Tax-Efficient International Philanthropy - The Problem of ‘Territoriality’ and Some Solutions

When I was young, someone told me a joke which seemed a lot funnier then than it does now: ‘When is a door not a door? – When it’s ajar’. International philanthropy is affected by a similar question, which many will find even less funny. This is: ‘When is a charity not a charity?’The answer in many cases is, of course: ‘When it’s abroad’.

Whilst many jurisdictions give charities favourable tax treatment for their own income and gains and grant deductions against donors’ tax liabilities for gifts made to charity, what those jurisdictions regard as a ‘charity’ may vary. But even where jurisdictions are agreed that the pursuit of particular purposes in particular ways is ‘charitable’, that is not necessarily enough for a charity from a foreign jurisdiction, operating abroad, to be able to enjoy the same benefits as a charity which is indigenous to the jurisdiction in which it is operating. Similarly, a taxpayer making a donation which would have attracted tax relief had it been made to an indigenous charity may not enjoy the same relief if the gift is made to an otherwise identical but, crucially, foreign charity.

The reason for this is the concept of ‘territoriality’. Historically, many jurisdictions (including the United States, the United Kingdom and many others in Europe) have adopted this approach. This has led to the establishment of indigenous ‘friends of’ organisations in those jurisdictions which operate their charitable tax reliefs on the basis of ‘territoriality’ to enable foreign charities to operate or raise funds tax-efficiently. Where it has not been considered cost effective to establish a stand alone ‘friends of’ organisation, many donors have used donor advised funds, such as those which are members of Transnational Giving Europe (see: http://www.kbs-frb.be/philantropy.aspx?id=171742&LangType=1033 ).

The problem for US citizens subject to tax elsewhere who wish to make tax-efficient charitable donations

However, ‘friends of’ organisations are unlikely to provide an entire solution for US citizens who wish to make tax-efficient gifts and who are resident in another jurisdiction which applies the ‘territoriality’ approach, and are thus potentially subject to two countries’ systems of tax. This is because, irrespective of where they are domiciled or resident, US citizens are subject to US income tax on a worldwide basis regardless of the source of their income or gains. They may also be taxable in the jurisdiction of their residence or in the jurisdiction in which their income arose, subject of course, to the application of any relevant tax treaty. For example, US citizens who have UK source income or gains will generally pay tax first in the UK and receive a credit against their US income tax liability equal to the UK tax paid; they will then only pay US tax to the extent that their US liability exceeds their UK liability.

A problem can arise, however, when US citizens who are also subject to another country’s tax decide that they wish to make a tax-efficient donation to charity. Because the tax systems of the US and the country in which their income is primarily taxable may contain conflicting requirements for obtaining a tax deduction for a gift to charity, they may have had to choose to obtain tax relief only in one jurisdiction and accept that the overall benefit will be limited by the constraints of the other jurisdiction’s tax system.

For US income tax purposes, an individual donor is only eligible for a charitable deduction if the recipient organisation is created or organised under the laws of a US state, the District of Columbia or a US possession. In the UK, however, in order to be eligible for income tax or capital gains tax relief, the gift must be made to a charity which is organised in the UK and governed by the law of England and Wales, Scotland or Northern Ireland.

The interaction of these rules puts a taxpayer who is subject to both US and UK tax on the same income or gains in a difficult position. While a gift to an English charity may qualify for UK income tax and capital gains tax relief, effectively reducing the donor’s UK taxable income or gains by the amount of the gift, the gift will not qualify for a US income tax deduction. This is because the English charity will, by definition, not be organised under the laws of a US state (or the District of Columbia or a US possession). Because the donor’s UK tax liability (and therefore the donor’s US foreign tax credit) will have been reduced (and no US income tax deduction is available for the gift) the gift may increase the donor’s overall US income tax liability.

If on the other hand the donor makes a gift to a US qualified exempt organisation, he or she will be eligible for a US income tax deduction. However, if the donor’s income or gains are primarily subject to UK tax there will be no UK tax relief available as the gift was made to a non-UK charity. After payment of, and credit for, the (unrelieved) UK tax liability, the donor may have no, or only very little, US tax liability against which to set the US tax deduction derived from the gift. In that case, the US tax deduction will be of limited use to the donor.

Securing the tax deduction in both countries - the ‘US/UK Dual Qualified’ structure

In order to secure effective tax relief for a donor who is subject to both US and UK tax on his or her income or capital gains, it is necessary that the gift should be made to a charity which is simultaneously treated as governed by English law (for UK tax purposes) and by US law (for US tax purposes). In normal terms, this might seem impossible; however the US tax code contains a provision which, like the Seventh Cavalry, can come to the rescue.

The solution to the problem turns on the use of a dual corporate structure in which a US corporate exempt organisation owns all of the share capital of an English charitable company. Although share companies are no longer generally the vehicle of choice for the creation of an English charity, many English charities are constituted as share companies. Because the US exempt organisation is the sole member of the English charity, it is possible under the US Internal Revenue Code for a US tax ‘entity election’ to be made under the ‘check the box’ rules. The consequence of this is that the English charity is treated as a ‘disregarded entity’ and as a foreign branch of the US exempt organisation for US tax purposes.

As a result, a gift to the English charitable company will be eligible for income tax (or capital gains tax) benefits in both the US and UK because: for UK tax purposes, the gift is to the English charity and therefore eligible for UK income and capital gains tax relief; and for US tax purposes the gift to the UK disregarded entity is treated as a gift to a US qualified exempt organisation, giving rise to a simultaneous US income tax deduction.

Structures such as these are therefore valuable in enabling US citizens who have a UK tax liability to make tax-efficient charitable gifts despite the tax problem described above.

