Investment funds, including private equity funds, often receive capital contributions from tax-exempt organizations. These tax-exempt institutions may include U.S. and foreign pension funds, as well as U.S. and foreign charities and college and university endowment funds. This article addresses some of the U.S. withholding tax exemptions and obligations as they relate to foreign tax-exempt organizations invested in investment funds.
Taxation of Foreign Investors on U.S.-Source Investment Income
Private equity, venture capital and domestic hedge funds typically are formed as partnerships for U.S. federal tax purposes so that (1) the entity is not itself subject to tax, and (2) the nature of the income (such as capital gain or qualified dividends) flows through to the investors in the fund. These funds generally derive investment income, such as interest, dividends and capital gains. Foreign investors that derive such investment income generally are subject to tax in the United States only on their U.S.-source fixed or determinable, annual or periodical (FDAP) income, such as interest and dividends. U.S.-source FDAP income derived by foreign investors generally is taxed at a flat 30 percent on gross (i.e., with no deductions) basis, though this rate may be reduced by applicable tax treaties between the recipient’s country of tax residence and the United States. Moreover, the tax generally is collected by way of withholding at the source. Thus, withholding is done by the investment fund, if it is a U.S. partnership or withholding foreign partnership, or the portfolio company itself, if the fund is a foreign fund that is not a withholding foreign partnership. The United States generally does not tax foreign entities on capital gains or portfolio interest derived by foreign entities.1
Withholding Exemption for Foreign Tax-Exempt Organizations
Treasury Regulation Section 1.1441-9(a) provides that no withholding is required on amounts paid to a foreign organization that is described in Section 501(c) of the Internal Revenue Code of 1986, as amended (the “Code”)..2 In order to be exempt from withholding tax, the amount paid must not constitute unrelated business taxable income. Further, Treasury Regulation Section 1.1441-9(b)(2) provides that the withholding agent may rely on a claim of exemption from withholding if it receives IRS Form W-8 to which is attached an opinion of a U.S. counsel acceptable to the withholding agent that concludes that the organization is described in Section 501(c)(3). Form W-8EXP is used for this purpose.
Organizations Are Described in Section 501(c)
In order to qualify as an exempt organization under Section 501(c)(3), the organization must be both organized and operated exclusively for one or more exempt purposes. The organizational test relates to the purpose of the organization as described in its organizational charter, articles of incorporation, or other governing instrument. The operational test relates to the actual activities conducted by the organization.
The organizational test contains requirements pertaining to three subjects: (1) the organization’s purposes and activities; (2) legislative and political activities; and (3) distribution of assets upon dissolution. Each must be satisfied for an organization to qualify under Section 501(c)(3). The governing documents of an organization qualified under Section 501(c)(3) must limit its activities to one or more exempt purposes and cannot empower the organization to engage in activities that do not further this purpose. Exempt purposes include religious, charitable, scientific, literary and education, although other purposes also have been recognized as exempt purposes. As to dissolution, to qualify under Section 501(c)(3), the governing documents of the organization must provide that, upon dissolution, the assets of the organization will be distributed exclusively for Section 501(c)(3) purposes. If the organization’s governing documents expressly authorize the organization to devote more than an insubstantial portion of its activities to attempting to influence legislation by propaganda or otherwise, or to participate in any political campaign, the organization fails the organizational test.
In order to qualify under Section 501(c)(3), an organization must be operated exclusively for one or more exempt purposes. In addition, no part of its net earnings may inure in whole or in part to the benefit of any private individual. The law firm providing the opinion to be attached to Form W-8EXP will consider each of these requirements as they relate to the organization claiming the exemption. In addition, it likely will be necessary to consider the impact of local law. For example, if the organization is formed for “charitable purposes,” within the meaning of the applicable not-for-profit law, are those charitable purposes consistent with those for which an exemption is available under Section 501(c)(3)?
Unrelated Business Taxable Income (UBTI)
U.S. entities that otherwise are exempt from U.S. taxation under Section 501 are subject to tax on their share of UBTI. UBTI includes income from unrelated trades or businesses (including certain fee income). Interest, dividends, capital gains and foreign currency gain or loss generally are excluded from the definition of UBTI, unless they are derived from debt-financed property. Any such income recognized during a tax year in which there is outstanding acquisition indebtedness will be, at least in part, UBTI. In addition, capital gains recognized from a sale of debt-financed securities within 12 months of the repayment of acquisition indebtedness will be, at least in part, UBTI. Just as U.S. tax-exempt organizations are subject to tax on their UBTI, foreign tax-exempt organizations are not exempt from tax on their UBTI. Unlike U.S. tax-exempt organizations, foreign tax-exempt organizations may claim exemptions or reductions in tax that other, non-exempt, foreign entities may claim. For example, even if it otherwise would be UBTI, portfolio interest and capital gains generally would be exempt from tax.
To the extent that a foreign tax-exempt organization receives income that is not UBTI, the Form W-8EXP provided to a withholding agent should indicate that the income in question does not constitute UBTI.
