Foreign foundation's indirect investment avoided excess business holdings

Plain-English summary

A foreign private foundation proposed investing in a foreign passive holding company that could own all of an operating business. The foundation would own the holding company's nonvoting shares and voting shares carrying no more than 20 percent of the director-election power, while an unrelated foreign grant-making trust held the remaining voting power. Because the holding company and intermediate entities expected at least 95 percent passive income, the excess-business-holdings rules looked through them to the operating business. The IRS treated the foundation's constructive voting interest in that business as no more than 20 percent. The foundation's nonvoting shares and unexercised option to buy the other voting shares did not increase that voting percentage, and no disqualified person held an interest. The IRS ruled that the investment alone would not create excess business holdings under section 4943.

Ruling snapshot

• Question: Would the foundation's proposed indirect interest in the operating business exceed the permitted 20 percent voting-stock limit?
• Outcome: approved
• Key authorities: IRC §§ 4943, 4948; Treas. Reg. §§ 53.4943-3, 53.4943-8, 53.4943-10

Full text (IRS public release)

Internal Revenue Service                                      Department of the Treasury
                                                              Washington, DC 20224

Number: 201737003                                             Third Party Communication: None
Release Date: 9/15/2017                                       Date of Communication: Not Applicable
Index Number: 4943.03-00
                                                              Person To Contact:
----------------------                                        -----------------------, ID No. -------------------
------------------------                                      ---------------------------------------------------
--------------                                                Telephone Number:
-------------------                                           --------------------
                                                              Refer Reply To:
                                                              CC:TEGE:EOEG:EO1
                                                              PLR-134282-16
                                                              Date:
                                                              May 15, 2017


Legend:

Foundation       =    ----------------------
Company          =    -------------------------------------------
Trust            =    ---------------------------------------------
Business         =    -----------------------------------------


Dear -------------:

This letter responds to Foundation’s October 20, 2016, request for a ruling that a
proposed business holding will not constitute an excess business holding under
section 4943 of the Internal Revenue Code (Code).1

Facts

According to the information provided by Foundation, Foundation is a foreign
organization recognized as exempt from federal income tax under section 501(c)(3) and
as a private foundation. Foundation has received substantially all of its support (other
than gross investment income) from sources outside the United States.

Consistent with the investment goals of its endowment, Foundation proposes to make
an investment in Company, a foreign organization that expects to be treated as a
corporation for U.S. federal income tax purposes. Company is not a disqualified person
with respect to Foundation. Company will indirectly hold more than ---- percent, and as
much as 100 percent, of the voting stock in a foreign business entity (Business), which
expects to be treated as a corporation for U.S. federal income tax purposes.

1
  Section 4943 of the Internal Revenue Code of 1986, as amended, to which all subsequent section
references are made unless otherwise stated.

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Foundation represents that Business is a “business enterprise” under section 4943 and
Treas. Reg. § 53.4943-10.

Company and intermediate holding companies or partnerships through which Company
holds its interest in Business are each expected to derive ---- percent or more of their
gross income from passive sources, including dividends and capital gains from
Business. Foundation represents that each of Company and such intermediate holding
companies or partnerships is expected not to be a business enterprise within the
meaning of Treas. Reg. § 53.4943-10(c).

Foundation will not hold any shares in Business directly (nor does it directly own any of
the shares of any other entity owned or controlled by Company). No disqualified
persons with respect to Foundation have ever held any stock in Company or any entity
in which Company holds an interest, nor will any disqualified person with respect to
Foundation hold, directly or indirectly, any stock in Business.

As part of Foundation’s ongoing effort to ensure that its investments comply with the
excess business holdings rules, Foundation seeks to ensure that it holds, actually or
constructively within the meaning of Treas. Reg. § 53.4943-8, no more than 20 percent
of the voting stock of Business. Foundation will not hold, directly or indirectly, any stock
in Business, other than through Company. Because its interest in Business is held
indirectly through an interest in Company, Foundation seeks to ensure that it holds no
more than 20 percent of the voting stock of Company.

