27 April 2016 Final regulations clarify range of program-related investments for private foundations The IRS has issued final regulations (TD 9762) adopting new examples of program-related investments that will not be treated as jeopardizing investments. Section 4944(a) imposes an excise tax on a private foundation that makes an investment jeopardizing the foundation's exempt status, as well as on foundation managers that knowingly participate in making such an investment. Under Treas. Reg. Section 53.4944-1(a)(2), a jeopardizing investment occurs when, based on facts and circumstances at the time the investment is made, the foundation managers failed to exercise ordinary care and prudence in providing for the foundation's financial needs. There is an exception from jeopardizing investment characterization under Section 4944(c) for "program-related investments" (PRIs). The accompanying regulations set forth three requirements for an investment to qualify as a PRI: (1) the investment's primary purpose must be to accomplish one or more of the purposes described in Section 170(c)(2)(B) (charitable purposes); (2) the production of income or the appreciation of property cannot be a significant purpose; and (3) one or more of the purposes described in Section 170(c)(2)(D) (legislative/political intervention) cannot be a purpose. Prior to the new final regulations, Treas. Reg. Section 53.4944-3(b) included nine examples of investments that qualify as PRIs and one example of an investment that does not qualify. These former regulations and original 10 examples were finalized in 1972 and were limited to domestic situations and principally involved economically disadvantaged individuals and deteriorated urban areas. While these examples are still relevant today, they do not consider many of the modern practices of private foundations in furthering their exempt missions. The final regulations add nine new examples to the regulations to illustrate a wider range of investment activities and vehicles that qualify as PRIs. The IRS had initially included the new examples in proposed regulations issued in April 2012 (REG-144267-11, see Tax Alert 2012-756{}). In proposing the new examples, the IRS noted the need in the private foundation community for additional PRI examples to reflect current investment practices of private foundations in furthering their exempt purposes. The new examples — as proposed and now finalized — are based on previous guidance and letter rulings, and they do not otherwise modify existing guidance on PRIs. The examples in the final regulations include some small modifications in response to comments received on the proposed regulations. Under the final regulations, new examples 11 through 19 demonstrate that charitable purposes for PRI purposes include: — Example 11: advancing science in the public interest, such as by investing in the research and development of new drugs (while the proposed example involved an investment agreement that required making the drugs available to affected poor individuals at an affordable price, the final example clarifies that the agreement need not preclude selling the drug at fair market value to others) — Examples 12 and 13: combating environmental deterioration, such as by investing in the recycling of solid waste materials in a developing country — even if through obtaining an equity position with a potentially high rate of return or through other investment instruments, such as loans — Example 14: providing relief to the poor and distressed by alleviating the detrimental impact of a natural disaster to the business operations of their employer — Example 15: making microloans to poor individuals in developing countries (the final regulations remove reference to the loans being in the context of a natural disaster) — Example 16: funding educational programs for poor individuals in foreign countries, such as farm training programs — Examples 18 and 19: promoting education by funding a new child care facility loan to a non-profit corporation through a commercial bank under either a deposit agreement or a guarantee agreement The final regulations incorporate several notable changes suggested by commenters that clarify the 2012 proposed regulations. Specifically: — Example 11 was amended to clarify that when the exempt purpose of a PRI is to promote science, sales of vaccines need not only be made to poor individuals; rather, vaccines may also be sold at fair market value to people who can afford it. — Example 13 was amended to clarify that a foundation receiving stock in a business enterprise does not need to sell its stock in a PRI that becomes profitable. Tying an exit condition (such as a self-imposed condition to sell the stock if it becomes profitable or worthless) to the foundation's exempt purpose, however, can indicate that the investment was indeed undertaken primarily to fulfill the foundation's exempt purpose. — Example 15 was amended to eliminate the reference to a natural disaster, indicating loans may be made to poor individuals in developing countries without a natural disaster as a qualifier. The preamble to the proposed regulations highlighted certain principles illustrated in the new examples. Commenters requested that these principles be explicitly stated in the final regulations. The IRS declined to include such a statement of principles in the final regulations, noting that it believed the principles were adequately reflected in the examples. Nonetheless, the IRS stated that it will post the principles on its website. These principles include: — PRIs are not limited to situations involving economically disadvantaged individuals and deteriorated urban areas, but may accomplish a variety of exempt purposes. — Loans and capital may be provided to individuals or entities that are not within a charitable class themselves, if the recipients are the means through which the private foundation accomplishes its exempt activities. — The existence of a potentially high rate of return and/or the acceptance of an equity position in connection with a loan will not necessarily preclude an investment from qualifying as a PRI. — An investment related to the funding of activities in foreign countries that would further an exempt purpose if the same activity were conducted in the US may qualify as a PRI. The IRS declined requests to add additional new examples in the final regulations, noting that organizations seeking guidance with respect to whether other particular activities further charitable purposes may request private letter rulings, and that the regulations are not intended to provide an example of every exempt purpose. Commenters also requested the regulations include a means of getting guidance that is more expeditious and less costly than private letter rulings, but the IRS stated this request goes beyond the scope of the regulations. The IRS also declined commenters' recommendations to allow private foundations to rely on private letter rulings issued to other foundations regarding PRIs, citing tax administration issues. New examples 11 through 19 become applicable upon the date of publication of the final regulations (April 25, 2016). Under the proposed regulations, however, taxpayers could rely on the new examples before final regulations were published. These regulations finalize examples added by proposed regulations to the list of sample qualifying program related investments for private foundations. The regulations incorporate years of previous guidance and letter rulings in an attempt to validate investment activities of today's foundations. The proposed and final regulations include two examples of foundations assuming risks to catalyze the entry of private investment capital. Notably, the IRS declined a commenter's suggestion to add more examples of situations in which foundations might assume risks as part of a PRI, leaving room for foundations to interpret the principles illustrated to their own unique situations. The final regulations do not add new examples to the proposed regulations issued in April 2012, but slight changes were made. Any foundation previously relying on the proposed regulations to structure its PRIs should review the final regulations, comments, and preamble to the final regulations. Foundations could also look to the statement of principles, which are now on the IRS website, and no longer included as part of the regulations. While these principles do not have the effect of law, they are reflected in the examples and helpful as guidance. Foundations should also still consider seeking IRS guidance or a private letter ruling if they are in situations not outlined by these examples. — For more information about EY's Exempt Organization Tax Services group, visit us at www.ey.com/ExemptOrg.
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