With international investment opportunities and connections becoming more attainable than ever, nonprofit organizations are finding themselves in a complex web of cross-border tax issues. In this piece, we identify the challenges of nonprofit organizations with global reach and offer considerations to help organizations navigate these issues.
U.S. Withholding Tax & Form W-8 Validation
Generally, a foreign person is subject to U.S. tax on its U.S. source income. For U.S. tax purposes, foreign persons can be nonresident alien individuals, foreign corporations, foreign partnerships, foreign trusts, foreign estates, and any other person who is not a U.S. person. Most types of U.S. source income received by foreign persons are subject to U.S. tax at a rate of 30% withheld at source. Tax withheld and remitted to the IRS typically relieves the foreign person of any further filing requirements on that item of income in the United States. In most cases, the payor of the U.S. source income is the withholding agent and is responsible for withholding and remitting the tax. The withholding agent is personally liable for any tax required to be withheld, and failure to withhold could result in interest and penalties. In addition, absent U.S. source effectively connected income, the act of withholding generally ought to satisfy the foreign person’s U.S. tax obligations.
Common scenarios in which U.S. nonprofit organizations make payments to foreign persons include:
- Payments for foreign independent contractor services
- Payments for foreign dependent personal services
- Payments for software subscriptions
- Payments for scholarships or fellowship grants
Under certain circumstances, a foreign person can provide documentation to the withholding agent to reduce or eliminate the withholding tax requirement on its U.S. source income. Absent such documentation, the withholding agent should withhold tax at the default rate of 30%.
Common forms of documentation received from foreign persons to reduce or eliminate withholding requirements are:
- Form W-8BEN-E: This is received from foreign entities to certify the foreign status as the beneficial owner of the U.S. source income and used to claim tax treaty benefits entitling the beneficial owner to a reduced rate of withholding.
- Form W-8BEN: This is received from foreign individuals to certify the foreign status as the beneficial owner of the U.S. source income and used to claim tax treaty benefits entitling the beneficial owner to a reduced rate of withholding.
- Form 8233: This form is received from foreign individuals performing independent or dependent personal services in the U.S. who are claiming an income tax treaty benefit. This form is also received by foreign individuals receiving non-compensatory scholarship or fellowship income and personal services income from the same withholding agent (typically colleges and universities) claiming income tax treaty benefits.
- Form W-8ECI: This is received from a foreign person claiming that income is effectively connected with the conduct of a trade or business in the United States.
Payors of U.S. source income ought to obtain Form W-8 series documentation from all foreign payees to certify the recipients’ foreign status regardless of whether the payment is subject to withholding tax. New W-8 forms must be provided every three years. Obtaining a Form W-8 also satisfies the withholding agent’s obligation to identify the foreign payee’s status under the Foreign Account Tax Compliance Act (FATCA).
Foreign Tax Reclaims
Nonprofit organizations have been expanding their investment portfolios to include foreign-based alternative investments such as foreign hedge funds and foreign publicly traded securities.
Like typical investment vehicles, foreign investments may generate dividend and interest income. This type of income is typically sourced to the country of residence of the payor. Similar to the U.S. taxing regime, income sourced to a country is typically taxable in that country. Therefore, many countries require payors of income to foreign persons (foreign with respect to the country where the income is sourced) to withhold tax at source on that income. Tax withheld and remitted to the local taxing authority typically relieves the foreign investor of any further filing requirements in that country.
In the case of for-profit investors, the IRS allows taxpayers to take a credit or a deduction for the foreign taxes paid to offset the U.S. tax liability on that income that is also subject to tax in the U.S., as U.S. taxpayers are subject to tax on their worldwide income.
For nonprofit organizations, the investment income is only taxable in the U.S. if it is considered unrelated business income (UBI). Therefore, when tax is withheld on non-UBI investment income, the ability to credit the foreign taxes paid does not exist in the same way as it does for for-profit investors. Without proper planning, the foreign taxes paid may represent an additional cost that reduces the return on investment.
