A Matter Of Semantics: Validus Reinsurance Invalidates Foreign-To-Foreign Withholding

Keywords: Validus Reinsurance, federal excise tax, FDAP income, FATCA

President Bill Clinton famously attempted to come to terms with the meaning of the verb "is" when he was caught engaging in hanky-panky at the White House: "It depends on what the meaning of the word 'is' is. If the--if he--if 'is' means is and never has been, that is not--that is one thing. If it means there is none, that was a completely true statement."1 Not to be outdone, albeit over 10 years later, the Federal Court of Appeals for the District of Columbia in Validus Reinsurance, Ltd. v. United States,2 struggled for the better part of 19 pages over the definition of the word "cover." The court, much like our 42nd President, ultimately decided that linguistic contortions did not provide a basis for parsing through the intricacies of a particularly delicate situation. The Federal Court of Appeals instead annulled the application of the federal excise tax on reinsurance imposed by Code § 43713 on a foreign-to-foreign retrocession transaction on the ground that the statute did not have an extraterritorial reach. While the decision on its face appears to be of interest only to tax practitioners in a fairly obscure corner of cross-border insurance transactions and to linguists, the holding could reverberate across a wide swath of withholding issues.

1. Background on the Insurance Excise Tax

   Code § 4371(1) imposes a four percent (4%) excise tax on the premiums paid to a foreign insurer on a policy of casualty insurance or an indemnity bond by either (i) a U.S. corporation or (ii) a foreign corporation engaged in a trade or business in the United States with respect to insurance or indemnity bond protecting against hazards, risks, losses or liabilities within the United States. For this purpose, a policy of casualty insurance means "any policy or other instrument by whatever name called whereby a contract of insurance is made."4 An indemnity bond is "any instrument by whatever named called whereby an obligation of the nature of an indemnity, fidelity or surety bond is made."5 Code § 4371(3) imposes a one percent (1%) excise tax on reinsurance of a casualty insurance policy or indemnity bond described above. The excise tax does not apply to the extent that the premium paid to the foreign insurer is effectively connected with the conduct of a U.S. trade or business by the insurer (unless the premium is exempted from U.S. tax pursuant to an income tax treaty).6

   The excise tax is a transaction tax and is payable by "any person who makes, signs, issues, or sells any of the documents and instruments subject to the tax, or for whose use or benefit the same are made, signed, issued or sold."7 The liability to pay the tax arises when the insurance or indemnity bond premium is paid.8 In addition to the normal penalties for a failure to pay the tax, a person who fails to file an excise tax return and remit the tax "with intent to evade the tax" is liable for a penalty equal to double the tax itself.9

2. Cascading Imposition of Tax

   The federal excise tax is said to "cascade" when it is imposed more than once on the same transaction. For example, assume that a U.S. insurer reinsures a U.S. risk with a non-U.S. reinsurer ("X") that is not engaged in the conduct of a U.S. trade or business. The reinsurance would be subject to the one percent excise tax imposed by Code § 4371(3). Suppose further that X then retrocedes all or a portion of the risk to another non-U.S. insurer ("Y"). (The insuring of a reinsurer is referred to as retrocession, not reinsurance.) If the retrocession of the risk by X to Y, a foreign-to-foreign transaction, is also subject to the excise tax imposed by Code § 4371(3), the tax is said to "cascade," that is, the tax applies to each transaction in which the U.S. risk is further reinsured.

   Until the decision in Validus, supra, it was generally believed that the excise taxes on insurance, reinsurance and retrocession premiums could cascade, that is, be imposed on the laying off of the same risk via reinsurance and retrocession. In U.S. v. Northumberland Insurance Co., Ltd.,10 Northumberland, an Australian insurance company that was not doing business in the U.S., reinsured and retroceded U.S. risks. Northumberland entered into a reinsurance and retrocession agreement with a Swiss reinsurance company, AIM Reinsurance Co., Ltd. ("AIM Re"). Like Northumberland, AIM Re did not do business in the U.S. Northumberland retroceded almost 100% of the U.S.-based reinsurance that it wrote, to AIM Re. Some of the risks that Northumberland ceded to AIM Re initially had been written by foreign insurance companies and assumed through retrocession by Northumberland. The opinion states that the insurance excise tax was paid on the reinsurance premiums paid to Northumberland by those foreign insurance companies.11 Northumberland did not report or pay excise tax on the reinsurance premiums that it paid to AIM Re from 1971 through 1973 because it had been advised that the excise tax did not apply to foreign-to-foreign transactions. The IRS disagreed and assessed excise tax on the reinsurance premiums that Northumberland paid to AIM Re.

   The court rejected Northumberland's argument and focused on the definition of an insured. For purposes of the excise tax, an insured is any person, domestic or foreign, that insures a risk located in the United States.12 Once the transactions related to an insured (directly or through reinsurance or retrocession), the court reasoned that the excise tax was applicable:

   There is no requirement that a reinsured qualify as an insured to be subject to the excise tax, so long as the underlying primary policies were issued to "insureds" under section 4372(d).13

   Thus, the excise tax on policies of reinsurance and retrocession applied even though the "reinsured" was a foreign entity that was not engaged in a U.S. trade or business, since the underlying policy was issued to an "insured" as defined in Code § 4372(d).14

   Northumberland also argued that the excise tax did not apply to its reinsurance contract with AIM Re because the excise tax was previously imposed on the policies of reinsurance issued by Northumberland on the same underlying risks. In other words, the taxpayer set up cascading as a defense to the imposition of the excise tax. The court rejected this argument as follows:

   To the contrary, the plain language of section 4371 states that the tax is to be imposed on "each" policy of reinsurance issued by any foreign insurer . . . It applies to policies of reinsurance issued by a foreign insurer "to any person."15

   As to imposing the reinsurance tax a second time, the court explained, that:

   Reimposing the excise tax on the underlying premium accords with the . . . legislative intent, namely, eliminating the competitive advantage afforded foreign insurance companies. In the first instance, the excise tax was withheld from the premiums ceded by the direct insurers to Northumberland as reinsurer. This served to equalize Northumberland's position as a foreign reinsurer. In the second instance, the tax was imposed on the premiums as transferred to AIM Re as a separate foreign reinsurer. . . . Imposition of the tax to this transaction thus serves to further the legislative policy.16

   Thus, the court held that the reinsurance premium paid by Northumberland, a foreign reinsurer, to AIM Re, another foreign reinsurer, was subject to the one percent reinsurance excise tax imposed under Code § 4371(3).

3. The Facts and Holding of Validus

   The facts presented in Validus were not complex. In Validus, supra, the taxpayer was a Bermuda reinsurance company that was not engaged in the conduct of a trade or business in the United States. It reinsured U.S. risks written by a U.S. insurance company. The taxpayer itself obtained reinsurance of these assumed risks in a typical retrocession transaction, that is, the taxpayer purchased a retrocession policy under which it would receive payments if it was called upon to make payment under the initial reinsurance policies. Validus purchased the retrocession policies from other insurers not engaged in the conduct of a trade or business in the United States. If the holding of Northumberland, supra, applied to the retrocession policies, the federal excise tax on reinsurance would have applied to Validus' purchase of retrocession.

   The issue before the court was whether the excise tax on reinsurance applied to retrocessions. The trial court found that the excise tax only applied to reinsurance, not retrocessions. The trial court held that it was bound "to follow the plain language of the statute" and since the statute did not specifically impose the excise tax on retrocessions...