U.S. Withholding Tax Imposed on Foreign Tax-Exempt Organizations

Editor: Lorin D. Luchs, CPA, J.D., LL.M.

Imagine an unsuspecting foreign charity that inherits some U.S. stock from a well-meaning decedent. When a foreign charitable organization earns U.S. source portfolio income it often has a choice to make: It can do the apparently obvious thing and claim tax-exempt status (and thus an exemption from U.S. withholding tax). However, that would require an IRS certification or legal counsel opinion letter confirming its status as a Sec. 501(c) equivalent. Both can be costly and may have unintended consequences. Alternatively, the organization may find it easier to refrain from asserting its tax-exempt status and opt for treatment as a (nonexempt) foreign organization.

Sec. 871(a) imposes a 30% flat tax on U.S. sourced fixed or determinable annual or periodical (FDAP) income of a nonresident alien individual. Under Sec. 881(a) the same 30% tax rate applies to the U.S. source FDAP income of a foreign corporation. The tax is withheld at source in connection with Secs. 1441 and 1442 and the regulations thereunder. Naturally, no such tax is imposed on the FDAP income derived by a foreign organization that enjoys tax-exempt status in the United States.

Claiming Tax-Exempt Status

The exemption from withholding on FDAP income paid to a foreign tax-exempt organization requires that the foreign organization qualify under Sec. 501(c) and that the income not constitute unrelated business taxable income.  Specifically, Regs. Sec. 1.1441-9(b)(2) requires that the foreign tax-exempt organization provide the U.S. withholding agent with a withholding certificate (Form W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding) along with a favorable IRS determination letter confirming its tax-exempt status, certifying what portion, if any, of the amounts received constitutes unrelated business income and specifying whether it is a private foundation described in Sec. 509. Alternatively, an opinion issued by U.S. counsel may be attached to the withholding certificate. An organization that provides an opinion by U.S. counsel may generally submit the same opinion to more than one withholding agent.

Note that special withholding rules and rates apply where the foreign tax-exempt organization earns unrelated business taxable income (see Sec. 1443). To the extent that the foreign tax-exempt organization is characterized as a private foreign foundation, it is subject to a 4% excise tax on its gross investment income. A foreign private foundation is described as an organization that is operated exclusively for charitable, religious, educational, or certain other purposes, if no part of its net earnings inures to the benefit of a private shareholder or individual (Sec. 509, Regs. Sec. 1.501(c)(3)-1(c)). It is determined to be a private as opposed to a public organization due to its sources of support, its activities, and its relationship to other excepted organizations. Gross investment income means the gross amount of income from interest, dividends, rents, payments with respect to securities loans and royalties, and similar sources, but not including any such income to the extent included in the foreign organization’s unrelated business income (Sec. 509(e)).

Once a foreign organization obtains tax-exempt status under Sec. 501, it may be required under Sec. 6033(a) to file an annual U.S. tax return (Form 990, Return of Organization Exempt from Income Tax). An exception may apply where the organization has gross receipts from U.S. sources of not more than $25,000 and has no significant activities in the United States (Rev. Proc. 94-17). The main reason a foreign charity may decide not to pursue a certification as a tax-exempt organization under U.S. tax principles is simply the cost associated with such a procedure. The documentation and disclosure requirements to be submitted to the IRS are substantial. Moreover, the costs of an opinion letter prepared by U.S. counsel may often exceed the tax liability it is supposed to avoid.

Claiming Treaty Benefits

If the foreign charity abstains from asserting tax-exempt status in the United States, it should issue a withholding certificate (Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) that establishes its foreign status and its beneficial ownership of the U.S. FDAP income. Where the organization is entitled to a reduced withholding tax rate with respect to, say, dividends or interest, it must be a qualified resident of a treaty country. Most income tax treaties recognize a charitable organization as a resident of the country where it is organized. However, the charity should also meet the limitation on benefits (LOB) clause under the respective treaty, which may contain additional requirements for the organization to be eligible for treaty benefits. For instance, the U.S.-Germany income tax treaty was only recently amended to eliminate such requirements. Before the new protocol became effective in December 2007, a German charitable organization could claim treaty benefits only if more than half of its beneficiaries were themselves entitled to treaty benefits.

In practice, foreign charities often send a Form W-8EXP to the U.S. withholding agent (or a qualified intermediary (QI)) that does not contain the necessary IRS determination or U.S. counsel opinion letter. Clearly, without such certification, the charity cannot be exempt from withholding. But could the withholding agent or QI reduce the withholding tax under a presumably applicable treaty? The answer is no. Although the withholding agent or QI can identify the organization’s country of residence based on the Form W-8EXP, this form does not contain the required LOB language to determine that the organization is entitled to reduced withholding tax rates under a treaty.

Filing U.S. Tax Returns

If the foreign charitable organization was subject to overwithholding due to incomplete documentation, it may wish to file a U.S. tax return to reclaim the excess taxes. It must then decide which form to file to receive the desired refund.

If the organization did not apply for tax-exempt status under U.S. tax principles (Sec. 501), it should not file a Form 990. The only feasible option appears to be Form 1120-F, U.S. Income Tax Return of a Foreign Corporation.

Under Sec. 7701(a)(3), the term “corporation” includes associations, joint-stock companies, and insurance companies. If the corporation is not organized under domestic law, it is considered to be foreign (Secs. 7701(a)(4), (5)). Whether an unincorporated tax-exempt organization can be treated as a corporation for U.S. tax purposes has been addressed by the IRS. In GCM 34502, the Service acknowledged that there are no separate regulations determining the U.S. tax classification of not-for-profit organizations, concluded that the business entity classification rules should accordingly apply, and suggested that the profit objective be replaced by “an objective to carry on, jointly, activities in furtherance of the purposes for which the instrumentality was formed.” In GCM 39461, the Service confirmed this position and referred to a much broader legal definition of an association as a “collection of persons who have joined together for a certain object.”

Based on the above, it seems appropriate for a foreign charity that does not qualify under Sec. 501 to take the filing position that it is a foreign corporation. This, of course, applies not only where the foreign charity claims a refund of U.S. withholding taxes, but also where the organization must file on an annual basis, for instance because it holds a partnership interest and is thus deemed to be engaged in a U.S. trade or business.

EditorNotes

Lorin D. Luchs, Partner, Washington National Tax Office BDO Seidman, LLP, Bethesda, MD.

Unless otherwise indicated, contributors are members of or associated with BDO Seidman, LLP.

If you would like additional information about these items, contact Mr. Luchs at (301) 634-0250 or lluchs@bdo.com.