Like the U.S., most countries have a default withholding tax rate on specific items of income. If the country has an income tax treaty agreement in place with the U.S., the withholding tax rate may be reduced or eliminated. This can be achieved by providing documentation and claiming treaty benefits prior to remittance of income. If the income is remitted net of the default withholding tax, the nonprofit organization must actively take steps to claim a refund of the foreign taxes paid. The claim must be filed with the foreign taxing authority within the statute of limitations prescribed under the foreign country’s tax law.
Managing a nonprofit organization’s foreign tax reclaim process will help avoid unnecessary foreign tax costs and optimize the return on foreign investments.
International Form Compliance
Foreign investment may necessitate onerous U.S. tax reporting and international informational compliance. Whether the fund is structured as a foreign partnership, foreign corporation, or passive foreign investment company (PFIC), the penalties for failure to file information reports with respect to these foreign investments can be steep. A nonprofit organization should analyze its foreign investment activity on an annual basis to determine whether any informational reporting is required. The international filings should be attached to the nonprofit organization’s Form 990 or Form 990-T.
Common international forms filed by nonprofit organizations include:
- Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, to report certain property contributions to foreign corporations
- Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, generally, to report a 10% or more ownership interest in certain foreign corporations
- Form 8621, Information Return by a Shareholder of a PFIC or Qualified Electing Fund, to report an ownership interest in a foreign corporation that meets the definition of a PFIC
- Form 8865, Return of U.S. Persons With Respect to Certain Foreign Partnerships, to report certain property contributions to any foreign partnerships and to generally report a 10% or more ownership interest in certain foreign partnerships.
- Form 8886, Reportable Transaction Disclosure Statement, to disclose information with respect to reportable transactions in which the taxpayer may have been a participant
For tiered partnership structures, the reporting requirements also apply to foreign investments held indirectly through U.S. or foreign partnerships, and the capital contribution threshold is aggregated by foreign transferee and reported at the partner/investor level as opposed to the partnership level.
Furthermore, the U.S. international informational forms listed above are not exclusive to investment vehicles. Nonprofit organizations that operate foreign branches, foreign corporations, and/or foreign joint ventures must comply with the informational reporting requirements as a result of its foreign activities. In addition to the forms listed above, the following international informational forms may be required:
- Form 8858, Information Return of U.S. Persons With Respect to Foreign Disregarded Entities (FDEs) and Foreign Branches (FBs), to report the interest in and operations of a foreign branch or foreign disregarded entity by the tax owner
- Form 5713, International Boycott Report, to report business operations in or related to a boycotting country, or with the government, a company, or a national of a boycotting country
Nonprofit organizations should maintain awareness of their international operations and investing activity to remain compliant with the information reporting requirements in order to avoid costly failure to file penalties.
Transfer Pricing For Nonprofit Organizations
When nonprofit organizations participate in transactions with related, for-profit entities, the transfer pricing rules under Internal Revenue Code Section 482 apply to ensure the transactions are properly priced on an arm's length basis and are fully documented. Transfer pricing applies to any type of related-party transactions, including but not limited to the sale of tangible goods, financing provision of services, and the transfer of intangible property. The IRS and other foreign tax authorities focus on these relationships to identify whether there is any tax avoidance. Transfer pricing rules can differ by country, so it is important for nonprofit organizations to establish and document pricing for intercompany transactions to help avoid income adjustments and possible penalties.
Gifts & Grants to Foreign Persons
Operating on a global basis may require U.S. nonprofit organizations to make grants to foreign individuals or foreign organizations. When making grants to foreign organizations, the U.S. nonprofit organization must guarantee that the funds are utilized for the authorized purpose by limiting the allocation to projects that further the U.S. organization’s exempt purpose. This should be achieved by retaining control over the use of the funds and keeping records to document that the grant was used as intended in alignment with the U.S. nonprofit organization’s charitable purpose. When making grants to foreign individuals, the IRS requires certain record keeping in order to substantiate that the grants were made appropriately.
Grant recipient information for foreign individuals includes:
- Name and address of recipient
- Amount distributed to recipient
- Purpose for which grant was made
- Selection process
- Any relationship with the recipient and interested persons
In order to protect the exempt status of the U.S. nonprofit organization, it is extremely important to maintain adequate records and documentation of the funds granted to persons outside of the U.S. Unlike public charities, private foundations are subject to strict expenditure responsibility rules.
Reach out to a professional at FORVIS if you have questions.