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Memorandum on the Legal Environment for Endowments in Poland

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MEMORANDUM

TO: Bob Thomas

FROM: Lee Irish

DATE: 16 May 2001

SUBJECT: Legal Environment for Endowments in Poland

1. Background and Overview.

The Polish NGO sector is among the most dynamic and sophisticated in the
Central and Eastern Europe (CEE) region. Poland’s new Constitution guarantees the
freedom of association. Since the mid-1980s Polish law has provided for two legal
forms for NGOs — associations (membershi p organizations) and foundations (non-
membership organizations). Both th e Law on Foundations and the Law on
Associations have undergone significant re vision since 1989. The current NGO legal
framework in Poland is somewhat complex and confusing yet functional. NGOs can
generally be formed without undue delay or expense, and, once formed, can operate
quite freely, engaging in traditional social service provision as well as advocacy
activities. Significant tax advantages are provided to both associations and
foundations.

Substantial obstacles do exist for foundations, however, with respect to using
economic activities to achieve their statutory purposes and in partnering with local
government. These problems result from defects in existing legislation and
restrictive interpretations of the laws by the courts. This Memorandum, however,
will focus on the legal environment for en dowments in Poland, including the case
POLISH ENDOWMENTS MEMORANDUM

Memorandum to Bob Thomas 2
16 May 2001

involving the Foundation for Polish Scienc e, which threatens to make properly
invested endowments infeasible in Poland.

Additional information and analysis about the general legal framework for
NGOs in Poland can be found in the Poland Country Report written by ICNL for the
Council on Foundations:
http://www.usig.org/c ountrycodes/poland
Laws and other documents re lating to NGOs in Poland that are in the ICNL
database can be found at:
http://www.icnl.org

2. Establishment of Endowments

The Polish Law on Foundations, DZ.U. No. 19, item 82, as amended Dz.U.
No. 46, item 203 and regulations promulga ted there under are silent as to the
establishment of endowment funds or other forms of investments by foundations.
Furthermore, the concept of an endowment is relatively new in Poland. Professor
Hubert Izdebski in his leading treatise,
Foundations and Associations, observes that
the foundations in general do not rely on investment returns on endowments for
their operating income. Th e operations of virtually all Polish foundations are
instead supported either by donations (fu nd raising) or economic activities.
1

One feature of the Law on Foundations could be argued to apply to
endowments. Under that law foundation s are allowed to engage in economic
activities as long as any profits from thos e activities are used for the public benefit
purposes of the foundations and so long the statute of the foundation explicitly
describes the permitted economic activities. It could be argued that investing is an
economic activity and that, if it is provided for in the statute of a particular
foundation, the investment of an endowm ent is a permitted statutory purpose.

Unfortunately, this argument is not likely to succeed. Under Article 2.1 of the
Law an Economic Activities dated December 23, 1988, Dz. U. No.41, item 324, as
amended, “economic activities” consist of one or more active businesses —
production, construction, trade, or servic es. It is likely that this concept of
“economic activities” would be carried ov er to the Law on Foundations and that
investment activities, which are generally considered to be “passive activities”
would probably not be considered economic activities as that term is used in the
Law on Foundations. This would be especially true in the case of portfolio
management for a fee by a pr ofessional third party provider, for in that case there
would be no activity by the foundation other than the selection and oversight of the
portfolio manager. In sum, passive investme nt activities will in all likelihood not be
considered economic activities for purposes of the Law on Foundations.

3. Methods of Investing.

1 H. lzdebski, Foundations and Associations, Wydawnictwo Transit, 1997, at 47.

Memorandum to Bob Thomas 3
16 May 2001

Art. 3.3 of the Law on Foundation provid es the following list of assets that
the foundation can hold: currency, securiti es, donated personal, and real property,
and no Polish law prohibits foundations from acquiring or investing in securities.
Accordingly, it is permissible for foundation s to invest in equity instruments and not
just maintain their funds in bank accounts.

