International Philanthropy: Territoriality, Local Benefit and a Changing World

Even in times of profound global economic difficulties, philanthropy remains important to high net-worth individuals. When money is tight, efficiency in making philanthropic gifts go as far as possible becomes increasingly important.

This efficiency has two aspects. First, philanthropists, particularly those whose wealth is self made, wish to see that their gifts are applied efficiently, hence the rise of ‘performance philanthropy’. The second aspect is tax efficiency. Although nobody makes philanthropic gifts simply to save tax, most donors wish to structure their giving tax-efficiently, either reducing the cost of their donations or enhancing the value to the recipient at no additional cost.

In a purely domestic context, this may mean nothing more than taking advantage of the exemptions or reduced tax rates that most jurisdictions apply to the income and gains of charitable vehicles and gifts to them, and the tax deductions which are often available for gifts made to them. Increasingly, however, high net-worth donors have connections to, or interests in, more than one jurisdiction, which can cause complications when they make philanthropic gifts. This is because, when granting reduced tax rates, exemptions and reliefs, most jurisdictions impose restrictions of one form or another on the type of charitable vehicles to which they apply.

At the most basic level, different jurisdictions may have different concepts of what is, in principle, charitable. Even where this is not so, ‘local benefit’ rules or rules limiting the availability of the reduced tax rate, exemption or relief to the income or gains of, or gifts to, indigenous charitable vehicles, are common. Local benefit rules may require a certain percentage (in some cases, effectively all) of the work done by the charitable vehicle to benefit locals if tax benefits are to be available; in other cases the restriction of tax benefits is not driven so much by where, or by whom, the charitable benefit is enjoyed, but by the jurisdiction in which the charitable vehicle is located or by the laws of which it is governed.

For example, for a UK taxpayer to obtain a UK tax deduction for a gift to a charitable vehicle, not only must it be established for purposes which the UK regards as charitable, it must also satisfy two further ‘territoriality’ tests: first, it must be subject to the control of the courts of the UK (Dreyfus (Camille and Henry) Foundation v. IRC [1956] AC 39); secondly, it must be governed by the law of a UK jurisdiction (Gaudiya Mission v. Brahmachary [1998] Ch 341). If a UK taxpayer makes a gift to a charitable vehicle which meets these requirements, he or she will have no UK inheritance tax liability on the gift (whether inter vivos or on death), no capital gains tax liability on any increase in the value of assets given and may obtain an income tax or capital gains tax benefit, depending upon the nature of the gift. But if the gift were made to a vehicle which failed to meet any one of these criteria, not only would there be no UK income tax or capital gains tax benefit, but a charge to UK capital gains tax and/or inheritance tax could also arise.

Similarly, a body which is established for purposes that are exclusively charitable under English law, but which does not satisfy the two territoriality tests described above, will not, at present, enjoy any of the reliefs which the UK affords to charities’ income and gains and, if it is a trust, its assets may themselves be subject to UK inheritance tax under the ‘relevant property’ regime. Such a body operating in the UK may, therefore, find itself at a considerable fiscal disadvantage to an indigenous UK charity.

Some income tax treaties, such as those between the US and Mexico, Canada and Israel, or estate tax treaties, such as that between France and Belgium, may mitigate the effect of local benefit or territoriality rules; but they are the exception rather than the rule and the deduction is likely to be very circumscribed. Thus, the importance of giving to, or operating through, a vehicle which will satisfy any local benefit or territoriality rules which could be key to ensuring tax efficiency or avoiding unnecessary tax charges should not be underestimated.

Where a donor with a tax exposure in one jurisdiction wishes to support a philanthropic endeavour in another, the solution is generally to give to a vehicle which satisfies the requirements of the donor’s tax jurisdiction and for that vehicle to transfer funds to another vehicle which satisfies the requirements of the jurisdiction in which the work is to be done. There are then, however, generally further rules to be observed.

For example, US taxpayers must give to a body established in or under the laws of a US jurisdiction to obtain a US income tax deduction under Internal Revenue Code (IRC) section 170 (c). If they wish to support the work of the English National Trust, they may instead give to the Royal Oak Foundation, a US incorporated exempt organisation. The Royal Oak Foundation may then independently decide to transfer funds to the National Trust, complying with US tax requirements when doing so. (The Internal Revenue Service (IRS) has published detailed rules for ‘friends of’ organisations.) Similarly, UK taxpayers wishing to support a US exempt organisation may, instead, choose to give to a UK friends of charity which supports the US entity, complying with UK tax requirements. Where there is no dedicated entity in the donor’s jurisdiction, he or she may choose to use one of the donor advised funds which will accept gifts and apply them overseas.

But this cannot offer a complete solution for taxpayers who are potentially exposed to a contemporaneous tax liability on the same income in more than one jurisdiction. The US citizen is subject to US income tax on the entirety of his or her worldwide income, subject to the application of treaty relief. US citizens who derive income from another jurisdiction may also be subject to income tax where it is earned, although a double tax treaty will generally regulate the position. Thus, a UK-resident US citizen deriving income from a UK-based employment is likely to pay UK income tax on that UK income and to offset that UK tax against his or her US liability. However, if that taxpayer makes a tax-efficient charitable gift to a UK charity, reducing his or her UK income tax liability, only the reduced UK tax liability will be available to offset against the US tax liability. He or she may thus pay US tax on the income given to charity. Alternatively, if the donation were to a US exempt organisation, reducing the donor’s US tax liability, he or she would not enjoy any reduction in the (primary) UK tax liability.

