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    Validus Launches a Challenge to the IRS' Cascading Federal Excise Tax Ruling

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    On 25 January 2013, Validus Reinsurance Ltd (Validus), a reinsurer domiciled in Bermuda, filed a suit in the District Court of the District of Columbia against the United States of America for the repayment of taxes which they allege were wrongly demanded by the IRS. The tax was assessed under the Federal Excise Tax (FET) regime, which (among other things) imposes a 1%  tax on premiums under contracts of reinsurance with foreign reinsurers covering risks in the US (s4371 of the Internal Revenue Code). FET also applies at a rate of 4% to premiums for property and casualty insurance, and at 1% to policies for life insurance, sickness, accident and annuities. As reported in an earlier blog (available here), the IRS ruled on 7 March 2008 that the tax would apply to all contracts with an underlying risk based in the US (Revenue Ruling 2008-15).

    This ruling was controversial, as the analysis it included made it clear that the IRS considered the tax to apply to reinsurance and retrocession contracts even where both the cedent (or retrocedent) and the reinsurer (or retrocessionaire) were based outside the US, and neither party conducted any business within the US. Even in the case of insurers domiciled in countries with a tax treaty which exempts them from FET, the 1% tax on reinsurance premiums is still payable if they obtain reinsurance from a foreign reinsurer domiciled in a country without such a tax treaty. Furthermore, if a UK insurer (which is ordinarily exempt under a treaty) insures a US risk and passes it on to a foreign reinsurer as part of a conduit arrangement, FET becomes payable both on the reinsurance policy and the underlying insurance policy, which loses the exemption. This sort of arrangement is common with captive insurers, and would result in double (or multiple, if the risk is further reinsured) taxation on the same risk.

    While many have questioned whether this interpretation of the code is correct (as it appears to be double taxation), and whether the IRS has the authority to demand FET on a transaction between two non-US parties, neither of which conducts business in the US, the tax has been paid by a number of reinsurers since the 2008 ruling. Validus, as can be seen in their Complaint, was one such party. In February 2012, the IRS demanded $326,340 from Validus in unpaid FET for retrocession premiums paid to foreign retrocessionaires during 2006, and later demanded $109,040 in interest accrued on that sum. Validus paid both sums in full, and filed claims for a refund, as they considered the tax to have been wrongly assessed. In the absence of a response from the IRS, Validus has now launched a test case to recover the money paid plus interest.

    The result of this case has serious implications for other non-US insurers and reinsurers which have paid the cascading FET. However, the statute of limitations for tax returns in the US is relatively short, and expires for returns made for the first quarter of 2011 on 30 April 2013. In anticipation of the result of the claim, insurers and reinsurers who are concerned they may have paid this tax in error should file a protective refund claim with the IRS, which effectively freezes the limitation period for a particular claim.

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