United States: Foreign Tax-Exempt Organizations Exempt From Withholding Tax

Last Updated: July 3 2014
Article by Steven Bortnick, Lisa B. Petkun and Brian Allen

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).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Steven Bortnick
Lisa B. Petkun
Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions