United States: US Court of Appeals Effectively Kills "Cascading" Theory of Federal Excise Tax in Foreign-To-Foreign Retrocessions

The US Court of Appeals has upheld a lower court decision granting reinsurance company Validus Re a refund of federal excise tax (FET) the company had paid on retrocessions of US-source risks to non-US retrocessionnaires. The affirmance confirms the argument put forth by the international insurance industry that the FET does not apply on a "cascading" basis each time a US risk is retroceded from one foreign reinsurer to another. However, the appellate court's holding was limited to foreign-to-foreign retrocessions and will not apply to retrocessions from a US retrocedant to a foreign retrocessionnaire.

The Validus case began after the US Internal Revenue Service (IRS) announced in 2008 its view that the FET on policies issued by foreign insurers or reinsurers applied each time insurance of a US risk was shifted by reinsurance or retrocession. The FET on reinsurance had been in the statute since 1942, but the IRS did not adopt the view that the FET applies on a cascading basis until the publication of Revenue Ruling 2008-15, 66 years after the statute was adopted.

Section 4371(1) of the Internal Revenue Code imposes a 4 percent FET on casualty insurance or indemnity bond premiums paid to a foreign insurer with regard to US risks. Section 4371(2) imposes a 1 percent FET on life insurance, sickness and accident policies, or annuity premiums paid to a foreign insurer with regard to US risks. Section 4371(3) imposes a 1 percent FET on "Premiums paid on the policy of reinsurance covering any of the contracts taxable under paragraph (1) or (2)."

When the IRS announced its view that section 4371(3) applies on each successive transfer of a reinsured US risk to foreign retrocessionnaires, many in the offshore industry objected to this new interpretation of the law. Validus Re, a Bermuda reinsurer, challenged that interpretation in court in the only way available to it: Validus paid the FET on transactions in which it retroceded to foreign retrocessionnaires certain US risks that Validus had assumed from US insurers. Validus then filed a claim for a refund and then sued for that refund in federal district court when the IRS failed to act on that claim.

The district court treated the case as a simple matter of statutory construction. The court stated that section 4371(3) applies to "reinsurance," and that the transactions on which Validus paid the FET were "retrocessions," that is, reinsurance of reinsurance, and that because section 4371(3) did not apply to "retrocessions," Validus did not owe FET.1

The government appealed the case to the DC Circuit Court of Appeals. The appellate court found the language of section 4371(3) "ambiguous with regard to wholly foreign retrocessions," that is, retrocessions from a foreign reinsurer such as Validus to a foreign retrocessionnaire.

The appellate court resolved this ambiguity against the government because of the presumption against extraterritoriality. The appellate court referred to US Supreme Court cases for the "longstanding principal of American law 'that legislation of Congress, unless a contrary intent appears, is meant to apply only within the territorial jurisdiction of the United States.'" The appellate court ruled that the government's interpretation of section 4371(3) is plausible, but "plausibility does not rebut the presumption against extraterritoriality."

The appellate court also rejected the government's argument that the IRS's interpretation of the statute is entitled to judicial deference. The court ruled that the doctrine of judicial deference to administrative agencies "requires some indication that the agency has considered the effect of the presumption against extraterritoriality." In this case, the government did not show that it had considered the effect of the presumption against extraterritoriality in Revenue Ruling 2008-15 or other administrative rulings on which it had relied.

It is too early to tell whether the government will appeal this decision to the Supreme Court. Unless it does so, the "cascading" theory of FET in foreign-to-foreign retrocessions is effectively dead. Many foreign reinsurance companies in a position similar to Validus have for several years been paying FET and immediately filing administrative claims for a refund. It is likely that many of those foreign reinsurers will press the IRS to process those claims in the wake of the Validus decision. Because foreign reinsurers would be able to sue for refund in the federal district court in Washington DC, a court which is obligated to follow the decisions of the DC Circuit Court of Appeals, the IRS will have no basis to resist suits for refunds of those taxes paid unless the government convinces the Supreme Court to reverse the opinion of the DC Circuit Court of Appeals.

1 Validus Reinsurance Limited v. United States, 19 F. Supp. 3d 225 (D.D.C. 2014).

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