In two recent court decisions involving insurance tax issues, taxpayers prevailed against the IRS. Both cases remain subject to further appeals.

In Validus Reinsurance, Ltd. v. United States,1 the District Court for the District of Columbia held that the excise tax imposed under Section 4371 of the Internal Revenue Code (the “Code”) does not apply to certain retrocession transactions.

In Rent-A-Center, Inc. v. Commissioner,2 the U.S. Tax Court upheld the deductibility of premium payments made by members of a U.S. consolidated group to its Bermuda- based captive insurance subsidiary.


Validus Reinsurance, Ltd., a Bermuda company (“Validus”) sold contracts of reinsurance to third party insurers, under which it assumed its counterparties’ underlying insurance liabilities.  Validus then entered into nine retrocession agreements, under which third party retrocessionaires in turn assumed Validus’ reinsurance risks.

Each of the retrocessionaires was a non-U.S. company, like Validus itself.

The IRS assessed an excise tax against Validus under Section 4371 on the retrocession premiums that Validus paid to its retrocessionaires. Validus paid the assessment, then filed a claim for refund.

Section 4371 generally imposes

  1. a 4% excise tax on premiums paid under policies of casualty insurance or indemnity bonds issued by foreign insurers with respect to certain U.S. risks,
  2. a 1% excise tax on premiums paid on policies of life, sickness, accident insurance or annuity contracts issued by foreign insurers with respect to the life or hazards to the person of citizens or residents of the United States, and
  3. a 1% excise tax on premiums paid on reinsurance contracts issued by foreign reinsurers covering any of the contracts described in (1) or (2).

Validus argued on several grounds that the excisetax does not apply to the premiums paid by Validus under its retrocession agreements, including that

  1. Section 4371 does not apply to retrocession agreements under its plain language,
  2. Congess did not intend that Section4371 apply to agreements purely between foreign entities,and
  3. imposing the tax on “foreign-to- foreign” reinsurance transactions does not comport with international law or the Due Process Clause of the U.S. Constitution.

The District Court found the first argument dispositive and did not discuss the merits of any of the other arguments advanced by Validus. The District Court held that while Section 4371 reaches reinsurance contracts covering casualty insurance, indemnity bonds, and life, sickness and accident policies, the statute does not, on its face, include retrocession contracts covering other reinsurance contracts, even if underlying risk covered by the retrocession is described in Section 4371. While the IRS has long maintained in published guidance and rulings that the excise tax applies to all retrocessions where the underlying  risks are described in Section 4371, the District Court concluded that Section 4371 does not provide for this result and the IRS could not override the language of the statute.

On this basis, the District Court granted Validus summary judgment, holding that Section 4371 does not impose an excise tax on retrocession transactions, and that Validus is entitled to a refund of the excise tax and related interest. The District Court’s rationale is broad-sweeping and, if applied more broadly, would mean that not only foreign-to-foreign retrocessions (which was the fact pattern in Validus) are exempt from the excise tax, but so are U.S.-to- foreign retrocessions, even though the underlying policies cover U.S. risks. It has been suggested that an economic equivalent of a direct policy writer’s U.S.-to-foreign reinsurance (which would be subject to the excise tax) could now be accomplished without incurring any excise tax via a two-step transaction that involves an “onshore” reinsurance contract between the cedent and an intermediary U.S. reinsurer, followed by an “offshore” retrocession from that reinsurer to a foreign reinsurer. However, such a two-step structure might be subject to scrutiny under Section 845(b) of the Code, which gives the IRS broad authority to “make proper adjustments” with respect to reinsurance contracts that have a “substantial tax avoidance effect.”

The Validus decision could be a significant event for insurance company taxpayers, particularly if it is ultimately upheld by the D.C. Circuit Court, and subsequent developments should be carefully monitored.  Before taking any tax position based on the Validus decision, such as applying for a tax refund, failing to pay excise tax on future retrocession premiums or undertaking any tax structuring or restructuring, taxpayers should consider all relevant implications. For example, Treasury Regulations Section 1.1441-2(a)(7) provides that “insurance premiums paid with respect to a contract that is subject to the section 4371 excise tax” are not subject to U.S. federal withholding taxes.

By contrast, in the absence of this exemption, U.S.-sourced insurance premiums might be subject to a 30% withholding tax under Sections 1442 and 861(a)(7) of the Code, unless a treaty applies to reduce or eliminate the tax.


Rent-A-Center, Inc. (“RAC”) set up  a captive insurance subsidiary in Bermuda (the “Captive”) to insure certain risks of its other subsidiaries. RAC’s consolidated group of U.S. corporations claimed tax deductions for premiums paid to the Captive. The IRS challenged the deductions, arguing that the Captive was a sham and the arrangement did not involve a true transfer of risk – a key requirement to constitute “insurance” for tax purposes. The Tax Court disagreed, concluding that the Captive was a bona fide insurance company and the arrangement constituted insurance.

Prior to Rent-A-Center, there was already a well-developed body of tax caselaw involving captive insurers, in which the IRS challenged the deductibility of premium payments, and several rulings on this topic by the IRS. The cases are fact-specific and typically turn on factors such as risk shifting (from insured to insurer), risk distribution (how many different risks does the insurer cover), and  the captive insurer’s status as a  bona fide insurance company, which requires analyzing the activities and capitalization of the captive insurer.

One noteworthy aspect of the Rent-A-Center case is that RAC guaranteed the “deferred tax assets” and certain liabilities of the Captive in order to bolster the Captive’s balance sheet for Bermuda regulatory purposes. A vigorous dissent, signed by a significant minority of the Tax Court justices, argued that this parental guarantee indicated that RAC effectively stepped into  the shoes of the Captive so that RAC bore the risks of its subsidiaries, and no “risk transfer” to the Captive had occurred. The Tax Court majority dismissed this argument, based in part on its conclusion that a parent guarantee should only be treated as negating “risk transfer” in situations in which the captive is not adequately capitalized (without taking into account the guarantee) to cover the assumed risk. It is possible that the Tax Court’s consideration of this issue could have implications for other captive structures, including reinsurance arrangements, involving parent guarantees.