The federal district court for the District of Columbia recently ruled for the taxpayer in Validus Reinsurance Ltd. v. US, an important case involving the federal excise tax (FET) on premiums paid to foreign insurers and reinsurers for coverage of U.S. risks. The case is the first judicial response to the Internal Revenue Service’s (IRS) “cascading” theory of the FET. While the taxpayer emerged victorious, the court’s analysis may surprise some, and suggests that some taxpayers may have claims for refund.
The FET generally applies to policies of insurance and reinsurance issued by foreign insurers, or reinsurers covering U.S. risks. The tax is imposed at a rate of four percent of the premium paid for direct property-casualty insurance, one percent for direct life, health and annuity coverages, and one percent for reinsurance. The tax does not apply to amounts that are effectively connected to a U.S. trade or business. Also, some foreign insurers and reinsurers are exempted from the FET under the terms of applicable US tax treaties, provided they meet various requirements.
In 2008, the IRS issued Revenue Ruling 2008-15, in which it asserted that in the absence of a treaty or other exemption, reinsurance between two foreign reinsurers covering U.S. risks is subject to the FET. By implication, the FET would apply to each additional level of reinsurance, cascading as the risk was transferred and the premium paid to each additional foreign reinsurer.
The IRS’s cascading theory was controversial. Taxpayers and practitioners objected that it would be impractical to apply the FET to foreign-to-foreign transactions, and that Congress did not intend to do so.
Validus, a Bermuda reinsurer, challenged the IRS’s cascading theory in litigation filed last year.
The case involved Validus’s retrocession agreements with other foreign reinsurers. The underlying policies covered U.S. risks, and the IRS argued that the FET applied to the retrocession agreements, even though they were purely foreign-to-foreign transactions.
The District Court ruled for the taxpayer, but didn’t base its decision on the fact that the transactions were wholly foreign. Rather, the Court concluded from the language of the statute that the FET simply doesn’t apply to retrocessions. In the Court’s view, the FET applies only to direct policies covering U.S. risks, and to reinsurance of direct policies covering U.S. risks.
This somewhat surprising result suggests that retrocessions between U.S. reinsurers and foreign retrocessionaires would not be subject to the FET, even when the underlying policies cover U.S. risks and no treaty or other exemption is available. Taxpayers need to consider the options this presents, realizing that the IRS is likely to continue to contest the issue. Thus, for example, in some cases U.S. direct writers might want to restructure their reinsurance arrangements and reinsure their U.S. risks with U.S. reinsurers before any of the risks are transferred to foreign reinsurers. Likewise, U.S. reinsurers that retrocede U.S. risks to non-exempt foreign reinsurers need to consider how to handle the FET for those retrocessions. One possibility would be to file protective refund claims for tax previously paid and, for new premiums, to pay the tax and file protective refund claims for that tax as well.
It remains to be seen whether the IRS will appeal the Validus decision, and what other courts will say if presented with the same question.
For more information on the matters discussed in this Locke Lord QuickStudy, please contact one of the authors.