D.C. Circuit Court Rules Sec. 4371 Federal Excise Tax Does Not Apply To Foreign-To-Foreign Retrocessions

Article by Micah W. Bloomfield, Anthony J. Distinti, and Danielle E. Augustson (Summer Associate)

On May 26, 2015, the D.C. Circuit Court held in Validus Reinsurance, Ltd. v. United States1 that the federal excise tax ("FET") under Section 4371 of the Internal Revenue Code2 does not apply to foreign-to-foreign retrocessions. This decision will, unless the issue gets to the Supreme Court, have significant implications for the U.S. taxation of retrocession transactions between foreign (i.e., non-U.S.) parties. Nevertheless, as explained further below, the D.C. Circuit Court left many questions unanswered.

Background

The Validus case arose out of retrocessional protection purchased by Validus Reinsurance, Ltd. ("Validus Reinsurance"). The case addressed questions regarding the United States' ability to tax premiums retroceded by Validus Reinsurance under this agreement. Retrocession is the reinsurance of risks that were assumed by way of reinsurance. For example, assume Company A has issued a life insurance policy. Company A can enter into a reinsurance agreement with Company B, under which Company B agrees to indemnify Company A for some or all of the amount Company A is obligated to pay under the life insurance policy in the event that the insured dies.3 Company B, in turn, could then enter into a retrocession agreement with Company C, ceding some of Company B's reinsurance risk to Company C. Hedging by means of reinsurance and retrocession agreements enables insurers and reinsurers to achieve a variety of financial and operational objectives.

The question addressed in Validus - whether the United States could tax premiums paid by the foreign company, Validus Reinsurance, under a retrocession agreement - revolved around two sections of the Internal Revenue Code. The first - Section 4371(3) - imposes, among other things, a one cent per dollar FET on the premiums paid on reinsurance agreements that are issued by foreign reinsurance companies and that "cover" certain contracts.4 These contracts include casualty and life insurance, indemnity bonds, sickness and accident policies, and annuity contracts.

The second is Section 4372, which defines "reinsurance" as a policy of insurance made with respect to another company's casualty and life insurance contracts, indemnity bonds, sickness and accident policies, and annuity contracts.5 The company obtaining the reinsurance protection and paying the premium to the foreign reinsurer is responsible for the FET.6 If the tax is not paid by the company obtaining the reinsurance, Section 4371's tax must be paid by the foreign reinsurer.7

Congress implemented the FET under Sections 4371 and 4372 to level the playing field between domestic and foreign insurance companies engaged in the business of reinsurance and retrocession. According to the Validus court, Congress believed that foreign insurance and reinsurance companies had a competitive advantage over domestic insurance and reinsurance companies because, unlike the domestic companies, foreign insurance and reinsurance companies not engaged in trade or business in the United States would not be subject to U.S. federal taxation on their income relating to the policies.8

Under Section 4371, it is clear the FET applies when a domestic insurer seeking to hedge against a U.S.-based risk pays premiums on policies of reinsurance issued by any foreign reinsurer. At issue in Validus was whether Congress also intended for the FET to apply to a foreign reinsurance company paying premiums on a retrocession policy issued by another foreign reinsurance company to hedge against a U.S.-based risk. As explained below, this question arose because Section 4372 broadly defines a "policy of reinsurance" as a contract that "covers"...