Does your foundation make grants to foreign entities or non-U.S. individuals? Do these grants ever cover travel to and/or activities in the United States? If yes, you may have new tax withholding requirements as of January 1, 2001. John A. Edie, former General Counsel, and Jane C. Nober, Special Counsel at the Council on Foundations provide details on new tax withholding requirements for foreign grants that may pay for some activity conducted in the United States.
Tax Code Section 1441 sets forth the requirements for tax withholding that applies when a U.S. entity makes payments to a “nonresident alien” (individual). Section 1442 does the same for payments to foreign corporations and Section 1443 does the same for payments to foreign tax-exempt organizations. The new regulations were issued under Section 1441 but are applicable to all three of these sections. For reasons having nothing to do with foundations, Treasury badly needed to modernize these rules as they affected foreign investors and other entities. The resulting regulations of necessity include foundation payments to foreign individuals and foreign organizations in circumstances where the payment will result in some kind of activity performed in the United States.
The recently released Section 1441 final regulations generally require foundations that make grants or award prizes to foreign individuals or foreign organizations who perform all or part of their grant-funded activities in the United States to withhold U.S. taxes from these payments. Exemptions from this withholding requirement will be available if the recipient qualifies for an exemption under a U.S. tax treaty or the recipient organization can establish that it could qualify as a U.S. tax-exempt organization; the regulations provide details on the documentation required to take advantage of these exemptions. The withholding requirement will not apply to any portion of a grant that will be used exclusively for activities to be performed outside the United States.
Background: Sourcing Rules for Grants
In general, U.S. entities that pay scholarships, fellowships, grants, prizes or awards to foreign recipients in connection with activities the recipients have performed or will perform must withhold U.S. tax from such payments if the payment is considered to have a U.S. source. (Grants that are to be used by the foreign recipient to purchase property are not subject to withholding, irrespective of their source.)
A few years ago, as the result of the persistent efforts of a number of private foundations and the Council on Foundations working with the Treasury and IRS, the Treasury made it clear that scholarships, fellowships, grants, prizes and awards have a foreign source – and therefore are not subject to withholding – if they are made by a U.S. foundation to a non-U.S. individual or entity with respect to activities conducted outside the United States. This grant sourcing rule relieves foundations from the burden of withholding on most grants they make to foreign parties who do their work abroad.
However, U.S. foundations still need to be familiar with the withholding rules for grants or prizes they give to foreign recipients – whether to individuals or to organizations – that do some or all of their grant-sponsored work in the United States. These grants and prizes – or portions thereof – will require withholding unless: 1) the recipient qualifies for an exemption under a U.S. tax treaty or 2) the recipient can establish that it could qualify as a U.S. tax-exempt organization. The foundation must follow new procedures (outlined below) to establish that a treaty exemption or an exemption based on the recipient’s ability to qualify for tax-exemption applies for payments made on or after January 1, 2001.
When are foundation grants to foreign recipients potentially subject to withholding?
A grant or award from a U.S. foundation is generally subject to 30% withholding if it is paid in connection with the conduct of activities and goes to (1) a nonresident alien; (2) a foreign corporation or (3) a foreign trust. (For certain scholarship payments to foreigners studying in this country on certain specified types of visas, the withholding rate is lowered to 14%.) However, there are three important exceptions, described below, that eliminate the withholding requirement for many grants. In addition, grants or awards to foreign governmental entities are subject to special rules that generally do not require withholding. Furthermore, unlike grants made in connection with activities, grants that are intended to be used exclusively to acquire property are not subject to withholding.
When are foundation grants exempt from withholding?
Foundations may find it useful to take advantage of the following exceptions to the general rule that requires withholding on grants or awards made to foreign recipients:
Withholding is not required if the grant or award funds are given in connection with activities conducted entirely outside the United States.
Withholding is not required if the recipient qualifies for an exemption under a U.S. tax treaty and provides the foundation with appropriate documentation claiming the exemption.
Withholding is not required if the recipient is an entity that can demonstrate that it could qualify as a U.S. tax-exempt organization.
These exemptions will cover many grants, but in those instances where they do not apply, the foundation must withhold U.S. income tax from the payment before it is distributed to the grant recipient.
Funding Exclusively Foreign Activities
If all of the activities that are the basis for the grant or award were performed or are to be performed outside of the United States, no withholding is required. As long as the foundation can establish that the grant or award is being provided under these terms, no special forms or procedures are required. For example, if the written grant agreement specifies that the grant funds must be used exclusively to support activities conducted outside the United States, this exemption will apply, and no withholding will be required on the grant. Foundations making grants outside the U.S. that wish to take advantage of this exception should review their grant agreements to ensure that such language is clearly included. (This exception has been in effect since 1995, and is unaffected by the new rules on withholding that go into effect on January 1, 2001; the new rules change the procedures that must be followed only if the grant does fund some amount of activity in the United States.)
