Withholding Requirements for Tax-Exempt Organizations Making Foreign Grants

On Jan. 1, 2001, new U.S. tax withholding rules went into effect in the form of amended final regulations under Secs. 1441, 1442 and 1443. The regulations are intended to clarify certain issues that arose under the prior regulations and to change the overall administrative requirements to ensure proper withholding. Although the new regulations do not address tax-exempt organizations specifically, they can affect withholding requirements for certain payments made by a U.S. tax-exempt entity to a foreign individual or entity.

The regulations also modify the rules for reporting to the IRS certain payments made to foreign individuals and entities. Generally, reporting is not required if there is no withholding requirement; however, this is not always true, especially when withholding is averted by invoking an applicable treaty.

Under the new regulations, withholding by a U.S. tax-exempt organization that makes a grant to a foreign individual or entity generally is required if either will use part or all of the grant funds to conduct activities within the U.S. The withholding rate for such grants made to nonresident aliens, foreign corporations or foreign trusts generally is 30%. However, certain exceptions apply to the withholding requirements for foreign grants made by U.S. tax-exempt organizations.

Exceptions to Withholding Requirements

Activities outside the U.S. Withholding is not required if the foreign individual or entity uses the grant funds to conduct activities entirely outside the U.S. Thus, a U.S. tax-exempt organization that wants to ensure that grant funds paid to a foreign individual or entity will not be subject to withholding should be able to do so by including a clause in the applicable grant agreement that requires the foreign recipient to use the grant funds to conduct activities solely outside the U.S..

Scholarships. Sec. 117 qualified scholarship payments to nonresident alien individuals are not subject to the withholding requirements. Additionally, Sec. 117 qualified scholarship payments made to nonresident alien individuals after 2000 no longer must be reported on Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding. Of course, a private foundation interested in making Sec. 117 qualified scholarship payments to nonresident aliens should ensure that it has received appropriate IRS approval before doing so, to avoid making taxable expenditures under Sec. 4945.

Treaty exemptions. A U.S. tax-exempt organization may be able to claim exemption from withholding requirements on grants made to foreign individuals or entities if the grant recipients qualify for exemption under a U.S. tax treaty. To take advantage of this exception, the foreign grant recipient must provide the U.S. tax-exempt organization with a completed Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding. Note that the Form W-8BEN is provided to the U.S. tax-exempt organization, not to the IRS.

A foreign grant recipient must have either an individual taxpayer identification number (ITIN) or an employer identification number (EIN) to claim treaty benefits using Form W-8BEN. Foreign individuals can apply for an ITIN using Form W-7, Application for IRS Individual Taxpayer Identification Number, and foreign entities can apply for an EIN using Form SS-4, Application for Employer Identification Number.

The executed Form W-8BEN must indicate the treaty provision under which benefits are claimed and the applicable withholding rate (if any) under the treaty, and must explain why the grant recipient meets the terms of the treaty provision. The executed Form W-8BEN will remain in effect until a change in circumstances makes any information on the form incorrect, provided that the U.S. tax-exempt organization reports on Form 1042-S, Foreign Person's U.S. Source Income Subject to Withholding, at least one payment annually to the foreign individual or entity who provided the Form W-8BEN. As noted, if withholding is not required because of a treaty provision, care should be taken to determine whether any reporting requirement still applies.

Grants to Sec. 501(c) organizations. Withholding is not required on grants made to a foreign entity described in Sec. 501(c), except to the extent such payments constitute income includible under Sec. 512 in computing the foreign entity's unrelated business taxable income (UBTI). This exception applies even if the grant amounts are ultimately used to fund activities that will be conducted in the U.S.

To take advantage of this exception, the foreign entity must provide the U.S. tax-exempt organization with a completed Form W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding. Note that the Form W-8EXP is provided to the U.S. tax-exempt organization, not to the IRS. This Form W-8EXP must include an EIN for the foreign entity and either a statement that the foreign entity has received a determination letter from the Service (including the date of issuance) concluding that it is described in Sec. 501(c), or an attached opinion of U.S. counsel concluding it is described in Sec. 501(c).

If the determination letter or the opinion of U.S. counsel concludes that the foreign entity is described in Sec. 501(c)(3), it must indicate on Form W-8EXP whether it is a private foundation. If the foreign entity indicates it is not a private foundation, it must attach an affidavit of the organization setting forth sufficient facts for the IRS to determine that it is not a private foundation because it meets one of the exceptions described in Sec. 509(a)(1), (2), (3) or (4).

Finally, if any income to which Form W-8EXP relates constitutes income includible under Sec. 512 in computing the foreign entity's UBTI, a statement identifying such amounts must be attached to Form W-8EXP. The executed Form W-8EXP will remain in effect until a change in circumstances makes any information on the form incorrect, provided that the U.S. tax-exempt organization reports on Form 1042-S at least one payment annually to the foreign entity that provided the Form W-8EXP.

Failure to Withhold

A U.S. tax-exempt organization should request a Form W-8BEN or Form W-8EXP prior to making a payment to a foreign individual or entity, unless the exception for scholarships or grants for activities outside the U.S. applies. If a U.S. tax-exempt organization does not obtain one of these forms and fails to withhold as required, it may be assessed tax at the 30% rate, and also may be subject to interest and penalties for failure to withhold.

Other Considerations

U.S. private foundations that make grants to foreign entities may find these withholding requirements particularly troubling. Many U.S. private foundations that make grants to foreign entities choose to exercise expenditure responsibility over such grants, rather than obtaining an affidavit from each entity or an opinion of counsel regarding the foreign entities' tax-exempt status.

In many instances, this means that a U.S. private foundation will not make a determination as to a foreign entity's private foundation status and, as a result, will not treat the grant to the foreign entity as subject to the "out-of-corpus" distribution requirement of Sec. 4942(g)(3). This raises the question of whether a U.S. private foundation can continue this approach if it receives from the foreign grant recipient a Form W-8EXP indicating that the foreign entity is a private foundation.

Any tax-exempt organization that makes grants to foreign individuals or entities should review its grant-making procedures to ensure compliance with these new withholding (and reporting) rules.

From Christine Bernschein, J.D., CPA, MBA, Washington, DC