Another issue is the degree of investment risk that can be assumed by
foundations. In common law jurisdictions managers of endowments are required to
act prudently and to diversify investments. A manager must take into account both
potential risks and possible yields, and un der the “portfolio management” theory, it
is appropriate to hold a variety of kinds of investments and to balance the portfolio
so that there are some high-risk, high -reward investments as well as more
conservative ones.

In this respect, the Trust Investment Act of 1961 is clearly relevant.
Consistent with its provisions, a donor may determine the forms of permissible
investments in the trust or grant instrument itself. Furthermore, a board of directors
or trustees should develop for the foundati on an investment policy that assures an
appropriate balance of capital growth and a flow of income. The boards of directors
or trustees have a choice of managing inve stments internally or externally. Unless
the foundation has adequate investment expertise on staff, it is more prudent to
select a professional fund manager to mana ge the investments. The manager should
be instructed to maximize returns while ma intaining a level of risk consistent with
the investment policy appropriate fo r the particular endowment.

Currently there are no regulations or gu idelines in Poland on these issues
with respect to endowments of foundations. There is guidance, however, in the Law
on Pension Funds, enacted on June 25, 1997, with effective date of January 1, 1999,
and it can be argued that these stan dards provide relevant guidance for
endowments as well. Article 141 of the Law on Pension Funds includes a list of 13
types of permissible investments, including securities. This legislation puts a heavy
emphasis on the diversification requirement. Article 142 consists of specific rules
about how investment holdings should be diversified.

Unlike other countries in CEE, Poland has created a coherent regulatory
framework for professional management. In 1997 the Sejm enacted both a Law on
Investment Funds and a Law on Public Trad ing of Securities (“Securities Law”).
Article 38 of the Securities Law defines asset management activi ties as making and
implementing investment decisions for the account of a client. Such management
activities must be within the scope of authority given by the client. Portfolio
management services can be provided by brokerage houses and banking institutions
licensed by the Securities Commission to provide portfolio management services.
Foreign institutions licensed in OECD co untries to provide brokerage services can
operate in Poland (Art. 52 of the Securities Law). Furthermore, authorized portfolio

Memorandum to Bob Thomas 4
16 May 2001

managers can trade in securities on regulated foreign exchanges in the OECD
countries (Art. 30.3 of the Securities Law). The issue of investing abroad will be
further discussed below in connection with foreign exchange laws.

Currently, a number of financial institutions offer asset or portfolio
management services. For example, the Centrum, Operacji Kapitalowych is a
licensed investment arm of Bank Handlowy which offers portfolio management
services through its asset management divisi on. J.P. Morgan, with 12% of the equity
of Bank Handlowy, is its largest shareholder. Other domestic institutions like Bank
Przemyslowo-Handlowy or BANK PKO BP also offer investment and brokerage
services.

Among foreign banks offering fund management services is ING Bank.
Although ING Bank (as opposed to Bank Handlowy) does not have a seat on the
Warsaw Stock Exchange; it does offer fu nd management services through its
corporate banking department. Althou gh membership in the Warsaw Stock
Exchange is not a prerequisite for being a portfolio manager, it does indicate a
serious commitment to the investment and brokerage services of a particular
financial institution. Among foreign ba nks that are members of the Warsaw Stock
Exchange are Citibrokerage, Raiffeisen Capita l, and Pionier Polski Dom Maklerski.

4. Foreign Exchange.

The Foreign Exchange Law dated December 2, 1994, Dz.U. No. 136, item 703,
as amended, establishes the legal framewor k for dealing in foreign exchange. For
purposes of this law, foreign exchange in cludes both currency and securities. As a
general rule, domestic persons may not hold foreign exchange abroad unless
permitted by the Ministry of Finance.

A Regulation of the Minister of Finance on General Foreign Exchange Permits
dated January 16, 1996, Mon. pol. Np. 6, item 73, as further amended (“Regulation”),
provides that domestic persons may transfer foreign exchange to OECD countries
and other countries that are signatories to bilateral treaties on investments with
Poland for purposes of acquiring securiti es that are publicly traded in these
countries. Such acquisition must be made through authorized domestic persons that
are fully licensed by the Ministry to engage in these activities. Accordingly,
investing in securities or mutual funds tr aded in any OECD country is possible but
such investment have to be made through a licensed Polish broker. If a Polish
brokerage house provides portfolio manage ment services, investments in foreign
securities could be provided for in the portfolio/asset management agreement.