Excise Tax on Foreign Private Foundations
Tax-exempt organizations come in two varieties: public charities and private foundations. Public charities generally receive their funding from a wide group of contributors and from government grants. Private foundations, on the other hand, generally receive their funding from a smaller group of substantial contributors. Private foundations are subject to additional rules, and potential excise taxes. Foreign private foundations are subject to a 4 percent tax on their gross investment income derived from U.S. sources, excluding income that constitutes UBTI. This tax also is collected by way of withholding. Additionally, although it is counter-intuitive, this tax applies to U.S.-source income not otherwise subject to tax in the hands of foreign persons, such as portfolio interest and capital gains. (Note that capital gains from the sale of stock and securities generally are sourced based on the residence of the recipient. Thus, capital gain recognized by an investment fund on the sale of stock of a portfolio company and allocable to a foreign private foundation typically would be considered foreign source.) If the tax-exempt organization is question is not a private foundation, the Form W-8EXP provided to the withholding agent should indicate this, in order to avoid withholding of the 4 percent tax.
Impact of Treaties on UBTI and Excise Tax
The United States has entered into income tax treaties with many countries. These treaties are designed to avoid double taxation, and, where a resident of one jurisdiction derives income from the other, generally dictate which country may tax the income, and to what extent. For example, a resident of the United Kingdom which receives U.S.-source interest, and otherwise is eligible to claim the benefits of the treaty between the United States and the United Kingdom generally will be exempt from U.S. withholding tax on such income.
The applicable regulations addressing the tax on UBTI derived by foreign tax-exempt organizations and the 4 percent tax on U.S.-source gross investment income of foreign private foundations provide that a foreign tax-exempt organization may claim the benefits of an income tax treaty to reduce or eliminate the tax on UBTI and the tax on gross investment income. In the case of the tax on gross investment income, certain treaties specifically exempt all items of income while other treaties, although covering the 4 percent tax, do not provide for a specific exemption. If the applicable treaty does not provide for a specific exemption, the IRS has tentatively concluded in a Chief Counsel Memorandum.3 that the foreign private foundation will only be entitled to a reduction or elimination of the 4 percent tax to the extent that the applicable treaty rate is less than 4 percent. Of course, determinations must be made that (1) the tax-exempt organization is covered by the treaty, and (2) the treaty covers the tax in question.
For example, assume that a United Kingdom tax-exempt organization that would be treated as a private foundation receives $250,000 of U.S.-source dividend income and $750,000 of U.S.-source interest income that qualifies as portfolio interest. Assume further that the dividend income related to debt-financed stock and, thus, would be UBTI. In this case, the $250,000 dividend income would not qualify for the withholding tax exemption for tax-exempt organizations, because it constitutes UBTI. However, the tax treaty between the United States and United Kingdom specifically provides that the United Kingdom tax-exempt organization may be treated as a tax resident of the United Kingdom for treaty purposes. Thus, the organization can qualify for the 15 percent withholding tax rate (rather than the normal 30 percent) on the dividend income. The interest income is not UBTI, and, thus, would be exempt from 30 percent withholding tax, both because the entity qualifies as a foreign tax-exempt organization and because the interest qualifies as portfolio interest.
In addition, the tax treaty between the United States and United Kingdom covers the 4 percent tax; however, it does not specifically exempt all items of income from the 4 percent tax. Therefore, based on the IRS’s conclusion, withholding will be required at the lesser of (i) the applicable treaty rate that the organization qualifies for and (ii) 4 percent. The tax treaty between the United States and United Kingdom exempts withholding tax on interest income. Thus, the organization can qualify for a complete exemption from the 4 percent tax. Further, as the dividend income constitutes UBTI, it will not be subject to withholding on the 4 percent tax. However, if the dividend income did not constitute UBTI (for instance, because it did not relate to debt-finance stock) the dividend income would be subject to withholding tax at a rate of 4 percent (the lesser of the 15 percent applicable treaty rate and 4 percent).
It should be noted that the Form W-8EXP is not used to claim treaty benefits. Rather, Form W-8BEN is used for this purpose.
A Word about Foreign Pension Funds
Qualifying domestic pension funds obtain their tax exemption pursuant to Sections 401(a) and 501(a), and not pursuant to Section 501(c). Accordingly, foreign pension funds are not exempt from withholding pursuant to Treasury Regulation Section 1.1441-9. However, certain treaties, including the treaty between the United States and United Kingdom, specifically provide exemptions from tax on U.S.-source interest and dividends.
1 Foreign investors that are engaged in a trade or business are subject to U.S. taxation in the same manner as U.S. persons on income that is effectively connected to a U.S. trade or business, including effectively connected interest, dividends and capital gains. Moreover, gain on the sale of stock of a United States Real Property Holding Corporation (i.e., generally, a domestic corporation the assets of which are primarily comprised of U.S. real property and cash) is treated as effectively connected capital gain and, thus, foreign investors are subject to tax in the same manner as U.S. residents on such gain. Foreign investors are treated as being engaged in a U.S. trade or business conducted by partnerships in which they are partners. This article generally does not discuss income that is effectively connected to a U.S. trade or business.
2 Unless otherwise stated, Section references are to the Code.
3 IRS CCM 201010027 (November 30, 2009).