By Thomas Gray and John W. Weber, Jr.
Summary and Highlights:
On May 26th, the U.S. Court of Appeals for the District of Columbia Circuit held in favor of Validus Holdings Ltd. (“Validus Re”), a Bermuda reinsurance company, in the federal government’s appeal of the decision in Validus Reinsurance Ltd. v. United States, 113 AFTR 2d 2014-813 (D.D.C. 2014).
The case deals with the imposition of the federal insurance premiums excise tax (FET) imposed under Section 4371 of the Internal Revenue Code to retrocession transactions between non-U.S. reinsurers. The appellate court’s opinion rejects the Internal Revenue Service’s cascading excise tax theory. When read in a technical way, the decision applies only to a retrocession transaction from one non-U.S. reinsurer to another; it does not specifically address a reinsurance cession from a non-U.S. reinsured to a non-U.S. reinsurer. However, the principles discussed in the opinion could be seen as having broader applications.
Some highlights include:
- The D.C. Circuit Court of Appeals decided the Validus Re case by holding that retrocessional premiums paid from one non-U.S. reinsurer to another were not subject to the U.S. Federal insurance premiums excise tax (“FET”). This strikes down at least one aspect of IRS’s “cascading excise tax theory.”
- Technically, the court asserted that it was unclear as to whether the statute imposed the FET on retrocessional premiums. The court resolved this uncertainty by referring to the presumption against extra-territoriality.
- The question whether a reinsurance premium (i.e., not a retrocession) paid from a non-U.S. ceding company to a non-U.S. reinsurer was subject to FET, was not addressed by the Circuit Court. The District Court had determined that all retrocessions were outside the scope of the tax, including, in effect, U.S. to non-U.S. retrocessions; this issue also was not specifically before the Circuit Court.
- The language and general reasoning of the Circuit Court support the approach that had been taken by the industry prior to IRS’s announcement of the cascading theory in 2008: the FET is due (subject to a tax treaty exemption) on a U.S. to non-U.S. placement, whether insurance, reinsurance or retrocession. It is not due on a non-U.S. to non-U.S. one.
- Quite a large number of excise tax refund claims have been filed by non-U.S. reinsureds and retrocessionaires, as well as by some U.S. retrocedents. IRS was asked not to deny those claims until the Validus Re case was decided. The Government can still appeal to the U.S. Supreme Court or ask for an en banc review of the Circuit Court decision. However, the waiting period seems to be coming to an end.
- Having lost twice on the issue, it will be interesting to see whether the Government determines to continue the litigation, and more importantly, how IRS determines the dispose of the refund claims.
Historically, the FET has been applied to premiums paid by U.S. policyholders or U.S. ceding companies to non-U.S. insurers or reinsurers. In Revenue Ruling 2008-15, the Internal Revenue Service announced that it viewed the FET as applying to transactions between non-U.S. ceding companies and non-U.S. reinsurers and retrocessionaires, not just to transactions between a U.S. insured or reinsured and a non-U.S. insurer or reinsurer. This IRS position acquired the moniker of the “cascading FET theory.” Validus Re did not pay the FET on certain non-U.S. to non-U.S. retrocessions and the Internal Revenue Service challenged its position on audit. Validus Re paid the assessed tax, with interest, and claimed a refund on the grounds that the FET did not apply and, alternatively, that if it did, then the tax was unconstitutional. After the Internal Revenue Service failed to act on the refund claim, Validus Re sued in the Federal District Court in Washington, D.C.
DC District Court
In the D.C. District Court, Validus Re argued that:
- The plain language of Section 4371(3) does not apply to retrocessions.
- Section 4371(3) cannot be applied extraterritorially without clear Congressional intent.
- The Due Process Clause of the U.S. Constitution prevents the application of the FET to wholly foreign transactions.
The United States argued that:
- The plain language of Section 4371(3) indicates that Congress intended the FET to apply to each reinsurance policy, including non-U.S.-to-non U.S. retrocessions..
- Congress intended the FET to apply extraterritorially.
- Congress has the power to tax extraterritorially, as the reinsurance contracts are substantially connected to the United States, and taxing the associated premiums comports with international law and constitutional due process.
The D.C. District Court stopped at Validus Re’s first argument to rule favorably on its summary judgment motion. The court ruled that under the plain text of Section 4371(3) the FET applied only to reinsurance policies and not to retrocessions, and that “the transactions giving rise to the challenged tax assessment do not fall within the plain language of Section 4371.”
D.C. Circuit Court of Appeals
The D.C. Circuit Court affirmed the D.C. District Court’s holding, but on narrower grounds. With respect to the retrocession transaction that was directly before it, the D.C. Circuit Court concluded that both sides offered plausible interpretations of Section 4371(3), and that the word “cover” could have different meanings. Because neither party could decidedly demonstrate that “covering”, standing alone, should be interpreted per that party’s definition, the court concluded that the text of Section 4371 was ambiguous with regard to wholly non-U.S. retrocessions. The ambiguity was therefore resolved by reference to the presumption against extraterritoriality. The Circuit Court found that there was no clear indication that Congress intended the FET to apply to premiums paid with respect to wholly foreign retrocessions, and as a consequence, held that it did not.
