Victory for the Taxpayer in Validus: District Court Holds that Federal Excise Tax Does Not Apply to Retrocessions

On February 5, the U.S. District Court for the District of Columbia issued its opinion in Validus Reinsurance, Ltd. v. United States, which is the first case to involve a challenge to the IRS’s position on the “cascading” application of the federal excise tax (FET) to reinsurance agreements covering U.S. insurance risks. In brief, the court held that, although the statute, IRC § 4371, authorizes the imposition of the FET on “reinsurance,” it does not do so with respect to “retrocessions,” and granted Validus’ motion for summary judgment. In so holding, the court reasoned that (i) “reinsurance” between an insurance company and a reinsurer is not the same as a “retrocession” in which a reinsurer purchases insurance from another reinsurer, and (ii) there is no mention of the taxation of retrocessions in IRC § 4371.

Background

On January 25, 2013, Bermuda-based Validus Reinsurance filed its tax refund suit in the U.S. District Court for the District of Columbia challenging the imposition of a “cascading” 1% FET under IRC § 4371(3) on premiums that it paid in connection with retrocession contracts that it entered into outside of the United States with other non-U.S. reinsurers where some or all of the underlying insurance risks were in the U.S. Cross-motions for summary judgment ultimately were filed in the case.

The Court’s Analysis

In its opinion, the court found it unnecessary to address any of the arguments made by the parties regarding extraterritoriality or Congressional intent with respect to the application of the FET. It also saw no need to address arguments raised about international law and the Due Process Clause of the Fifth Amendment to the Constitution. Rather, the court simply concluded that, under the plain language of IRC § 4371(3), a retrocession contract is not a “policy of reinsurance” to which the statute applies.

Sutherland Observations

1. The Validus opinion is a favorable development for reinsurance companies that have been subjected to the cascading application of the FET pursuant to the IRS’s position in Rev. Rul. 2008 15, 2008-12 I.R.B. 633. Although the case could be appealed to the U.S. Court of Appeals for the District of Columbia Circuit, the Validus opinion nonetheless could have an immediate impact on current IRS examinations and appeals involving the cascading application of the FET.

2. In view of the Validus opinion, companies that have paid the FET on a retrocession should consider filing protective claims for refund with the IRS before the applicable period of limitations expires, i.e., generally three years from the date that the original return was filed or two years from the date that the FET was paid, whichever is later. As relevant here, a protective claim for refund can be made by filing Form 720X (Amended Quarterly Federal Excise Tax Return) with the IRS.