A ‘dual-qualified’ charity structure, now used by many wealthy US citizens living and earning money in the UK who wish to support charitable causes in a tax-efficient manner (as well as those charitable institutions which hope to raise funds, tax-efficiently, from UK-based US citizens who do not have their own structures of this kind), will help here.

A dual-qualified structure comprises a UK charity (established as a company limited by shares) and a US exempt organisation which wholly owns the shares in the UK charity. The donor makes a gift of cash to the UK charity under the gift aid scheme, leading to a reduction in the donor’s UK tax liability. However, because its shares are held by a US exempt organisation, an ‘entity election’ can be made under IRC section 7701. The consequence is that the UK charity is ‘disregarded’ for US tax purposes and donations to it considered, for US tax purposes, as having been made to its shareholder (the US exempt organisation). This gives a contemporaneous US tax deduction under IRC section 170 (c), and reduces the donor’s tax liability on both sides of the Atlantic.

Meanwhile, within the European Community (EC), the concept of territoriality is changing. Historically, taxpayers of one member state received no tax advantage for a gift to a charity established in another member state, even where that charity’s purposes were considered charitable under the laws of both states, and gifts to such charities could be subjected to considerable inheritance tax charges.

In 2002, the EC issued a reasoned opinion to the Belgian Government requesting a change in legislation, granting favourable tax treatment for gifts from the estates of those subject to Belgian inheritance tax to domestic (but not foreign) charities. (Belgian charities received their gift after deduction of 8.8 per cent tax, but charities established in other member states only received theirs after deduction of 80 per cent tax). Belgium amended its tax laws, although not to the EC’s total satisfaction.

Then, in 2006, the European Court of Justice (ECJ) decided the case of Centro di Musicologia Walter Stauffer v. Finanzamt München für Körperschaften (C386/04). Here, a German tax office had taxed income received by an Italian charity from a German investment property. The Italian charity’s objects were recognised as charitable under German law, and an equivalent German charity would not have been similarly taxed. The ECJ held that the taxation was an obstacle to the free movement of capital between member states (and thus contravened Article 56 of the EC Treaty).

Following this, the EC issued directions to Germany and other states, including the UK and Ireland, stating that granting preferential tax treatment only to indigenous charities did not comply with European law. Some European states have liberalised their stance, giving similar tax treatment to the income and gains of, and gifts to, charities established in other members states, and Germany may shift its focus from territoriality to local benefit. It remains to be seen what action the EC will take in relation to other states.

Despite all this, the Stauffer case concerned a narrow issue: the taxation of the internal income of a charity established in one member state, which would have been afforded more favourable treatment had it been established in the taxing state. The question of whether donations made by donors, who are taxpayers in one member state, to charities established in another should receive the same treatment as gifts made to charities of the taxpayer’s own state is now being considered by the ECJ in another case, Hein Persche v. Finanzamt Lüdenscheid (C318/07). This concerns a donation by a German taxpayer to a Portuguese charity. The donor (who is a German tax advisor) sought a ruling granting him the same deduction against his German tax liability as he would have been entitled to if his donation had been made to a German charity, again on the basis that his donation should benefit from the EC Treaty principle guaranteeing free movement of capital. The Advocate General's opinion, which was released on 14 October 2008, recommends that the court should hold that:

•   the issue does concern the free movement of capital within the meaning of Article 56 of the EC Treaty;
• it is a breach of the EC Treaty not to allow a taxpayer the opportunity to prove   that a recipient organisation recognised as charitable in another member state fulfils the requirements for being recognised as charitable applying in the taxpayer's member state;
•   the onus of establishing this status, so that a deduction should be given, lies with the donor taxpayer.   

What, then, does all this mean for international philanthropy? First, it is essential to understand the restrictions imposed by local benefit or territoriality rules. Second, in Europe these concepts are changing and, in due course, may enable a single vehicle (or dual qualified structure, if US citizens are involved) to be used across the EC, although first the ECJ must choose to follow the Advocate General's opinion, as it did in the Stauffer case. But even then, careful planning will be required to ensure that the vehicles used meet all the other requirements of the jurisdictions concerned.

Clive Cutbill
In addition to providing advice to a number of household name charities and charities with City livery connections on governance and operational issues, Clive Cutbill leads the philanthropy practice at Withers Worldwide, advising both charities and donors in relation to tax-efficient giving and funding. His practice extends beyond the domestic to the cross-border context and encompasses advice on venture philanthropy, social investment and the structuring of transactions involving charities and others so as to deliver maximum social benefit. Clive acted in two leading High Court cases concerning trustees' powers and duties: Hillsdown Holdings plc v. Pensions Ombudsman (1996); and Public Trustee and Anor v. Cooper and Ors (1999) and has been acknowledged as a major contributor to the debate concerning the powers of trustees to adopt a socially responsible approach to the investment of their funds. He is the firm's nominated officer for money laundering reporting purposes and, as chair of the STEP Anti-money Laundering Task Force, has been involved in discussions with HM Treasury, MEPs, the European Commission and the Financial Action Task Force of the OECD regarding the fight against money laundering and terrorist financing. In the latter role, he was a recipient of an outstanding achievement award at the STEP 2007 Private Client Awards for his role in securing key amendments to the Money Laundering Regulations 2007 at draft stage. His combination of knowledge and experience in the fields of trust and charity law, on the one hand, and money laundering and terrorist financing issues, on the other, has been described as ‘unique'.