On May 26, 2015, the United States Court of Appeals for the District of Columbia upheld a District Court decision and ruled that the Internal Revenue Service could not impose excise tax on certain wholly-foreign retrocessions of insurance under Section 4371 of the Internal Revenue Code.1 In reaching its decision, the Court of Appeals wrestled with the “correct” meaning of several terms in the statute in an attempt to glean whether Congress intended the statute to apply to certain wholly-foreign retrocession contracts. While initially hailed as an important victory for the taxpayer (and important precedent for other taxpayers), a close reading of the Court of Appeals’ decision reveals that its holding was more limited than the ruling of the District Court. While the decision gives both sides room to claim some margin of victory, it should be read taking into account its interaction with certain related income tax treaty provisions, and it potentially leaves unanswered questions regarding existing tax withholding provisions.
By way of background, Code Section 4371 generally imposes an excise tax on premiums paid to certain foreign insurers and reinsurers related to policies of insurance or reinsurance and indemnity bonds covering certain United States risks.2 Because this excise tax is by its terms payable by “any person who makes, signs, issues, or sells any of the documents and instruments subject to the tax, or for whose benefit the same are made, issued, or sold,” all parties in the chain of coverage should be concerned with the potential imposition of this tax. In addition, the Internal Revenue Service (IRS) has taken the position that this tax can apply multiple times through cascading layers of reinsurance with respect to the same ultimate risk, including where both parties to such reinsurance contracts are wholly outside the United States. Depending on the type of coverage, the rate for this tax can range from 1% to 4% of the premium paid.
Background of the Case
The current decision represents a second major victory for Validus, a Bermuda reinsurer, who was seeking a refund from the IRS of excise tax previously paid. In 2006, Validus paid premiums on nine retrocession policies that it entered into with respect to reinsurance it had previously issued related to certain U.S. risks written by a U.S. insurance company. During this period, Validus did not directly conduct business in the U.S. In February 2012, the IRS requested that Validus consent to the assessment of excise tax on those policies in the amount of $326,340. Validus paid the assessment, plus an additional $109,040 in interest, and then filed for a refund. Six months later, not having received any response from the IRS, Validus filed suit in the U.S. District Court for the District of Columbia.
The District Court granted summary judgment for Validus and held that the imposition of the Code Section 4371 excise tax with respect to the covered reinsurance policies was not permitted under the applicable statute, determining that “retrocessions” fell outside the literal definitions of reinsurance and other types of taxable insurance subject to this excise tax.3 Left standing, this exclusion of retrocessions from the coverage of the Code Section 4371 tax, under the District Court’s holding, would apply regardless of whether the cedent was a U.S. or non-U.S. person, a feature that some commentators felt may have extended the exclusion too far.
The Appellate Court Decision
In its decision, the Court of Appeals held that the excise tax assessed against Validus with respect to its retrocession contracts with other foreign insurers was not authorized by Code Section 4371, although, as stated above, on different, more narrow grounds than the District Court. After examining the plain language of the statute, and determining that both parties had offered plausible explanations as to the proper interpretation of various terms,4 the Court of Appeals found the text of Code Section 4371 to be ambiguous as to whether Congress intended to tax wholly-foreign retrocessions such as those involved in the case (that is, where both the initial reinsurer and the retrocessionaire are non-U.S. persons). To resolve this ambiguity, the Court of Appeals turned to the legislative history of the statute, noting the long-standing judicial doctrine that, unless a contrary intent is apparent, congressional legislation is not meant to apply to transactions wholly outside the territorial jurisdiction of the United States, generally known as the “presumption against extraterritoriality.” The Court of Appeals could not find any explicit evidence of Congress’ intent to apply the Code Section 4371 excise tax to wholly-foreign retrocessions and, accordingly, applied the presumption against extraterritoriality to refuse to interpret the statute to allow the IRS to impose excise tax on wholly-foreign retrocessions. The court cited to the fact that the tax could otherwise cascade, as mentioned above, as an additional basis for concluding that extraterritorial application of the tax was not intended by Congress.
By focusing on this extraterritoriality feature, rather than drawing a distinction between retrocessions and other types of reinsurance as the District Court did, the Court of Appeals avoided the potential pitfall of excluding reinsurance even where the cedent was a U.S. person. Thus, a major distinction between the District and Appellate Court decisions is that the excise tax would apply under the Appellate Court’s decision where a U.S. reinsurer retrocedes relevant coverage to a non-U.S. retrocessionaire, whereas the District Court’s decision would have presumably excluded this transaction.
While clearly an important victory for Validus, this case could be viewed by the IRS as a partial victory as well, because of the potentially more limited grounds upon which it was decided, as distinguished from the District Court decision. As with the District Court decision, there remains the possibility of a further government appeal of this case (for example, if another federal circuit decision results in a split in the relevant circuits). However, the narrower holding of the Court of Appeals' decision may provide a middle ground sufficient to placate both sides of the issue. In the interim, taxpayers who have paid federal excise tax on wholly-foreign retrocessions should consider seeking a refund of such taxes based upon the current holding.
Although the Court of Appeals' decision determined that wholly-foreign retrocessions are not themselves subject to the Code Section 4371 excise tax, this determination may be tempered at least in part by the potential application of relevant income tax treaty provisions. Applicable treaty provisions may under appropriate circumstances exempt from this tax transactions entered into between a U.S. insured (or reinsured) and a non-U.S. insurer (or reinsurer). These provisions, however, often contain a carveout from this exemption for situations where the non-U.S. party subsequently reinsures with another non-U.S. party not entitled to a similar treaty exemption. Thus, while such a wholly-foreign transaction may not itself be subject to the Code Section 4371 excise tax under the rationale of the Court of Appeals' decision, it may nonetheless trigger the application of this tax to an earlier transaction that had originally claimed a treaty exemption (that is lost by virtue of the later transaction).
Further, as the application of Code Section 4371 to the various forms of cross border insurance and reinsurance plays out, taxpayers should be cognizant of any potential effects of the final determination regarding the applicability of this tax upon the existing tax withholding provisions of the Internal Revenue Code potentially applicable to these same cross border transactions. United States source insurance premiums paid with respect to a contract that is subject to the Code Section 4371 excise tax have traditionally enjoyed an exemption from the potentially applicable withholding provisions of Section 1441 of the Code. As the application of Code Section 4371 is pared back, taxpayers should consider the potential impact, if any, of these withholding provisions.
1 Validus Reinsurance, Ltd. v. United States, No. 14-5081 (D.C. Cir. May 26, 2015).
2 One of the primary purposes of this statute when originally enacted was to help U.S. insurance companies better compete with foreign insurers by leveling the playing field between such U.S. companies, subject to U.S. income taxes, and their non-U.S. counterparts not so burdened.
3 Note that the District Court stated that its decision was based upon the application of these definitions to a situation involving retrocessions, and was not predicated on Validus’ argument that Congress did not intend and did not have the power to tax purely foreign-to-foreign transactions, an argument that, as discussed below, would form the ultimate basis for the Appellate Court’s decision.
4 The Court of Appeals devoted a significant portion of its opinion to the determination of the proper definition of the terms “cover” and “with respect to” in coming to its final determination.