Elsewhere in the EU, and the implications of European law

Although, historically, most EU states had rules similar to those of the US and the UK, granting charitable tax reliefs only for the income and gains of entities established in or under the laws of their own jurisdictions and for gifts to such entities, the position has been changing of late.  

In 2002, the European Commission issued a ‘reasoned opinion’ to the Belgian Government requiring it to change its legislation on gift and inheritance tax on the basis that applying a preferential rate to gifts or legacies to Belgian charities, but not to charities established in other EU states, was a discriminatory practice which contravened the EU Treaty. Eventually, Belgium complied.

Then, in 2006, the European Court of Justice decided the case of Centro di Musicologia Walter Stauffer v Finanzamt München für Körperschaften (C386/04). In this case, a German tax office had taxed income received by an Italian charity from German investment property. The Italian charity’s purposes were recognised as charitable under German law, and an equivalent German charity would not have been taxed on that income; fundamentally, the Italian charity was only taxed because it was not German. The ECJ followed the opinion given by its Advocate General and held that this was an obstacle to the free movement of capital between member states which contravened Article 56 of the EU Treaty.

Although the impact of the Stauffer case was limited to the one issue of the taxation of a charity’s own income, once the Advocate General gave his opinion the European Commission issued directions to a number of EU member states, including Germany, Ireland and the UK, requiring them to remove all discriminatory tax practices in relation not just to the income and gains of charities based in other member states which would, had they been ‘indigenous’ have been treated more favourably, but also in respect of gifts made to them.

Hein Persche v Finanzamt Lüdenscheid (European Court of Justice, C318/07)

On October 14 2008, the Advocate General of the ECJ gave his opinion in another case, which the European Court of Justice followed in their judgment delivered this January. This case concerned a claim by Mr Persche, a German tax advisor, that the German tax authorities’ refusal to grant him a tax deduction in relation to gifts he had made to a retirement home and children's centre in Portugal, on the grounds that the recipient was not a German charity, similarly contravened the EU Treaty. In its judgment, (see: http://curia.europa.eu/jurisp/cgi-bin/form.pl?lang=EN&Submit=rechercher&numaff=C-318/07), the European Court of Justice built upon its 2006 decision in the Stauffer case by extending a similar ‘non-discriminatory’ approach to the tax-deductibility of gifts to other EU Member States’ charities.

It concluded that donations made by individuals resident in one EU state to organisations based in and recognised as charitable by another are covered by Article 56 of the EU Treaty. Thus, it said, if an EU state provides tax relief for donations to organisations recognised as charitable and located in its own jurisdiction, it is contrary to the EU Treaty not to allow a taxpayer the opportunity to prove that charitable organisations based in other EU states also fulfil the requirements for tax relief. It held, however, that the burden of establishing that the foreign recipient charity was ‘equivalent’ to an indigenous charity fell on the donor who was seeking the tax deduction.

What does the Hein Persche case mean in practice: generally and for US citizens in particular?

The judgment in the Hein Persche case does not mean that gifts to entities which are recognised in one EU state as being eligible for beneficial tax treatment as charities will automatically enjoy the same treatment as is given by other EU states to gifts to ‘indigenous’ charities. Both the Stauffer and the Hein Persche cases recognise that each EU state is entitled to prescribe which activities it will an organisation must pursue if it is to be eligible for beneficial tax treatment and the reliefs it will give in respect of such organisations. Similarly, the cases recognise that each state may specify the level of evidence it considers appropriate to ensure that an organisation satisfies the tests which it requires to be met in this regard. However, the cases indicate that as a matter of European law, discriminating simply on the grounds that an organisation which would otherwise qualify for charitable tax reliefs (or which would make a donor eligible for tax relief in respect of gifts made to it) is established in another EU state is no longer an option.

Some EU member states have already changed their law: most notably the Netherlands (which has set up a mechanism under which non-Dutch charities, both from other EU states and some non-EU states, may apply for tax approval). Others, for example the UK, are resisting change and may find themselves proceeded against by the European Commission.

There is undoubtedly a wind of change blowing through Europe and it is to be hoped that before long charities from one EU state which have objects which would be recognised as acceptable in other EU states, and which are supervised to the satisfaction of those latter states, will be able to enjoy the same reliefs as the latter states’ indigenous charities. Similarly, gifts to those charities should eventually attract the same benefits as gifts to indigenous charities. If this is so, the need to make use of ‘friends of’ structures, at least within the European Union, should decline.

But how does this help the US citizen who is also liable to tax in an EU state? Although the US is not a member of the EU, the UK is. The Hein Persche case therefore means that an English charity which forms part of a US/UK dual qualified structure (and gifts to such a charity) should not be denied equivalent tax treatment to an indigenous charity (or gifts to such an indigenous charity) in another EU state simply on the grounds that it is not indigenous to that state.

If properly framed to take into account the purposes regarded as charitable elsewhere, the objects of an English charity forming part of a US/UK dual qualified structure should thus be capable of satisfying the requirements for charitable recognition in other EU member states. It is to be hoped that the system under which the Charity Commission regulates and supervises English charities, including those forming part of a US/UK dual qualified structure, should demonstrate to other EU states that English charities are properly regulated, although they may well have to report to the appropriate authorities in those EU states in which they wish to be recognised.

So although the Stauffer and Hein Persche cases may not be of direct help to US citizens in Europe, there are grounds for optimism that the US/UK Dual Qualified structure may eventually be able to make life easier for them (and charities seeking their support) where they are subject not just to UK tax but also to tax elsewhere in the European Union.

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'.