United States: 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" insurance risks, without explicitly stating whether a foreign-to-foreign retrocessional agreement would also be subject to the FET.

Facts and Holding

Validus Reinsurance, a foreign reinsurer, entered into a retrocessional agreement with another foreign reinsurer. The IRS determined Validus Reinsurance was liable for Section 4371's FET and assessed $326,340 in excise tax against the company together with $109,040 in accumulated interest. Validus Reinsurance paid the FET and filed suit in the D.C. District Court for a tax refund.

Before the D.C. District Court, Validus Reinsurance argued that Sections 4371 and 4372 did not apply beyond the level of original reinsurance contracts and thus could not apply to retrocessional agreements. The United States Government, however, maintained that the plain language of the statutes also extended to retrocession "policies." It argued that as long as the property or insured risk was located or resident in the United States, Section 4371's FET should apply to each reinsurance and retrocession. The IRS had previously set forth its position on the cascading effect of the FET in Revenue Ruling 2008-15,⁹ and before the D.C. District Court, the Government adhered to this position, stating that, absent a tax treaty, foreign-to-foreign reinsurance and retrocession agreements were subject to the FET.

The District Court, however, agreed with Validus Reinsurance. The presiding judge, Judge Jackson, found the statute "clearly" only applied to reinsurance and could not extend to any purchase of retrocessional protection.¹⁰ Consequently, she granted summary judgment against the Government.

The Government appealed the District Court's decision to the D.C. Circuit Court. The D.C. Circuit Court upheld Judge Jackson's decision, but it disagreed with her reasoning. Although the D.C. Circuit Court found the statute did not explicitly exclude retrocession transactions, it held the statute was ambiguous. That is, Section 4371, standing alone, seemed to extend the FET to insurance and reinsurance contracts "anywhere in the world."¹¹ The D.C. Circuit Court was unclear, however, about the scope of Section 4371 when viewed in conjunction with Section 4372. Section 4372 defines a "policy" of "reinsurance" as a contract made with respect to the risks covered by insurance policies. Before the D.C. Circuit Court, the Government and Validus Reinsurance gave competing arguments on the meaning of "to cover." The Government argued that the term "to cover" applied to all contracts of reinsurance issued with respect to U.S.-based risks (including retrocessions). Validus Reinsurance maintained "to cover" only applied to a contract of reinsurance directly indemnifying the original insurance contract's risk, not to all subsequent hedges. Because both parties offered plausible interpretations of the statute, the court concluded the text was ambiguous.

The D.C. Circuit Court resolved this ambiguity by applying a presumption against extraterritoriality. This presumption rests on a "longstanding principle of American law" that United States laws only apply within the territory of the United States, unless Congress explicitly states otherwise.¹²

The Supreme Court emphasized the importance of this presumption in Morrison v. National Australia Bank, a 2010 case involving the Securities Exchange Act (the "Act").¹³ In Morrison, the Supreme Court held the Act's definition of "interstate commerce" was insufficient to rebut the presumption against extraterritoriality, because the Act did not include an "affirmative intention" clearly expressed by Congress to give the statute extraterritorial effect.¹⁴ Justice Scalia, writing the majority opinion in Morrison, noted that the Circuits had repeatedly disregarded the presumption against extraterritoriality as it applied to the Act. The Second Circuit, in particular, relied on Congressional intent to apply extraterritorially despite the lack of clear statutory language suggesting this application. Although Morrison's holding centered on the Act, the Court highlighted the importance of applying "the presumption in all cases, preserving a stable background against which Congress can legislate with predictable effects."¹⁵

The D.C. Circuit Court in Validus applied Morrison's reasoning, stating that because Congress had not given clear indication that Sections 4371 and 4372 applied extraterritorially, the statutes must be presumed to apply only within the U.S. territorial jurisdiction. Otherwise, Section 4371 would allow the cascading tax to "compound into perpetuity with the creation of every new reinsurance contract" despite the absence of a contractual relationship with any U.S. entity.¹⁶ In its holding, the D.C. Circuit Court relied on this presumption and found for Validus Reinsurance.

Remaining Questions

Based on the D.C. Circuit Court's opinion, will the presumption against extraterritoriality apply only when there is ambiguity?

In Validus, the D.C. Circuit Court found that each party offered "plausible interpretations" for whether the statutory text applied to wholly foreign retrocessions.¹⁷ Consequently, the D.C. Circuit Court applied the presumption against extraterritoriality to resolve the ambiguity. Morrison, however, implied the presumption was to be used in all circumstances – regardless of ambiguity. The Supreme Court emphasized the need for an "affirmative intention" of Congress to apply a statute extraterritorially,¹⁸ but the D.C. Circuit Court only used the presumption to resolve the "statutory ambiguity."¹⁹ Will the D.C. Circuit now only apply this presumption when a statute is ambiguous?

