Section 4371 of the U.S. Internal Revenue Code imposes a U.S. federal excise tax (US FET) on certain insurance policies issued by a foreign insurer to either (1) a U.S. corporation, a U.S. partnership or an individual resident of the United States, against or with respect to hazards, risks, losses or liabilities wholly or partly within the United States; or (2) a foreign corporation, foreign partnership or nonresident individual, engaged in a trade or business within the United States, against or with respect to hazards, risks or liabilities wholly within the United States.
Pursuant to income tax treaties between the United States and about twenty countries, the United States will exempt the imposition of the US FET if the foreign insurer is, under the applicable U.S. tax treaty, a “resident” that meets one of the clauses of the Limitation on Benefits article under such treaty. Under most U.S. tax treaties, because the excise tax is a “covered tax,” the United States may not, pursuant to either the Business Profits or Other Income article of the applicable treaty, impose the US FET tax on the income of any foreign insurance company that is not attributable to a permanent establishment in the United States. However, most treaties limit this exemption under either a qualified exemption provision or an anti-conduit provision. Currently, only three U.S. income tax treaties provide for an unqualified exemption to the US FET, and only one treaty contains an anti-conduit provision (the U.S.-U.K. tax treaty).
The remaining treaties that provide for an exemption to the US FET contain only a qualified exemption. This exemption generally states that “the convention shall apply to the excise taxes imposed on insurance premiums paid to foreign insurers only to the extent that the risks covered by such premiums are not reinsured with a person not entitled to exemption from such taxes under this or any other income tax convention which applies to these taxes.” [Emphasis added.] At least one treaty with a qualified exemption (the U.S.-Ireland tax treaty) further limits the exemption under § 4371 by requiring such premiums to be subject to tax under the general laws of the treaty partner. Two treaties (the U.S.-Sweden tax treaty and the U.S.-Finland tax treaty) eliminate the application of the qualified exemption under their so-called “triangular branch” provisions to the extent that the covered insurance risks are reinsured through a low-taxed nonresident branch of a foreign insurer that is located in a third country.
Increased US FET Audit Activity
Under Revenue Ruling 2008-15, the IRS ruled that the US FET is imposed on certain premiums paid on reinsurance transactions between foreign insurers (not otherwise engaged in a trade or business in the United States) and foreign reinsurers (not otherwise exempt under the Code or a U.S. tax treaty). In conjunction with the issuance of Revenue Ruling 2008-15, the IRS issued Announcement 2008-18, which provides a Voluntary Compliance Initiative (VCI) for certain eligible foreign insurance and reinsurance companies. If a foreign insurance company participated in the VCI, the IRS would not examine the cascading US FET liabilities and other disclosure liabilities for participating entities incurred before October 1, 2008.
In the wake of Revenue Ruling 2008-15 and Announcement 2008-18, the IRS is expected to significantly (and immediately) increase its audit activity relating with respect to all aspects surrounding the US FET, including the accurate reporting of US FET, the cascading US FET position and treaty disclosure issues. In this audit environment, it is quite important to review your current administrative practices, including properly documenting the application of exemptions, reviewing your current Closing Agreements and reviewing your IRS reporting and disclosure obligations.
US FET Closing Agreements
A person otherwise required to remit the US FET on account of premiums paid to a foreign insurer may consider such premiums exempt under a U.S. tax treaty if, prior to filing an Internal Revenue Service (IRS) Form 720 (the U.S. federal excise tax form), such person has knowledge that there was in effect for such taxable period a closing agreement between the IRS and the foreign insurer (Closing Agreement). Revenue Procedure 2003-78 provides the rules for obtaining such a Closing Agreement. That Revenue Procedure provides two separate standard Closing Agreement models, depending on the particular US FET exemption provided in the applicable treaty.
Under the Revenue Procedure, the foreign insurer must also submit:
- A letter of credit in the amount of $75,000 (or higher if so determined by the IRS);
- A complete IRS Form SS-4 (if the applicant does not already have an Employer Identification Number);
- A list of the position titles, names, addresses and telephone numbers for those persons who will be responsible parties for performance under the Closing Agreement; and
- A signed statement under penalty of perjury that the foreign insurer (a) is a resident for purposes of the applicable U.S. tax treaty; and (b) qualifies for benefits under the Limitation on Benefits Article of such treaty, accompanied by an explanation of the basis on which the foreign insurer so qualifies.
An often overlooked requirement of the Closing Agreement is that ¶ 9 of the agreement requires that the treaty eligibility statement is valid only until the earlier of (1) the last day of the third calendar year following the year in which the statement was signed or (2) the day that a change in circumstances occurs that makes any information on the statement incorrect. For example, a statement signed on September 1, 2006, remains valid until December 31, 2009, unless circumstances change that make the information on the statement no longer correct.
On or before the expiration of the treaty eligibility statement, the foreign insurer must file with the IRS a renewed statement, again signed under penalty of perjury, along with one copy of the Closing Agreement, to the address provided in Revenue Procedure 2003-78. Failure to file this statement will render the Closing Agreement terminated and may expose the payor of a premium to a US FET liability.
Accordingly, whether you are the foreign insurer or a payor of premiums subject to the US FET, it may be wise to take a look from time to time at your Closing Agreement, or the Closing Agreements you have received from your foreign insurer, and verify that they remain in force.
Treaty-Based Disclosure Requirement
Foreign insurers who take the position that a U.S. tax treaty overrules, or otherwise modifies, the imposition of the US FET must disclose such position. This disclosure must be made once a year on a statement that must report the payments of premiums for the previous calendar year that are exempt from the US FET on policies issued by foreign insurers. This statement is filed with the first quarter IRS Form 720, which is due before May 1 of each year. You may be able to use IRS Form 8833, Treaty-Based Return Position Disclosure Under § 6114 or § 7701(b), as a disclosure statement.
A corporate taxpayer who fails to disclose as provided above is subject to a $10,000 penalty for each failure to disclose a position taken with respect to each separate payment or separate item. Because of the number of reinsurance transactions in which a foreign insurance company may engage, the penalties associated with failure to make this annual information disclosure can be substantial.