Taxability of private foundations

Background
A foundation is an independent legal entity created by law. It draws its features from both a company and trust. Similar to a company, a foundation has a separate legal entity, its own seal, a council to manages its operations and takes decisions, like a board of directors; it makes distribution to its beneficiaries in the manner similar to dividends, and holds assets in its own name, and acts for itself. But unlike a company, a Foundation is an orphan entity, i.e. it has no shareholder and is an end in itself.

It’s similarity with a trust in the manner in which ring-fences the assets, but goes far beyond as there are no owners. Also, it is tax transparent like a Trust. It follows that a Foundation will not be taxed on its income, but it's income will be split and added to the income of the beneficiaries for the purpose of taxation in proportion of their beneficial interest. While in some jurisdictions, this transparency is automatic, in others, it may have to be achieved by process of election.

A foundation achieves the objective ringfencing of assets without losing control to external trustees and incur costs on the same, and achieve even a higher level of tax advantage than a trust.

Private foundations originated as a tax arrangement in the US in 1910s, with Andrew Carnegie forming the first such arrangement. Rockefeller and Cleveland shortly followed suit. While these foundations were renowned for philanthropic purposes, they fortified the tax advantages for the contributing families and
beneficiaries.

Today, there are circa ten million foundations registered worldwide, of which, approximately 15% of them are registered in the USA. Of these, circa fifty thousand are private foundations.

This article is focused on tax aspects of a private foundation.

Taxability of a Foundation
While Foundation commenced as a tax concept in US, today, circa 40 countries have a codified foundation law. In these jurisdictions, the governments register the foundation as an independent entity and issues the formation certificate.

USA
US is yet to promulgate laws for formation of a Foundation as a separate legal entity, but continues to strengthen this concept only under the tax laws. To achieve the tax optimization, the owners of the assets usually form a not-for-profit corporation in the US. The corporation will then elect to register under federal law 501(c) as a private foundation. Upon meting the conditions, it may end up paying only 1.39% tax on its income. This can be achieved if such foundation pays out 5% p.a. of its assets for charitable purposes. (The 1.39% tax rate arises from the simplified rate notified by the Further Consolidated Appropriation Act of 2020).

The 5% payouts include the actual payouts to other charitable organizations and all the expenses incurred to achieve the charitable payout. Then there is a question of a small excise tax to be paid, but that is not usually material in the larger context.

This is a fairly complex process, but may result in effective tax optimization.

Europe
European countries like Luxembourg and Switzerland became the first to codify foundation laws. These Foundations are widely used in Europe for asset protection and also optimizes tax as a consequence, both by Europeans and outsiders.

A Luxembourg or a Swiss Foundation offers protection for asset safety. Dividends, capital gains, income from movable assets are exempt, but the transfers are subject to gift tax. The grantors can be the beneficiaries, but it requires a careful drafting of the deed and how the balance sheet of the underlying profit generating assets are structured.

Also, the principals of International Financial Reporting Standard 12 on tax, as well as EU directives on various aspects like Anti-money-laundering have to do considered.

Other Countries
Countries including Belize, Cayman Islands, Jersey, Seychelles, Mauritius, Panama, Vanuatu, Dutch Antilles offer good foundation structures.

The grantors can opt to be beneficiaries as well as council members and there is no third-party trustee reliance.

Income from outside these territories are tax neutral, whether it arises from dividend or from contracts concluded outside their jurisdictions, interest and other forms.

However, they should be appropriately structured to ensure that they meet the place of effective management rules and economic substance requirements for most international transactions. Care has to be specifically taken for royalty income, due to the specific provisions relating to IP ownership and exploitation being in force in most of these jurisdictions. It is also critical to calibrate with the accounting requirements in these jurisdictions, as well as with IFRS or the accounting standards of jurisdictions where underlying entities are located.

United Arab Emirates
Coming home, For years it has been a common for expats to hold properties in UAE and shares in UAE companies through a company incorporated in the British Virgin Islands, Isle of Man or such other jurisdictions. Over a decade ago, we commenced the process of using offshore foundations for the purpose.

Today the ownership in UAE properties is restricted only to either individual ownerships or an entity in DIFC, ADGM, or RAKICC. Trusts and foundations are used primarily used for family business organization, succession and testamentary purposes. But the UAE corporate tax laws give an option to these foundations to elect as being tax transparent. This implies that the income accruing to the foundation from its assets will be taxable not in the hands of the foundation, but in the hands of the beneficiaries in the proportion of their beneficial interest.

While dividend income is exempt under UAE law in any case, it is now becoming usual for placing properties in the Foundation, so that the rental income and capital gains may become tax exempt. This implies that if the property is held by the foundation for succession purpose, then the income from the same will become taxable in the hands of the beneficiaries of the Foundation in proportion of their beneficial interest. As on date, individuals are exempt from tax.

However, it is critical to structure the foundation charter, regulations, and financial arrangements to ensure that expenses are accounted for in the appropriate way, for managing present and future tax impacts.

Conclusion
Foundations are globally used by high net-worth individuals to achieve succession and tax optimization. Careful drafting of the Foundation charter and regulations, as well as the synchronization with the underlying financials is critical to achieve the objective.

Anuraag Malhotra

About the Author: Anuraag is a practicing Solicitor (England & Wales), Chartered member of the chartered institute of securities and investments, UK, a management accountant & a company secretary from India and a member of Delhi Tax Bar Council. He is focused on financial structuring, taxation, setting up trusts & foundations globally, and listing of debt and quasi equity instruments on various jurisdictions.