The Regulation also requires that a dome stic person interested in transferring
foreign exchange in the amount of more than 50,000 ECU (now EUROs) abroad for
purposes of acquiring foreign securities must notify the National Bank of Poland by

Memorandum to Bob Thomas 5
16 May 2001

filing an appropriate form. Transfer of foreign exchange can take place 3 months
from the filing date (Art. 20a.2). Regulatory restrictions on investing abroad are
likely to be relaxed even further as a result of adjustments for European Union
membership in accordance with the European Union Associ ation Agreement.

5. Liability.

The issue of liability for bad investment decisions is not clear at the present
time. A major reason is that, being a civil law country, Poland does not have the
concept of trust and fiduciary duty in the sense used in common law countries such
as the England or the United States. In co mmon law countries, issue of liability with
respect to endowment funds has largely been derived from trust and fiduciary law.

The Law on Foundations provides one mechanism that could be used to
sanction improper investments. Article 14 states that the Minister overseeing the
operations of a particular foundation may call on the management board to take
action or refrain from certain action or request the removal of the management
board in the event the manageme nt board acts (i) in violation of law, (ii) in violation
of the statute, or (iii) in violation of th e purposes of the foundation. There is no
reported instance, however, when this authority has been used with respect to
investment decisions.

Another relevant piece of legislation may result in criminal liability. The Law
on Safeguards of Business Operations dated October 12, 19941 Dz. U. No 126, item
615 (“‘Safeguards Law”) may be applicable to the investment decisions of the
management boards of the foundation. Ar ticle 1.1 of the Safeguards Law provides
that whenever a person responsible pursua nt to law, administrative decision, or
contract to manage assets of a third party, abuses its authority or does not fulfill
obligations and consequently causes damages to the third party, that person may be
sentenced to prison for 1 to 10 years. Agai n, there is no reported instance of this
sanction being used against those respon sible for improper investment of an
endowment fund.

The general rules of donation, inheritance, and tort law may also come into
play under the Polish Civil Code. For example, liability pursuant to the operative
grant/gift instrument may arise under Title XXXIII of the Civil Code. Pursuant to
Article 893 of the Civil Code, a grantor ma y impose specific obligations on the
grantee, which could include investment obli gations or limitations. If the public
interest is involved, an appropriate gove rnment entity may seek compliance with
the grant/gift instrument (Article 894 of the Civil Code).

The question of the liability of portfolio managers who handle the investment
of endowments is fairly clear, thanks to the relatively new legislation on investment
funds. Pursuant to Article 44.1 of the Law on Investment Funds, an investment

Memorandum to Bob Thomas 6
16 May 2001

company is liable for damages resulting from non-performance or inadequate
performance of its portfolio management responsibilities. An almost identical
provision is included in Article 48 of the Law on Pension Funds.

In Polish law there is no equivalent of the American Trustee Investments Act
of 1961, which defines the standards for determining the reasonableness of
investments as well as the legal and financia l responsibility of the Trustees. In a
nutshell, US trustees are required to (i) abide by the provisions of a deed of trust, (ii)
act in a reasonable and prudent manner, (iii) diversify investments, (iv) seek
independent financial advice, and (v) use due care in their all their investment
dealings. Trustees are personally liable for failure to live up to these requirements.

The management board of a Polish foundation that has an endowment is
essentially in the same position as trust ees of a U.S. foundation, and it would be
good practice for members of a manage ment board to follow the standards
established in the Trustee Investments Act , especially in dealings with the American
donors.

6. Taxation.

Tax liabilities are governed by the Law on Income Taxation of Legal Persons
dated February 15, 1992, Uniform Text Dz. U. of 1993 No. 106, item 482, as further
amended (“‘Income Taxation La w”). Turning to the kinds of revenues that can be
earned from endowments, interest on investments generally constitutes taxable
income under Article 12.1.(1). However interest income from treasury bonds may be
exempt under Article 17.1-19. Furthermore, foreign legal persons are taxed at a 20%
rate on interest income received unless a bilateral treaty on double taxation provides
otherwise (Article 21.1.).

