U.S. withholding tax imposed on foreign tax-exempt organizations.

• Author: Karges, Martin

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 IP, S 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% fiat 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, Kegs. 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...