U.S. charities are now more than ever diversifying their investment portfolios to include foreign investments, especially foreign program-related investments. They are also offering services on the ground in foreign countries with essential charitable programs.
Most charities are aware of the foreign bank account reporting obligations for those accounts and for individuals with signing authority over such accounts. What charities that invest or operate abroad may not be aware of is the complexity of the federal compliance issues that govern other foreign activities. These activities can involve making grants to foreign entities, sending U.S. employees abroad, hiring and working with foreign employees, and program operations or investments. It can be common for charities to be caught off guard by all the red tape and filing requirements when they are just trying to do good and help the rest of the world.
Here are several key considerations for charities when operating or investing abroad:
- Understand the rules and regulations in the foreign country where the charity is considering conducting business. Each country has different rules and regulations. Some may require that the U.S. based charity set up a legal entity while others may let the same charity operate as a branch or in-country office. Before setting up a foreign operation, contact an advisor in that country to understand the legal and tax ramifications of maintaining operations in the foreign jurisdiction. Make sure the advisor has dealt specifically with several U.S. charities that have already set up operations there. Ask for the advisor’s success rate and what their challenges were. It is important to understand if they have a track record and to speak with references.
- Determine whether to create a separate legal entity. Once you understand the rules and regulations of the foreign country, you will understand whether you need to create a separate legal entity. If that is necessary, you will have to determine what type of entity to set up and the impact on your U.S. tax filings. Often a non-governmental organization (NGO) is created and the U.S. charity controls the new organization. While the entity in the foreign country may be considered a non-governmental organization (NGO), the U.S. usually considers foreign entities such as these to be a “corporation” rather than a “nonprofit.” This is the default rule for most entities; however, there are exceptions to this general rule. Similar to a nonprofit corporation organized under U.S. state law, the entity would have to apply for tax-exempt status with the U.S. government in order to be considered a 501(c)(3) tax exempt organization.
You should be aware of the implications of “working with” foreign organizations. Has your charity funded the foreign organization? Does your charity control the board? The answers to these questions won’t necessarily cause a tax liability, but it may require a U.S. informational filing. Failing to file foreign informational returns can result in hefty penalties beginning at $10,000 for each missed filing. The good news is there is an open offshore voluntary disclosure program. If your organization has previously missed filings but owes no tax related to the filings, you can voluntarily disclose without triggering penalties. The process includes the charity amending its returns to include the missing foreign filings. If done correctly there will no penalties assessed by the IRS.
- Be aware of unrelated business taxable income (UBTI). The same UBTI rules apply to charities whether they are investing offshore or at home; however, UBTI can create additional complexities when it occurs in a foreign investment or operations. UBTI can arise for U.S. charities when debt is used to purchase investments or when the charity conducts a trade or business outside its exempt activity purpose. There are many exclusions, exemptions and modifications to UBTI. Working with an experienced tax advisor is important. The key item to remember in avoiding UBTI is that foreign investments should not be funded with acquisition debt.
- Know the rules for employees abroad. Employees working abroad may be required to file a tax return in both the U.S. and the foreign jurisdiction. Your charity may further be required to withhold tax and to report this to the IRS or foreign jurisdiction. This is often a surprise for U.S. employees working abroad or foreign workers in the United States. Also, be aware of foreign labor laws, which often are much different from those in the United States. Employees in other countries frequently have greater rights with respect to pension benefits, insurance, paid leave and severance and it may be difficult to terminate employment.
- Know the boycott rules when working in the Middle East. Charities operating with or in the Middle East may have to file a boycott report if they are working with a country that boycotts Israel. The United States wants to regulate all entities operating within or with a boycott country, including nonprofits. This can be a complex determination, so please consult your tax advisor.
- Be vigilant about potential ties to terrorist organizations. Almost immediately after the Sept. 11, 2001 terrorist attacks, President Bush signed an order to “prohibit transactions with persons who commit, threaten to commit or support terrorism.” Thus, charities that make grants to or do business with terrorists, even if it is unintentional, risk criminal prosecution, civil penalties and frozen assets. There is no safe-harbor provision to these laws. You should check lists maintained by the U.S. Treasury Department’s Office of Foreign Assets Control (OFAC) and the Department of Justice’s U.S. Government Terrorist Exclusion List to make sure you aren’t funding terrorist operations. To mitigate risks, you also should create a policy and a set of procedures to follow each time funds are paid to foreign entities.
- Special rules for private foundations apply. Private foundations that make program-related investments to foreign entities may be required to have additional documentation known as “expenditure responsibility.” If they don’t meet the requirements, the investment will be considered a taxable expenditure and the foundation may subject to an excise tax. This also may be true, if a private foundation creates a foreign organization to run programs.
U.S. based charities that support efforts abroad contribute significantly to the world. To get the most of their foreign investments and operations, it’s important that you understand all the U.S. tax filing requirements you need to follow. Tax advisors who understand this area can help.