letter also cautions against paying funds to a director when the funds could have been paid directly to the institution:
Over a four year period the taxpayer made payments of over ______ dollars directly to a director of CO-1 • The oral testimony of the representative indicated that these
payments were reimbursements for advances by the director of C0-1. If the director did advance C0-1 that much money and the organization wanted to assist in alleviating the foreign organization's debt, the organization could just as easily given the money to C0-1 and not the individual. The organization has not established that these payments did not serve private interests more than insubstantially. (See Section 1.501(c)(3) -1(d)(1) of the income tax regulation)
Do you require legal advice with respect to Canadian or Ontario non-profits or charities?
Mark Blumberg is a partner at the law firm of Blumberg Segal LLP in Toronto and works almost exclusively in the areas of non-profit and charity law.