The United States Court of Appeals for the District of Columbia has affirmed a lower court’s grant of summary judgment in Validus Reinsurance, Ltd. v. United States, in favor of the taxpayer, though on narrower grounds than the lower court, ruling that the US federal excise tax (the FET) on insurance and reinsurance contracts does not apply to wholly foreign retrocession contracts.
Believing that the taxpayer and the government both offered plausible interpretations as to the taxing statute’s application to wholly foreign retrocessions, the court concluded on May 26 that the text of the statute is ambiguous in this respect and that, therefore, absent a specific Congressional intention for the statute to have extraterritorial application, the statute would be presumed not to have such application under longstanding case law precedent.
Those who have withheld the FET (or who have agreed to withhold the FET) on retrocession contracts implicated by this ruling are urged to review contract language, which may obligate them to file refund claims if protective refund claims have not already been filed.
The court left certain questions unanswered, such as whether wholly foreign reinsurance contracts are still subject to the FET (we expect that the same rationale that the court applied in this case would apply in the case of a reinsurance contract) and whether the regular 30 percent withholding tax will apply in lieu of the FET (regulations provide that income that is subject to the FET and that is otherwise subject to withholding tax is not subject to withholding tax). It is unclear whether the government will seek review by the Supreme Court and, if so, whether the Supreme Court would grant review.
Background and court challenge
Generally, the Internal Revenue Code of 1986, as amended imposes a tax on each policy of reinsurance whereby a contract of reinsurance is made, continued or renewed, if issued (1) by a nonresident alien individual, a foreign partnership or a foreign corporation, as reinsurer; and (2) to any person against, or with respect to any policy of (A) casualty insurance or an indemnity bond or (B) life, sickness or accident insurance, or annuity contract, in each of (A) and (B) where the insurance related to US-situsrisks. The tax is imposed at a 1 percent rate by reference to the gross premium paid.
In 2008, the IRS took a position in a revenue ruling that the FET applies on a “cascading basis” − that is, it applies sequentially to every insurance and reinsurance arrangement regarding the same US-situs risk without regard to whether such risk has already been subject to the FET; this was the basis on which the IRS asserted a deficiency for the FET on the wholly foreign retrocession contracts at issue in theValidus case. To foster its position, the IRS announced a voluntary compliance initiative pursuant to which foreign persons who, inter alia, had failed to pay the cascading FET could become compliant with the way the IRS views the law. Many taxpayers questioned the IRS view. In January 2013, Validus Reinsurance, Ltd., a Bermuda-based reinsurer, filed a tax refund suit in the US District Court for the District of Columbia challenging the imposition of the cascading FET with regard to premiums it had paid to non-US reinsurers in connection with retrocession contracts reinsuring US-situs risks entered into outside of the US.
The district court granted summary judgement to Validus and concluded that under the plain language of section 4371(3) of the Code, retrocession contracts do not “cover” contracts taxable under Section 4371(1) or (2) of the Code and, thus, premiums paid under a retrocession contract were not subject to the FET.1 The United States Department of Justice appealed this decision.
The court’s analysis and holding
In affirming the lower court grant of summary judgment in favor of the taxpayer, “albeit on narrower grounds”, the court ruled that because both the taxpayer and the government offered “plausible explanations” as to whether the FET applies to wholly foreign retrocession contracts, the text of the statute is, therefore, “ambiguous” in this respect and such ambiguity must be resolved by “applying the presumption against extraterritoriality” because Congress did not explicitly specify its intent to impose the FET on an extraterritorial basis. The government’s interpretations, the court highlighted, would impose the FET on all retrocession contracts, including an unlimited number of contracts retroceding the same US-situs risk, but this “cascading” tax would go beyond Congressional intent in passing the FET, which was to “eliminate an unwarranted competitive advantage” enjoyed by foreign insurers. The taxpayer’s interpretation, noted the court, would exempt from the FET all retrocession contracts, including those where a US reinsurer retrocedes US-situs risks to a foreign retrocessionaire; this interpretation “would create a distinction between retrocessions and reinsurance issued by foreign entities and domestic insureds that would be at odds with a clear purposes of the statute.” The court’s decision analyzes the legislative history of the FET and concludes that the only relevant indication of Congress’s intent on the scope of the FET indicated applicability to insurance “taken out in the United States.”
To resolve the ambiguity in the statutory scheme regarding the scope of the FET, the court applied the long-standing presumption elaborated by the Supreme Court and other lower courts against the extraterritorial application of US tax laws. Doing so, it determined that there exists in the statute and legislative history no clear intent to apply the FET on an extraterritorial basis. As a result, the court held that FET does not apply to Validus’ retrocession contracts with other foreign reinsurers and affirmed the lower court’s grant of summary judgement, on narrower grounds than the lower court, in favor of Validus.
Implications and remaining questions
Although the ruling may be appealed by the government to the Supreme Court (and the Supreme Court may grant its discretionary review of the ruling), it nonetheless represents a favorable development for reinsurance companies (and intermediaries) that have either acted as withholding agents or should have so acted, at least in the eyes of the IRS, with respect to the cascading FET. In recent years, it has been common to see retrocession contracts containing provisions obligating a party to file administrative claims for refunds of the cascading FET or to file “protective claims” preserving a party’s right to seek such a refund if there is a change in law, which may include the ruling. We urge those who may be affected by the ruling to review recent contracts for such provisions and to negotiate such provisions in current contracts, if not already doing so.
Reinsurers that have paid the cascading FET (or had such FET withheld or deducted from premiums paid to them) on foreign-to-foreign retrocession contractions should consider filing protective claims or refund claims with the IRS before the applicable statute of limitations expires (generally, the later of three years from the date that the original return was filed or two years from the date that the FET was paid) to preserve their refund claims.
The court did not address two very important issues, which we expect will take the spotlight shortly. These are (1) the application of a 30 percent withholding tax on underwriting income that applies but for the application of the FET and (2) whether the FET applies to foreign-to-foreign reinsurance contracts, as the ruling was limited to “wholly foreign retrocessions.”
While the ruling was narrow and only applied to wholly foreign “retrocessions,” we believe that the same rationale would apply to wholly foreign reinsurance contracts as well. This issue may be addressed in future IRS guidance or subsequent court challenges. In general, a 30 percent withholding tax applies to certain fixed or determinable annual or periodic income, which includes “premiums.” Regulations provide, however, that a premium paid with respect to a contract that is subject to the FET is not an amount subject to such withholding tax. As a result of the ruling that the FET does not apply to wholly foreign retrocessions, it would appear that such premium income may be subject the 30 percent tax. The issue is far from resolved, especially in light of the income sourcing rules applicable to “underwriting income,” a net concept, which appears in stark contrast to the 30 percent tax, which applies, generally, on a gross basis. Further, as a net tax, the 30 percent tax could be greater or less than the FET would have been.