Does the D.C. Circuit Court's holding apply to reinsurance contracts?

The D.C. Circuit Court's opinion in Validus does not address whether the holding also applies to foreign-to-foreign reinsurance contracts – stating only that the statute is ambiguous "with regard to its application to wholly foreign retrocessions" (emphasis added).²⁰ Because the court did not explicitly apply its reasoning to foreign reinsurance contracts, it is uncertain whether the FET, as applied to wholly foreign reinsurance contracts, is also invalid.

It is possible that courts will interpret Validus as only invalidating Section 4371's FET on the premiums paid by a foreign reinsurance company that purchased a retrocession policy from another foreign reinsurer to hedge against its U.S.-based risk. If that were the case, the IRS could still apply Section 4371's FET to the premiums paid by a foreign insurance company purchasing original reinsurance from a foreign reinsurance company to hedge against its U.S.-based risk. However, courts might instead view Validus as holding that the presumption against extraterritoriality applies in all Section 4371 cases. In such circumstance, District Courts in the D.C. circuit most likely would find Section 4371's FET does not apply to premium payments on foreign-to-foreign original reinsurance contracts.

How did the D.C. Circuit Court have jurisdiction over the Validus Reinsurance case?

Taxpayers must follow procedural requirements to file a tax refund claim against the U.S. Government. The D.C. Circuit Court's opinion, however, does not clearly state how the D.C. Circuit had jurisdiction in Validus. Although we have not been able to determine the exact facts in this regard, the procedural statutes and the appellate briefs suggest that Validus Reinsurance was able to file its refund claim in Washington, D.C. because the company did not originally file an excise tax return.

Sections 1346 and 1402 of Title 28 state that the U.S. District Courts and U.S. Court of Federal Claims have original jurisdiction over any civil action filed against the U.S. Government for the recovery of federal taxes.²¹ If a corporation chooses to file a civil action with respect to a U.S. tax return in a District Court, the corporation must file in the U.S. judicial district in which the corporation has its principal place of business or principal office.²² If the corporation does not have a principal place of business or principal office in any U.S. judicial district, it must file the claim in the judicial district where the corporation filed the tax return in respect of which the claim was made.²³ If the corporation had never filed a return, the civil action may be prosecuted in the D.C. District Court.²⁴

Validus Reinsurance was a foreign corporation without a principal place of business in any U.S. judicial district. Had the company filed an excise tax return, the return should have been filed in Ohio.²⁵ These facts, in conjunction with Sections 1346 and 1402 of Title 28, suggest the D.C. Circuit Court had jurisdiction because Validus Reinsurance did not originally file an excise tax return and that it only paid the FET on the relevant contract once the IRS assessed Validus Reinsurance for taxes due. As a result, under Section 1402 of Title 28, Validus Reinsurance was able to argue its case in the D.C. Circuit.

Although the procedural posture of this case was somewhat unusual, in order to assess the binding effect of Validus, it is important to understand how Validus Reinsurance was able to argue in front of the D.C. Circuit. Although the Government cannot choose the jurisdiction in which it will argue future cases, if another company is forced to file a federal tax refund in another U.S. judicial district, the Government may have another opportunity to argue for Section 4371's application on foreign-to-foreign retrocessions. The Government may also be able to argue its case in front of the U.S. Supreme Court if the Court grants a writ of certiorari. At this point, the Government has not filed a petition for a writ of certiorari, but it has until August 24, 2015 to do so.

Footnotes

1. Validus Reinsurance, Ltd. v. United States, 786 F.3d 1039 (D.C. Cir. 2015).

.2 All "Section" references are to the Internal Revenue Code of 1986, as amended.

3. The reinsurance may be indemnity reinsurance or assumption reinsurance; the latter is similar to a novation.

4. Section 4371, in full, provides:

5. Section 4372 – Definitions

6. Treas. Reg. § 46.4374-1(c).

7. See id.

8. Validus Reinsurance, Ltd. v. United States, 786 F.3d 1039, 1043 (D.C. Cir. 2015) (citing H.R. Rep. No. 77-2333, at 61).

9. Rev. Rul. 2008-15, I.R.B. 2008-12.

10. Validus Reinsurance, Ltd. v. United States, 19 F. Supp. 3d 225, 227 (D.D.C. 2014).

11. Validus Reinsurance, