Many foreign tax-exempt organizations have been providing services in the performing arts in the United States for decades. The U.S. payers have only recently begun informing the organizations that, absent a Code exception or treaty exemption, the payments for these performances are subject to 30 percent withholding tax. (In some cases there may be state tax withholding as well). The payer must report both the income and tax to the organization and the IRS on Form 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding. Payers must also submit a Form 1042 tax return reporting gross income, taxes withheld, and tax deposits.

In 2001, the IRS introduced procedures for foreign tax-exempt organizations to follow to obtain an exemption from the withholding tax. The procedures depend on whether or not the foreign organization is a resident of a country that has an income tax treaty with the United States.

• An organization that satisfies the U.S. definition of a tax-exempt organization may use Form W-8EXP, Certificate of Foreign Government or Other Foreign Organization for United States Tax Withholding , to claim an exemption from withholding tax as a tax-exempt organization that meets U.S. rules for tax exemption.
• An organization resident in a country that has an applicable income tax treaty with the United States may use Form W-8BEN, Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding , to certify to facts supporting an exemption from withholding tax under the tax treaty provision.

In both cases, the foreign tax-exempt organization must record a U.S. employer identification number (EIN) on the form. Foreign organizations can apply for an EIN on Form SS-4, available on the IRS website at http://www.irs.gov/pub/irs-pdf/fss4.pdf. Entities with a foreign address cannot currently apply for an EIN online.

Form W-8EXP

A foreign organization is not exempt from U.S. withholding tax based on its foreign tax-exempt status because many foreign countries have more liberal tax-exempt rules than the United States. However, a foreign organization that is tax exempt under section 501(c)(3) of the Internal Revenue Code (the “Code”) (or that would be exempt under that section if the organization applied for tax-exempt status) is not subject to a withholding tax on amounts that are consistent with such tax-exempt status.

A foreign organization claiming tax exemption under U.S. rules must provide the payer a Form W-8EXP prior to payment. The submitter of Form W-8EXP must check:

• Box 12a: Certifying that the IRS has issued a determination letter and the date of such letter, or
• Box 12b: Indicating that a letter from an attorney in the United States attesting that the organization would likely obtain tax-exempt status from the IRS if it applied to the IRS for such status is attached.

In addition, such a foreign tax-exempt entity must attach an affidavit stating that it is not a private foundation and so indicate in Box 12c or indicate that it is a private foundation in Box 12d. (The 4 percent excise tax on private foundations is not overridden by a tax treaty exemption because excise taxes are not covered by income tax treaties.)

U.S. income of a foreign tax-exempt organization making such a claim is reported under Recipient Code 07 and Exemption Code 02 on a Form 1042-S. No U.S. tax return is required.

Form W-8ECI

If the organization’s income is unrelated business income under section 512 of the Code (and therefore not tax exempt) such income may be exempt from withholding if the income is effectively connected with the conduct of a trade or business in the United States. For exemption from the withholding tax as effectively connected income, the organization must provide the payer a Form W-8ECI, Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States, prior to payment. Form W-8ECI must include a U.S. EIN. Effectively connected income is reported under Exemption Code 01 on a Form 1042-S. The foreign organization must submit a Form 1120F income tax return.

Form W-8BEN

A foreign organization that is resident in a country that has an income tax treaty in effect with the United States may choose to make a claim of exemption from tax under an applicable tax treaty provision. To make a claim under the tax treaty, the organization must meet the conditions for exemption and submit the claim to the payer on Form W-8BEN. The Form W-8BEN must contain a U.S. EIN in order for any type of treaty claim to be honored. The specific claim depends on the provisions available for tax exemption under the tax treaty.

Exempt Business Profits

Net income from services performed in the United States by employees or contractors of a foreign organization, regardless of the organization’s foreign tax-exempt status, is considered business profits for U.S. income tax purposes. Generally under the Business Profits Article of tax treaties, the business profits of an organization that is a resident of the treaty country are not subject to tax in the United States unless the organization has a permanent establishment (PE) in the United States and the profits are attributable to that PE.

The Permanent Establishment Article typically finds a PE if the organization has either an office or other fixed place of business in the United States, or a dependent agent in the United States that habitually negotiates contracts on behalf of the organization. Some PE articles also find a PE if the organization has employees or contractors performing non-sales services in the United States for a specified period of time. See, for example, Article 5(2)(1) of the treaty with India.

Tax treaty-exempt business profits are reported under Exemption Code 04 on Form 1042-S. No U.S. income tax return is required of the foreign organization. However, a protective Form 1120F may be submitted with the tax treaty claim to preserve deductions and credits should the organization’s income later be determined to be attributable to a U.S. PE.

Special Provisions for Exempt Organizations

The tax treaties with Canada, Germany, Mexico, and the Netherlands include special provisions for organizations that are tax-exempt under the laws of the respective countries. For example, Paragraph 1 of Article XXI (Exempt Organizations) of the tax treaty with Canada provides that income derived by a religious, scientific, literary, educational or charitable organization shall be exempt from tax in the United States if the organization is resident in Canada but only to the extent that the income is exempt from tax in Canada. A similar provision can be found in Article 27(1) of the treaty with Germany, Article 22(1) of the tax treaty with Mexico, and Article 36(1) of the treaty with the Netherlands.

Under such tax treaty provisions, it is the tax-exempt rules of the respective treaty country that determine whether the income is exempt from tax. Therefore, a tax-exempt organization resident in one of these four treaty countries is not required to follow the more costly Form W-8EXP alternative. An organization making a claim under such a tax treaty provision makes the claim on Form W-8BEN. To support the validity of the claim, the organization should include evidence of its tax-exempt status in the respective treaty country. For example, Canadian tax-exempt organizations could attach a copy of their Canadian registration letter. For practical reasons, an English-language translation should accompany foreign-language documentation of tax-exempt status in Germany, the Netherlands, or Mexico.

Tax treaty-exempt income is reported under Exemption Code 04 on Form 1042-S. No U.S. income tax return is required for the tax-exempt claim based on these provisions.

©Copyright 2007 by Windstar Technologies, Inc. Windstar reserves all rights to this electronic material. Information contained in this publication is based on the best information available at the time of publication.  While believing the information in this publication to be accurate, Windstar accepts no legal responsibility for its accuracy.

Since 1995 educational institutions, hospitals, research institutions, and corporations have relied on Windstar Technologies, Inc. to deliver the expertise to comply with the U.S. tax residency rules, tax rates, and special tax exemption rules under the law and U.S. treaties.  When government agencies require information about foreign nationals in the workplace, Windstar provides straightforward analysis and reporting.  Comprehensive software for analysis and reporting, expert knowledge, and unparalleled customer service combine to make Windstar the first choice for nonresident alien tax compliance.

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