Company has three classes of shares, one class of non-voting ordinary shares (“Non-
Voting Shares”) and two classes, A and B, of voting fixed coupon preferred shares
(“Voting Shares”). The holders of class A Voting Shares have the right to elect up to ----
------A directors (or ----% of Company’s directors) and remove those directors at any
time, while Foundation, as the holder of all class B Voting Shares, has the right to elect
up to ------B director (or ----% of Company’s directors) and to remove that director at any
time. Directors serve indefinite terms until they resign or are removed by the pertinent
holders of Voting Shares. If a director vacancy arises and the pertinent holders of
Voting Shares do not appoint a replacement director, the remaining directors may
appoint a replacement director, who may be removed only by the pertinent holders of
Voting Shares.

The remaining ----percent of the Voting Shares of Company (all of class A) are held by
Trust, a foreign non-profit grant-making trust. Trust is unrelated to, and is not a
disqualified person with respect to, Foundation. Trust has not applied for a
determination letter from the IRS. Trust was formed and funded in --------by an
individual who is unrelated to, and not a disqualified person with respect to, Foundation.
Foundation is not a beneficiary of Trust, and no trustee of either Foundation or Trust is a
trustee of the other. The terms of Company’s articles of organization entitle Trust to
elect and remove ----percent of Company’s directors, including ----percent of the initial
directors. The articles provide that decisions of Company directors are made by a

PLR-134282-16                                3

majority, and that a director appointed by Foundation and a director appointed by Trust
is needed for a quorum for a director’s meeting.

At the present time, all of the directors of Company are also employees of Foundation,
though ----% of these directors could be removed at any time by vote of Trust. There is
not, and has never been, any restriction requiring director candidates to be Foundation
employees. There are no separate shareholders’ agreements or voting agreements
relating to the voting of Company stock, though Trust and Foundation do discuss the
management of Company and its investments in their capacity as shareholders.

Holders of Voting Shares of Company are entitled to a fixed amount of cash per share
per year. Company must pay the accrued dividend on the Voting Shares before it can
pay any amount to Foundation as the holder of the Non-Voting Shares, and Company’s
directors otherwise have full discretion regarding whether or not to pay any such
amount to Foundation as the holder of the Non-Voting Shares. Upon liquidation of
Company, the Voting Shares are entitled to a liquidation preference equal to the sum of
any unpaid accrued dividend and a nominal amount equal to the original capital
invested per Voting Share, after which the Nonvoting Shares are entitled to the
remaining proceeds of liquidation.

Foundation holds a call option over the Voting Shares held by Trust that permits
Foundation to purchase the voting stock of Company at fair market value upon ------
months' notice. The call option has not been exercised.

Trust is not required to make capital contributions to Company. Foundation has a
capital commitment to Company, a portion of which has been drawn down to date in
connection with Company’s prior portfolio investments.

Neither Foundation nor any disqualified person with respect to Foundation has any
power of appointment over any interest in Business exercisable in favor of Foundation
or a disqualified person.

Ruling Requested

Foundation requests a ruling that, for purposes of section 4943, it will own, directly or
indirectly, no more than 20 percent of the voting stock of Business, and that it therefore
will not have excess business holdings under section 4943, solely as a result of making
and holding an investment in Business in the manner described above.

Law

Section 4943(a)(1) imposes a tax on the excess business holdings of a private
foundation in a business enterprise during any taxable year which ends during the
taxable period.

PLR-134282-16                              4

Section 4943(c)(1) generally defines “excess business holdings,” with respect to the
holdings of any private foundation in any business enterprise, as the amount of stock
or other interest in the enterprise which the foundation would have to dispose of to a
person other than a disqualified person in order for the remaining holdings of the
foundation in such enterprise to be permitted holdings.

Section 4943(c)(2) generally defines the permitted holdings of a private foundation in
an incorporated business enterprise as 20 percent of the voting stock, reduced by the
percentage of the voting stock owned by all disqualified persons. In any case in
which all disqualified persons together do not own more than 20 percent of the voting
stock of an incorporated business enterprise, nonvoting stock held by the private
foundation shall also be treated as permitted holdings.

Section 4943(d)(1) generally provides that in computing the holdings of a private
foundation, or a disqualified person with respect thereto, in any business enterprise,
any stock or other interest owned, directly or indirectly, by or for a corporation,
partnership, estate, or trust shall be considered as being owned proportionately by or
for its shareholders, partners, or beneficiaries.

Section 4943(d)(3)(B) provides that the term “business enterprise” does not include a
trade or business at least 95 percent of the gross income of which is derived from
passive sources. It also provides that, for this purpose, gross income from passive
sources includes certain items that are excluded from unrelated business income.
Among those items are dividends and capital gains that are excluded from unrelated
business income by section 512(b)(1) and (5). See also Treas. Reg. §§ 53.4943-
10(c)(1) and (2).

