Potential Significant U.S. Withholding Tax Relief for Offshore Captives
On January 2, 2013, the President signed into law the long-anticipated extensions of certain taxpayer-friendly rules in response to the “fiscal cliff” debate. Contained within the American Taxpayer Relief Act of 2012 (Act) were measures that could provide valuable U.S. withholding tax benefits for offshore captives that earn U.S. investment income and have not elected to be classified as domestic corporations (under Internal Revenue Code Section 953(d)) or as disregarded entities (according to the “check the box” rules) for U.S. federal income tax purposes. This U.S. withholding tax relief applies retroactively to the 2012 tax year and prospectively to the 2013 tax year; based on the approach followed in recent federal tax reforms, it is possible that it could be extended again in the future.
Although U.S. federal income taxes generally only apply to foreign corporations that have onshore operations or sufficient connections to the U.S., certain types of U.S. investment income earned by offshore captives can nonetheless be subject to U.S. withholding taxes. For example, unlike “short-term” capital gains from the sale of U.S. equities and some forms of U.S.-sourced interest income received directly by foreign investors, U.S. withholding taxes have traditionally been imposed on these types of investment earnings when generated through U.S. mutual funds and paid out as dividends to offshore captives.
In order to eliminate this disparity of treatment for arguably the same type of investment activity, Congress changed its approach in 2004 (starting with the 2005 tax year) and generally provided for an exemption from U.S. withholding tax when a U.S. mutual fund paid a dividend to a foreign investor that was generated from certain types of U.S. capital gains and interest income. This relief was originally scheduled to expire in 2007 but was extended on two previous occasions to include periods through to December 31, 2011. The Act continues Congress’ prior approach of providing seamless relief by delaying the expiration date of these provisions until the end of 2013.
Since these rules were not modified during 2012 (and had otherwise expired at the end of 2011), it is possible that certain dividends paid by U.S. mutual funds to their foreign investors last year were subject to U.S. withholding taxes that have now been eliminated by the Act. Accordingly, there may be opportunities for an offshore captive to improve its U.S. withholding tax position in connection with its U.S. investments by examining the application of the Act to its situation.
If you have questions regarding the impact of the Act on captive arrangements or seek assistance in applying its measures to a captive investment portfolio, please contact any member of the Insurance Department listed here.