If the terms of the grant leave open the possibility that the grant may be used to fund activities in the United States, such as attendance at a conference or course, a site visit with colleagues, temporary work in a laboratory, or a teaching stint, and the foundation can establish with certainty the portion of the grant that will be used to fund these U.S.- based activities (including the costs of travel to and from the United States and living expenses while here), withholding will be required only on the portion funding the U.S. activities. If the foundation is uncertain as to what proportion of the grant will be used to fund activities in the United States, the foundation is technically required to withhold on the entire grant, unless a treaty exemption applies or the recipient can establish that it could qualify as a U.S. tax-exempt organization. Therefore, foundations have a strong incentive to establish the specific amount of the grant that funds U.S.- based activities. There is no written guidance that specifically indicates that a foundation may rely on the representations of the potential grantee regarding the grantee’s plans (or budget) for spending the funds, but the proposal or budget for the project should provide the basis for this calculation. NOTE: in some circumstances, it may be useful to write two grants – one to cover the activities solely to be performed inside the U.S. and a second to cover everything else.
If a foundation is facing potential withholding because part or all of a grant will fund U.S.-based activities, it can still rely on either of the following two exemptions to avoid withholding.
Recipient Benefits from an Exemption Under a Tax Treaty
If the grant recipient qualifies for a tax exemption under a U.S. tax treaty, no withholding will be required if the grant recipient provides the foundation with a completed Form W-8BEN, available for download from the IRS’s Web page: http://www.irs.gov/pub/irs-irbs/irb00-23.pdf.
Under the new rules that go into effect on January 1, 2001, this form replaces the old Form 1001, and a variety of new requirements apply to make the form valid. In order for the W-8BEN to be valid, it must include the grant recipient’s Taxpayer Identification Number (“TIN”). For a foreign recipient that is not an individual, the TIN consists of an Employer Identification Number (“EIN”). The recipient can apply for an EIN on Form SS-4. For a foreign individual recipient, the TIN consists of an Individual Taxpayer Identification Number (“ITIN”). The recipient can apply for an ITIN on Form W-7.
In addition to the TIN, the Form W-8BEN must state the treaty provision under which benefits are claimed and describe the reasons why the recipient meets the terms of that provision. This requirement is especially important for grant recipients claiming exemption pursuant to a treaty provision specifically applicable to exempt organizations (as opposed to an “other income” treaty provision). It may be beneficial to have the recipient attach an affidavit to the form asserting any facts relevant to applying the treaty provision. For example, the German treaty exempts payments made to German charities that are exempt from tax in Germany and are the equivalent of a Section 501(c)(3) organization. An affidavit could state the basic facts necessary to establish that the grant recipient would qualify as a charitable organization under 501(c)(3).
Establish that Recipient is Foreign Equivalent of a U.S. Tax-Exempt Organization
No withholding is required on a grant made to a foreign organization that is described in Section 501(c)(3), 501(c)(4) or any of the other subsections of 501(c) even if the grant funds activities that will be conducted in the United States. However, the new rules permit a foundation to rely on this exemption only if the foreign grantee provides a Form W-8EXP (to obtain a copy, see same Web page noted above) that includes a TIN and is accompanied by either a determination letter from the IRS establishing the tax-exempt status of the foreign recipient or an opinion of U.S. counsel concluding that the organization is described in Section 501(c). NOTE: even if the foundation is using a grantee affidavit to establish that the organization is the equivalent of a U.S. public charity, an opinion of U.S. counsel regarding its 501(c) status will be required to avoid withholding requirements (an opinion of non-U.S. counsel is not sufficient). If the recipient claims to be a public charity, an affidavit from the recipient setting forth sufficient facts to establish public charity status must also be attached.
The foundation can rely on the Form W-8EXP and its attachments as a basis for not withholding on grants made to the foreign recipient that provides them, unless the foundation knows or has reason to know that the recipient’s claim is incorrect. For example, if a recipient claims on its Form W-8EXP that it is described in Section 501(c)(3), but the foundation knows that the recipient is publicly endorsing candidates for public office, the foundation would not be able to rely on the form as a basis for not withholding on grants to this recipient. The opinions of counsel have to be renewed only when facts relevant to their conclusions change.
Consequences of Failure to Secure Needed Support for Exemption from Withholding and Failure to Withhold
A foundation risks penalties if it relies on a treaty exemption or on the status of a foreign recipient as being eligible for tax exemption in the United States without getting the required forms and supporting documentation or fails to withhold tax where required. In circumstances where a foundation is not required to withhold but has failed to collect the required documents, the regulations provide ample opportunities for the organization to obtain proper documentation after the fact and be relieved of the penalties. But where a foundation is required to withhold and fails to do so, the regulations provide that the IRS may collect the taxes due along with interest and penalties. Therefore, foundations should take time to review carefully their procedures for approving grants to foreign recipients.