Section 4948 provides in part that Chapter 42 of the Code (other than section 4948)
shall not apply to any foreign organization which has received substantially all of its
support (other than gross investment income) from sources outside the United States.
However, such a foreign organization’s exemption from taxation under section 501(a)
may be revoked under section 4948(c)(1) if that organization engages in a prohibited
transaction.

Section 4948(c)(2) provides that the term “prohibited transaction” includes any act or
failure to act (other than with respect to section 4942(e)) which would subject a
foreign organization described in section 4948(b) to liability for a penalty under
section 6684 if such foreign organization were a domestic organization.

Section 6684 imposes a penalty if a person becomes liable for tax under Chapter 42
by reason of any act or failure to act which is not due to reasonable cause and either
(1) such person has theretofore been liable for tax under such chapter, or (2) such act
or failure to act is both willful and flagrant.

PLR-134282-16                                5

Treas. Reg. § 53.4943-3(b)(1)(ii) provides that the percentage of voting stock held by
any person in a corporation is normally determined by reference to the power of stock
to vote for the election of directors, with treasury stock and stock which is authorized
but unissued being disregarded. Thus, for example, if a private foundation holds 20
percent of the shares of one class of stock in a corporation, which class is entitled to
elect three directors, and such foundation holds no stock in the other class of stock,
which is entitled to elect five directors, such foundation shall be treated as holding 7.5
percent of the voting stock because the class of stock it holds has 37.5 percent of
such voting power, by reason of being able to elect three of the eight directors, and
the foundation holds one-fifth of the shares of such class (20 percent of 37.5 percent
is 7.5 percent). The fact that extraordinary corporate action (e.g., charter or by-law
amendments) by a corporation may require the favorable vote of more than a majority
of the directors, or of the outstanding voting stock, of such corporation shall not alter
the determination of voting power of stock in such corporation in accordance with the
two preceding sentences.

Treas. Reg. § 53.4943-3(b)(2)(i) generally provides that in addition to permitted
holdings in voting stock, the permitted holdings of a private foundation in an
incorporated business enterprise also include any share of nonvoting stock in the
business enterprise, so long as the private foundation together with its disqualified
persons hold no more than 20 percent of the business enterprise’s voting stock. For
this purpose, all equity interests which do not have voting power attributable to them
are classified as nonvoting stock. Also under Treas. Reg. § 53.4943-3(B)(2)(i),
evidences of indebtedness (including convertible indebtedness), and warrants and
other options or rights to acquire stock shall not be considered equity interests.

Treas. Reg. § 53.4943-8(a)(2) provides that any interest in a business enterprise over
which a foundation or a disqualified person has a power of appointment exercisable in
favor of the foundation or a disqualified person shall be considered owned by the
foundation or disqualified person holding such power of appointment.

Treas. Reg. § 53.4943-8(a)(3) provides generally that if an interest in a business
enterprise owned by a corporation is constructively owned by a shareholder, each
shareholder's proportion of ownership is generally computed on the basis of the
voting stock each shareholder has in the corporation.

Treas. Reg. § 53.4943-8(a)(4) provides that if a private foundation, its disqualified
persons, or both, own (directly or constructively) nonvoting stock of a parent
corporation, the holdings of which are treated as constructively owned by its
shareholders by reason of section 4943(d)(1) and Treas. Reg. § 53.4943-8, such
nonvoting stock shall be treated as nonvoting stock of any corporation in which the
parent corporation holds an interest for purposes of the limitation on the holding of
nonvoting stock under section 4943(c)(2)(A) and Treas. Reg. § 53.4943-3(b)(2).

PLR-134282-16                                6

Treas. Reg. § 53.4943-10(c)(1) provides that for purposes of section 4943(d)(4), the
term “business enterprise” does not include a trade or business at least 95 percent of
the gross income of which is derived from passive sources; except that if in the
taxable year in question less than 95 percent of the income of a trade or business is
from passive sources, the foundation may, in applying this 95 percent test, substitute
for the passive source gross income in such taxable year the average gross income
from passive sources for the 10 taxable years immediately preceding the taxable year
in question (or for such shorter period as the entity has been in existence). Thus,
stock in a passive holding company is not to be considered a holding in a business
enterprise even if the company is controlled by the foundation. Instead, the
foundation is treated as owning its proportionate share of any interests in a business
enterprise held by such company under section 4943(d)(1).