Although the court found that the Government’s interpretations ran afoul of the principle against extraterritorial application, it also found that Validus’s interpretation of the scope of the statute had flaws. The court noted that a position exempting all retrocessions would be contrary to a stated Congressional purpose. The FET, according to the court, is intended to apply only to premiums paid to insurance companies not already subject to U.S. income tax to level the playing field between domestic and foreign insurance and reinsurance businesses. Following Validus Re’s interpretation would prohibit the application of the FET in situations where a U.S. reinsurance company arranges retrocessional coverage with a non-U.S. reinsurer. Since, the court noted, a retrocession is just another kind of reinsurance, Validus Re’s interpretation would create a distinction between reinsurance and retrocessions that was at odds with the clear purposes of the statute.
The Government now has the option asking the court to reconsider its decision by filing a petition for rehearing en banc, or filing a petition for review of the case by the Supreme Court by writ of certiorari. These reviews are rarely given. The Government could do nothing and allow the appeals periods to expire.
Non-U.S. taxpayers that file Federal excise tax returns are required to do so with the Internal Revenue Service Regional Office in Cincinnati, Ohio, and thus any refund claim litigation based on the filing of a return would be addressed by the Sixth Circuit. Taxpayers who paid the tax but did not file returns could turn to the D.C. Circuit. Of course, anyone who pays a tax and wishes to sue for a refund also can petition the Court of Federal Claims. The D.C. Circuit Court’s decision would be binding precedent in the D.C. Circuit, and would be useful for it is persuasive value in other Circuits.
One interesting question that the case does not specifically address is whether reinsurance from a non-U.S. ceding company (perhaps an insurer approved for U.S. surplus lines business) to a non-U.S. reinsurer (i.e., a reinsurance, not a retrocession) is subject to FET. Before Internal Revenue Service introduced the cascading FET theory, it was thought that the FET is imposed on U.S. to non-U.S. placements, not on non-U.S. to non-U.S. ones. The D.C. Circuit determined that it was ambiguous whether the statute applied to retrocessions, and decided the question in favor of the taxpayer with reference to the presumption against extraterroriality. It did not directly address the non-U.S. to non-U.S. reinsurance question.
A return to the traditional tax analysis that treated such a wholly non-U.S. transaction as outside the scope of the FET, would be logical and is supported by the general rationale of the Circuit Court. As the Circuit Court decision was unanimous for the taxpayer, and the District Court decision was also favorable to the taxpayer, it is possible that the Internal Revenue Service might not have the appetite to continue to pursue the “cascading FET theory.” A substantial number of protective refund claims have been filed with IRS. They include non-U.S. to non-U.S. reinsurance transactions, non-U.S. to non-U.S. retrocessions, and U.S. to non-U.S. retrocessions. Typically, IRS complied with the request of the taxpayer filing the refund claim, not to deny the claim until the Validus case had been decided. The case has now been decided and it will be interesting to see what actions IRS takes on the refund claims.
Companies required to pay the FET, can take solace in the fact that two federal courts have now resolved this matter in favor of Validus Re and it would seem difficult the Internal Revenue Service to successfully challenge a refund claim after the opinion of the D.C. Circuit.
 Section 4371 provides:
There is hereby imposed, on each policy of insurance, indemnity bond, annuity contract, or policy of reinsurance issued by any foreign insurer or reinsurer, a tax at the following rates:
(1) Casualty insurance and indemnity bonds. 4 cents on each dollar, or fractional part thereof, of the premium paid on the policy of casualty insurance or the indemnity bond, if issued to or for, or in the name of, an insured as defined in section 4372(d);
(2) Life insurance, sickness and accident policies, and annuity contracts. 1 cent on each dollar, or fractional part thereof, of the premium paid on the policy of life, sickness, or accident insurance, or annuity contract; and
(3) Reinsurance. 1 cent on each dollar, or fractional part thereof, of the premium paid on the policy of reinsurance covering any of the contracts taxable under paragraph (1) or (2).
 The statute provides that the tax applies to reinsurances “covering” taxable life or property/casualty policies. It is notable that the presumption against extraterritoriality is a technique of statutory interpretation. The Circuit Court did not reach the Constitutional argument.
 See Morrison v. Nat’l Austl. Bank Ltd., 561 U.S. 247,261 (2010) (providing that there is a presumption against extraterritoriality).
 On the basis of the District Court’s opinion, several large U.S. reinsurers had filed FET refund claims with respect to their outbound retrocessions.
 If IRS were to continue to take the view that a non-U.S.-to-non-U.S. reinsurance could be subject to FET, there is a potential tax treaty issue. Under most U.S. tax treaties that contain a FET exemption, inbound premiums are exempt only insofar as such premiums are not reinsured with a carrier resident in a country that does not have such a favorable tax treaty. Per Revenue Ruling 2008-15 (situations 2 and 3), IRS would also apply the cascading theory. Thus, by virtue of a reinsurance to a non-treaty country reinsurer, an original direct premium paid to a treaty country insurer would be subject to the 4% FET, and an additional 1% would be applied to the premium under the cascading rule. Such a result could be awkward as a matter of tax treaty policy. The Senate Finance Committee Reports that support several U.S. tax treaties contain examples of the basic FET look-through rule described above. That is, the examples show a $200 insurance premium paid to an insurer resident in a treaty country followed by a 50 percent quota share cession to a reinsurer in a non-treaty country. The examples show a tax result of $4 (i.e., 4% of $100), not of $5 (5% of $100, when the cascading tax is included).