European charities often invest their assets in US stocks. The problem for European charities is that the US imposes a 30% withholding tax on certain US source income of foreign organizations. As a result, European charities may receive significantly lower returns than they could obtain on their US source investment income if they were not subject to US withholding tax. Fortunately, there are solutions to this problem. With some assistance of US legal counsel, European charities can avoid the 30% withholding tax entirely, and can also request a refund of income previously withheld.
Qualifying for the withholding tax exemption
Under US tax law, foreign organizations that could be recognized as exempt from US federal income tax under Section 501(c) of the Internal Revenue Code (the Code) generally are not subject to withholding on their passive income. European charities that have passive investments in the US can qualify for exempt status under Code Section 501(c), and thereby avoid the 30% withholding tax, by taking one of the following actions:
- File an Application for Exemption with the Internal Revenue Service. European charities can file an exemption application with the US federal taxing authority, the Internal Revenue Service (IRS), and obtain a determination letter from the IRS recognizing the Foundation as a tax-exempt organization under Code Section 501(c); or
- Obtain an Opinion of US Legal Counsel. Instead of filing an exemption application with the IRS, European charities can obtain an opinion of US legal counsel concluding that the organization would qualify as a tax-exempt organization under Code Section 501(c) if it was formed in the United States.
European charities that obtain an IRS determination letter have the security of knowing that they qualify for exemption from US federal income tax under Code Section 501(c) and are therefore not subject to the 30% withholding tax on their passive US source income. Despite this benefit, many European charities elect not to file an application for exemption with the IRS for three reasons: (a) the application process is administratively burdensome and requires European charities to disclose significant amounts of information to the IRS, which can be both time consuming and costly; (b) the IRS typically takes at least 6 months to process and approve applications for exemption from European charities, and may take more than 1 year to issue a final determination letter; and (c) European charities that obtain an IRS determination letter generally are required to annually file an extensive information return with the IRS. As a result of these limitations, many European charities prefer to obtain an opinion of counsel rather than an IRS determination letter when seeking to avoid US withholding tax.
Avoiding US withholding
Armed with an IRS determination letter or an opinion of US legal counsel, European charities can begin the process of obtaining exemption from the 30% US withholding tax on US source income. In general, the exemption from withholding requires European charities to submit to the party responsible for making the payment of the US source income (the withholding agent) (a) the IRS determination letter or opinion of U.S. legal counsel, and (b) a US Form W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Withholding.
European charities should be aware of the disclosures they are required to make when filing the Form W-8EXP with a withholding agent. In particular, the Form W-8EXP requires European charities to certify what portion, if any, of the income they receive from their US investments constitutes unrelated business income. In general, unrelated business income is any income from a trade or business regularly carried on that is not substantially related to a particular charity’s exempt purposes. European charities that receive unrelated business income generally are subject to US federal income tax with respect to such income, even if they have an IRS determination letter or opinion of legal counsel indicating that they are exempt from federal income tax under Code Section 501(c). In most cases, any income received by European charities from passive US source investments, such as dividends, royalties, rent, or interest, will not constitute unrelated business income and will therefore be exempt from US federal income tax withholding.
The Form W-8EXP also requires European charities to disclose if they would be classified as private foundations under US tax law, and therefore subject to a special 4% private foundation excise tax on their US gross investment income. In general, European charities would be classified as private foundations under US tax law if they receive their funding from a limited number of sources. European charities that are uncertain whether they would be classified as private foundations under US tax law can refer to their respective IRS determination letters or opinions of US legal counsel, which should indicate their classifications for US tax purposes.
Obtaining a refund of amounts previously withheld
European charities that have already earned passive income from US investments may be able to use their IRS determination letter or opinion of US legal counsel to request a refund of amounts previously withheld. European charities that obtain an IRS determination letter can request a refund by filing an annual information return with the IRS on Form 990 or, if they are classified as private foundations, on Form 990-PF. European charities that have not obtained an IRS determination letter (i.e. European charities that have instead obtained an opinion of counsel) can file a refund request with the IRS using Form 1120-F, US Income Tax Return of a Foreign Corporation. European charities established as charitable trusts may be able to request a refund from the IRS by filing other applicable returns.
In some cases, European charities may determine that they cannot or should not assert that they qualify for exemption under Code Section 501(c). In such cases, European charities can still minimize their US withholding tax liability if they are resident in a country that has a tax treaty with the US that provides for reduced withholding tax rates. To take advantage of such treaty benefits, European charities generally have to complete and file Form W-8BEN, Certificate of Foreign Status of Beneficial Owner.