Analysis

Although Foundation, as a foreign private foundation described in section 4948(b), is not
subject to tax under section 4943, Foundation must comply with the requirements of
section 4943 so as to avoid engaging in a “prohibited transaction” under section
4948(c)(2).

Under section 4943(c)(2), the pertinent interests in defining the permitted holdings of a
private foundation in a corporation are the voting stock, and are generally limited to 20%
of the voting stock. Given that Company (and any other intermediate holding company
or partnership through which Foundation holds an indirect interest in Business)
represents that it will receive at least -----percent of its gross income from passive
sources (as dividends and capital gains), Company (and each other intermediate entity)
is not a business enterprise under section 4943(d)(3)(B). Instead, Foundation is treated
under section 4943(d)(1) as owning its proportionate share of any interests in any
business enterprise, including Business, that is owned by Company (or other
intermediate passive holding company). See also Treas. Reg. §§ 53.4943-8(a) and
53.4943-10(c)(1).

Under Treas. Reg. § 53.4943-8(a)(3), Foundation’s constructive ownership of Business
is computed on the basis of the voting stock Foundation has in Company. Under Treas.
Reg. §53.4943-3(b)(1)(ii), the Voting Shares in Company are the voting stock, because
the percentage of voting stock held by any person in a corporation is normally
determined by reference to the power of stock to vote for the election of directors, as is
the case with the Voting Shares. Moreover, under Treas. Reg. §53.4943-3(b)(2)(i),
Foundation’s option to purchase Trust’s voting stock in Company is not considered an
equity interest. Accordingly, Foundation owns 20 percent of the voting stock of
Company and thus constructively owns 20 percent of the interest of Company in
Business. In addition, under Treas. Reg. § 53.4943-8(a)(4), even though Foundation
owns nonvoting stock of Company, such nonvoting stock is treated as nonvoting stock
of any corporation, including Business, in which Company holds an interest. Thus,

PLR-134282-16                                  7

Foundation’s 100% nonvoting stock of Company does not result in Foundation’s
constructive ownership of additional voting stock of Business.

Furthermore, as described above, no disqualified person of Foundation holds any
interest in Company or Business, and Foundation holds no interest in Business other
than through its interest in Company.

Under these circumstances, Foundation will not be treated as owning more than 20
percent of the voting stock of Company, and therefore will not be treated as owning
more than 20 percent of the voting stock of Business, even if Company owns 100% of
the interests in Business.

Ruling

Based solely on the facts and representations submitted by Foundation, we rule that, for
purposes of section 4943, Foundation will own, directly or indirectly, no more than 20
percent of the voting stock of Business, and that Foundation therefore will not have
excess business holdings under section 4943, solely as a result of making and holding
an investment in Business in the manner described above.

The rulings contained in this letter are based upon information and representations
submitted by or on behalf of Foundation and accompanied by a penalty of perjury
statement executed by an appropriate party, as specified in Rev. Proc. 2017-1, 2017-1
I.R.B. 1, § 7.01(15)(b). This office has not verified any of the material submitted in
support of the request for ruling, and such material is subject to verification on
examination. The Associate Office will revoke or modify a letter ruling and apply the
revocation retroactively if: (1) there has been a misstatement or omission of controlling
facts; (2) the facts at the time of the transaction are materially different from the
controlling facts on which the ruling is based; or (3) the transaction involves a
continuing action or series of actions and the controlling facts change during the
course of the transaction. See Rev. Proc. 2017-1, § 11.05.

No ruling is granted as to whether Foundation qualifies as an organization described in
section 501(c) or section 509(a). Except as expressly provided above, no opinion is
expressed or implied concerning the federal income tax consequences of any aspects
of any transaction or item of income described in this letter ruling.

This letter is directed only to Foundation. Section 6110(k)(3) provides that it may not be
used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to each of Foundation’s authorized representatives.

PLR-134282-16                              8

If you have any questions about this ruling, please contact the person whose name
and telephone number are shown in the heading of this letter.

                                    Sincerely,



                                    Amy F. Giuliano
                                    Senior Technician Reviewer
                                    Exempt Organizations Branch 1
                                    (Tax Exempt & Government Entities)




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