Section 4371 Excise Tax on Insurance and Reinsurance Contracts D.C. Circuit Holds that Federal Excise Tax Does Not Apply to Wholly Foreign Retrocession Agreements SUMMARY On May 26, 2015, in Validus Reinsurance, Ltd. v. United States, 1 the United States Court of Appeals for the District of Columbia Circuit (the D.C. Circuit, or the court ) held that the excise tax imposed on insurance and reinsurance contracts under Section 4371 of the Internal Revenue Code (the Code ) does not apply to retrocession agreements (reinsurance policies that protect against potential liabilities arising under other reinsurance policies) between two foreign entities. The D.C. Circuit s opinion narrowed the previous holding of the District Court, 2 which had held that the excise tax does not apply to any retrocession agreements. BACKGROUND Section 4371 of the Code imposes an excise tax on each policy of insurance... or policy of reinsurance issued by any foreign insurer or reinsurer. 3 Validus Reinsurance, Ltd. ( Validus ) is a Bermuda reinsurer that reinsured its own liabilities relating to U.S. risks by entering into retrocession agreements with other foreign reinsurers. 4 In 2006, Validus entered into nine such agreements, but did not pay the excise tax with respect to such agreements. Pursuant to Treasury Regulations under Section 4371, the excise tax generally applies to policies issued with respect to U.S. risks, including to U.S. persons and foreign persons engaged in a trade or business in the United States, and that insure against hazards, risks, or liabilities within the United States. 5 Generally, the person paying the premium to the foreign insurer or reinsurer bears the responsibility for New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
paying the tax; if the tax is not paid by such person, however, then the issuer of the insurance or reinsurance policy may also be liable for payment. 6 In 2012, the Internal Revenue Service (the Service ) assessed an excise tax on the 2006 retrocession agreements. 7 Validus paid the tax and accrued interest in full, then filed a claim for refund. 8 Since the Service did not timely act on the refund claim, Validus filed a cause of action against the United States in the District Court for the District of Columbia. The facts were undisputed and each party filed a crossmotion for summary judgment, based on the question of whether the excise tax applies to retrocession agreements. DISTRICT COURT DECISION The District Court held that the excise tax does not apply to retrocession agreements. In particular, the District Court found that the plain language of Section 4371 imposes the excise tax only on direct insurance and reinsurance of those insurance contracts. Inasmuch as retrocession agreements are in essence reinsurance policies on reinsurance and not on direct insurance, the District Court considered such agreements to be outside the scope of Section 4371 and not subject to the excise tax. The District Court acknowledged that its holding was contrary to the Service s long-standing position as set forth in published rulings. 9 Nonetheless, the District Court stated that the rulings were entitled to respect to the extent they have the power to persuade, 10 but courts will not defer when a ruling contrasts with clear statutory language. 11 D.C. CIRCUIT DECISION The Service appealed the District Court s decision in favor of Validus. The D.C. Circuit, reviewing the case de novo, upheld the District Court s decision, but narrowed the scope of the District Court s ruling. In a departure from the District Court, the court found that the statute does not exclude from the excise tax all retrocession agreements. The court noted that the purpose of the excise tax was to level the playing field between U.S. insurers and reinsurers who are subject to U.S. income tax and non-u.s. insurers and reinsurers who generally are not subject to U.S. income tax. If the excise tax were to exclude retrocessions, which the court stated were just another kind of reinsurance, i.e., reinsurance for reinsurers, foreign reinsurers would be advantaged with respect to retrocessions as compared to U.S. reinsurers. 12 The D.C. Circuit did, however, find that the statute is ambiguous with respect to retrocession agreements between foreign reinsurers. Further, relying on the presumption against extraterritoriality the notion that, absent a clear indication to the contrary, legislation applies only within the United States the court held that the excise tax does not apply to retrocessions between foreign reinsurers. The court seems to -2-
have been particularly troubled by the Service s position that the excise tax can apply to successive retrocession agreements between foreign reinsurers a so-called cascading tax that could in theory result in excise taxes with respect to the same underlying risk that exceed the income tax that would have been imposed in the case of a U.S. reinsurer. 13 The court also declined to defer to the Service s interpretation of the laws to any extent, in part because the Service had not previously considered the presumption against extraterritoriality in its interpretation. 14 IMPLICATIONS OF THE D.C. CIRCUIT OPINION The Service has not yet announced whether it intends to accept or appeal the D.C. Circuit s holding, or whether it will continue to assess excise tax in respect of wholly foreign retrocession agreements. In the interim, foreign reinsurers that have paid excise tax in prior years in respect of wholly foreign retrocession agreements should consider filing a claim for refunds of amounts previously paid if they have not already done so. 15 Foreign reinsurers should also consider whether to continue to pay the excise tax on existing or future retrocession agreements given the D.C. Circuit s holding. Direct reinsurance by a foreign company (as contrasted to next-level-removed retrocession agreements) remains subject to the Section 4371 excise tax. It is also worth noting that, while the D.C. Circuit s opinion did not explicitly distinguish between assumption reinsurance (whereby the reinsurer is substituted for the ceding insurer and becomes directly liable for policy claims) and indemnity reinsurance (whereby the reinsurer agrees to indemnify the ceding insurer for policy claims but has only indirect liability to the original insured), it is not clear whether the court would have viewed an assumption reinsurance transaction that results in the foreign reinsurer having privity of contract with a U.S. insured as being extraterritorial and, therefore, whether the excise tax would apply to such a transaction. * * * Copyright Sullivan & Cromwell LLP 2015-3-
ENDNOTES 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 2015 WL 3371689 (C.A.D.C. May 26, 2015). Validus Reinsurance, Ltd. v. United States, 19 F.Supp.3d 225 (D.D.C. Feb. 5, 2014). I.R.C. 4371. Validus, 2015 WL 3371689, at *1. See Treas. Reg. 46.4371-2(a). See Treas. Reg. 46.4374-1(c). Of note, the Service did not assess penalties, seemingly accepting that Validus had a reasonable basis for its position that no excise tax was payable. Validus, 19 F.Supp.3d 225, at *228. Id. In Revenue Ruling 2008-15, for example, the Service assumed that the Section 4371 excise tax was applicable to retrocession agreements. Id. at *231, n.4. Id. (internal quotations omitted). Id. Validus, 2015 WL 3371689, at *6 (internal quotations omitted). Id. at *7. Id. at *9-10. Foreign reinsurers should be able to sue for a refund in the D.C. Circuit as Validus did, as federal district courts have original jurisdiction of [a]ny civil action against the United States for the recovery of any internal-revenue tax alleged to have been erroneously or illegally assessed or collected under 28 U.S.C.A. 1346(a)(1). -4-
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