Validus Affirmed for All the Right Reasons – The FET Does Not Apply to Wholly Foreign Reinsurance Transactions

by Eversheds Sutherland (US) LLP

On May 26, the U.S. Court of Appeals for the District of Columbia affirmed the result of the U.S. District Court for the District of Columbia in Validus Reinsurance, Ltd. v. U.S., 19 F. Supp. 3d 225 (2014), which was the first case to involve a challenge to the Internal Revenue Service’s (IRS) “cascading” application of the federal excise tax (FET) to premiums paid by one foreign insurer or reinsurer to another foreign reinsurer in connection with insurance policies covering U.S. risks.  In reaching its decision, however, the Court of Appeals rejected the plain-language reasoning embraced by the District Court, and instead primarily relied on the presumption against extraterritorial application of a statute without clear Congressional intent. In so doing, the Court of Appeals effectively extended the impact of the District Court’s decision to apply to all wholly foreign reinsurance or retrocession transactions.

The Validus case arose as a result of Rev. Rul. 2008-15, in which the IRS concluded that the FET imposed by IRC section 4371 was applicable to premiums paid to any foreign insurance company with respect to insurance or reinsurance transactions covering U.S. risks. Under the IRS’s position, payments of premiums from one foreign insurance or reinsurance company to another foreign reinsurance company would be subject to the FET if the underlying risks are U.S. risks, regardless of how many times the risk was ceded or whether the ceding company had any other connection to the U.S.

Validus Reinsurance, Ltd. (Validus) is a foreign corporation that both purchases and sells reinsurance. The contracts at issue in Validus were reinsurance contracts that Validus had purchased to protect itself against losses it might incur on reinsurance contracts it had sold to U.S. insurers with respect to certain U.S. risks. During the years in question, neither Validus nor its retrocessionaires conducted business in the U.S. The IRS determined that the FET was applicable to these wholly foreign retrocession transactions. Validus paid the assessed tax and filed claims for refunds.

There were no factual disputes in Validus. The District Court decided the case on cross motions for summary judgment. Validus made a number of arguments as to why the FET should not apply to wholly foreign retrocessions, including arguing that (1) the plain language of the statute does not apply to retrocession transactions, (2) there is no clear evidence that Congress intended to tax wholly extraterritorial transactions, and (3) the FET must be construed to avoid violating international law.

The District Court granted Validus’ motion for summary judgment, agreeing that the FET does not apply to retrocessions. The District Court concluded that, although the FET applies to reinsurance contracts that are issued by foreign reinsurers and cover U.S. risks, the premiums at issue were paid for retrocession contracts, which are not encompassed by the operative provisions of IRC section 4371. In reaching its decision, the District Court rejected the IRS’s argument that, if Congress had intended to have an exception to the FET for retrocessions, the statute would have explicitly provided for the exception. The District Court did not address any of the other arguments raised by Validus, including the argument against the extraterritorial application of a statute without specific Congressional direction. The IRS appealed the decision of the District Court.

On appeal, the IRS argued that the District Court had misinterpreted the language of the statute and that, looking at the statute as a whole, section 4371 clearly was intended to apply to retrocession transactions, as well as to “regular” reinsurance transactions. The IRS also argued that Congress intended the FET to have extraterritorial application even in circumstances in which neither party to the retrocession transaction was doing business in the U.S. Validus continued to rely on the plain meaning of the statute and argued that retrocessions as compared to reinsurance were not covered by the statute. They also reiterated some of their earlier alternative arguments.

Sutherland filed an amicus curiae brief on behalf of the International Underwriting Association of London and the London & International Insurance Broker's Association. The amici argued that the District Court’s decision should be affirmed, but focused on the argument that the FET cannot be applied extraterritorially unless Congress clearly intended such application and that there was no evidence of such intent.

In affirming the decision of the District Court, the Court of Appeals essentially adopted the argument made by the amici.  After analyzing the plain language of IRC section 4371 and concluding that it was not determinative regarding the application of the FET to wholly foreign retrocession transactions, the Court of Appeals noted that a statute has no extraterritorial application unless there is clear Congressional intent to give the statute that effect. Inasmuch as neither the language of IRC section 4371 nor its legislative history give any indication that Congress intended to impose the FET on wholly foreign transactions, the Court of Appeals stated:  “Section 4371 is ambiguous with respect to its application to wholly foreign retrocessions. Neither the text, context, purpose, nor legislative history provide a clear indication of congressional intent to rebut the presumption against such expansive extraterritorial application.” Accordingly, it affirmed the District Court’s grant of Validus’ summary judgment motion, but on narrower grounds.

Sutherland Observation: Although the facts in Validus involved a retrocession transaction, the reasoning of the holding of the Court of Appeals clearly applies to any transaction in which a foreign insurer or reinsurer makes a premium payment to another foreign reinsurance company. All of such transactions appear to be exempt from the FET.

Sutherland Observation: In the Court of Appeals, the government argued that its guidance regarding the application of the FET (referring to Rev. Rul. 2008-15) was entitled to deference. The Court of Appeals declined to accord that revenue ruling deference because there was no evidence that the IRS had considered the presumption against extraterritoriality when it promulgated the revenue ruling. Query whether the court might have reached a different conclusion if the IRS had demonstrated that it had considered, but rejected, the presumption against extraterritorial application of the FET.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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