Dividends and other revenues realized from participation in profits of a legal
person constitute income and are also taxe d at 20% rate (Art.22.1.). Traditionally,
capital gains have not been taxed in Poland. However, under Article 10-1., which
was added in 1997, income that is realized from participation in profits of a legal
person, including the value received in co nnection with the liquidation of a legal
person, is considered income for income tax purposes.

Different tax issues arises in conne ction with taxation of portfolio
investments. The Law on Investment Funds of 1997 amended the Income Taxation
Law to exempt from income taxation investment funds formed under the Law on
Investment Funds. This in effect make s investment funds into “pass-through”
entities, with the result that taxes are imposed at the investor level.

Foundations that operate in Poland re ly on tax exemptions provided in
Article 17 of the Income Tax Law. Pursuant to Article 17.1.(4), income of taxpayers

Memorandum to Bob Thomas 7
16 May 2001

whose statutory purposes are education, spor t, cultural activities, physical fitness,
health, social services, environmental prot ection, support of rural development, or
religion, is not subject to income taxation in that part of its income that is designated
for the above statutory purposes. However, income that is used to support other
worthy purposes, such as the care of injured or homeless animals or the
development of a free market economy is subject to taxation.

A recent decision of the Supreme Administrative Court (NSA) has deeply
shaken the Polish foundation world. This decision, unless reversed, will make it
impossible to establish or maintain a properly invested endowment. The
Foundation for Polish Science (FNP), with an endowment of about $75,000,000,
invested a large part of it in state bonds and traded equity securities. In 1998 the
office of tax inspection audited FNP for the years 1995-1997 and assessed a bill for
back taxes and interest of about $20,000,000. The tax authorities took the position
that the purchase of securities was an expenditure that was not for statutory
purposes and therefore the exemption under Article 17.1.(4) was unavailable. Only
money placed in fixed-rate bank depo sits would escape income taxation.

The decision of the tax authorities was upheld by the Tax Revenue Chamber,
whose decision was in turn affirmed by the Supreme Administrative Court. In
doing so the NSA rejected the argument of the FNP that it had designated its
endowment and any income earned on it fo r exempt statutory purposes and that it
had purchased securities only to assure that there would be an adequate return on
its endowment.

The NSA did make one favorable ruling in the FNP case. It held that
financial support through grants to institutions that carry out statutory activities
(e.g., a grant to an institution to do scientific research) qualified for the exemption of
Article 17.1.(4). It was not necessary for the FNP to directly conduct all of the
statutory activities that it supported.

The practical effect of the decision in the FNP case is to limit investments by
endowed Polish foundations to interest-bearing savings accounts in banks. The
premise of the ruling is that any other kind of investing is an expenditure for a non-
statutory purpose. Money placed in a savings account is regarded as not having
been expended.

7. Conclusion.

Poland has probably gone farther to establish an enabling legal environment
for investment and portfolio management than any other country in Central and
Eastern Europe. Poland has developed a small but growing capital market that
offers readily tradable securities, but it has also put in place rules that allow
diversification through foreign investing. On their face the income tax laws allow

Memorandum to Bob Thomas 8
16 May 2001

exemption for the income of foundations enga ged in a wide variety of public benefit
activities. The recent adverse decision of the NSA in the FNP case, however, poses a
serious threat to the growth and viability of endowed foundations in Poland.

It is likely that the recent decision of the NSA will be appealed to the
Supreme Court of Poland. A group of civil society organizations in Poland,
including the Forum for Non-Governmental Organizations (FIP), the Academy for
the Development of Philanthropy in Pola nd (ARFP), the Polish Foundation Forum
(PFF), the Foundation Notwithstanding St ormy Weather (KLON), and the Support
Office for the Movement of Self-Help Orga nizations (BORIS), has formed to study
the problem and propose legislation to rectify it. It will be important to follow both
developments to see what the ultimate resolution of this difficult issue is.

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