In light of the pending Validus federal excise tax (FET) litigation, non-U.S. reinsurers paying “cascading” FET should consider filing claims now for protective refunds with the Internal Revenue Service (IRS). 

Bermuda-based reinsurer Validus Reinsurance, Ltd. filed suit in U.S. District Court to recover FET paid in connection with reinsurance contracts it entered into outside the United States with other non-U.S. reinsurers to reinsure underlying U.S. risks.1

As background, a reinsurer sometimes transfers to another reinsurer (referred to as a retrocessionaire) a portion of the risk it assumes from the direct writing insurer; the retrocessionaire sometimes in turn transfers that risk to another retrocessionaire, and so on, in what is known in the insurance industry as “retrocessions,” so that a particular underlying risk sometimes is transferred to multiple reinsurers in succession. The IRS takes the position that the one percent FET under section 4371 of the Internal Revenue Code “cascades” with no limit. Under the IRS’ position, each succeeding reinsurance transfer to a non-U.S. reinsurer with respect to underlying U.S. risks generates its own FET, unless exempt under an income tax treaty with the U.S. This application of the FET is commonly referred to as the “cascading” FET.2 Depending on the number of reinsurance transactions in the chain, the cascading FET could exceed premiums paid on the initial insurance contract.

The issue of whether the FET cascades is a topic of much debate within the insurance industry. The Validus litigation is the first to challenge the IRS’ position on the cascading FET.

Case background3

Validus is a reinsurance company organized under the laws of Bermuda with its principal place of business in Bermuda. Validus sells reinsurance to unrelated insurance companies (“ceding companies”) that have underwritten direct insurance coverage of various insurance risks. Occasionally, Validus retrocedes a portion of its risk under these contracts to other reinsurers in retrocessions. All of the retrocessions at issue were executed outside of the U.S. For the years in dispute, Validus conducted no U.S. business.

The IRS examined Validus and assessed tax against Validus for “cascading” FET. The IRS asserted Validus owed FET with respect to its reinsurance business even though the transactions Validus was engaged in during the years in dispute occurred outside of the U.S. and between non-U.S. insurance companies. Validus filed suit in U.S. District Court challenging the IRS’ determination and assessment of tax on the grounds that the FET does not apply to transactions between two non-U.S. reinsurers that occur outside the United States. Validus also contends that the IRS lacks the power to tax transactions between non-U.S. parties.

What should non-U.S. reinsurers engaged in similar reinsurance transactions consider?

A claim for protective refund should be considered if a non-U.S. reinsurer has already paid the FET for prior and/or current tax periods. The IRS is not currently processing refund claims on this issue, and likely will continue to hold claims for refund until the Validus litigation is resolved. Filing a protective claim for refund is a relatively inexpensive procedure, and will preserve the statute of limitations on the claim for refund.

If a non-U.S. reinsurer has not, and is not currently, filing Form 720 (Quarterly Federal Excise Tax Return), it should consult with its tax advisor on whether to pay the FET and file a protective claim for refund as each taxpayer’s circumstances are different and must be fully considered.

Protective claim for refund

A protective claim for refund is appropriate when the right to a refund is contingent on future events and may not be determinable until after the time period for filing a claim for refund expires. Protective claims are often based on current litigation or expected changes in the tax law, other legislation, or regulations. Filing a protective claim for refund preserves the right to receive a refund once the contingency is resolved. A protective claim can be made by either filing a formal claim on Form 8849 (Claim for Refund of Excise Taxes) or on an amended return for credit or refund with the IRS (for example, a Form 720). A protective claim does not have to state a particular dollar amount or demand an immediate refund. The claim must be made in writing and signed, including certain taxpayer identifying information. Additionally, the claim must identify and describe the contingencies affecting the claim, clearly alert the IRS to the essential nature of the claim, and identify the specific tax quarters for which a refund is sought.

Generally, the IRS will delay action on the protective refund claim until the contingency is resolved. Once the contingency is resolved, the IRS will generally either allow or disallow the claim.

A protective claim for refund must be filed within three years from the date the original return was filed or two years from the date the tax was paid — whichever is later. The statute of limitations expires on April 30, 2013, with respect to payments of FET for the first quarter of 2010. Accordingly, a protective claim for refund must be filed on or before that date with respect to excise taxes remitted for that period. For quarters after first quarter 2010, claims can also be made now.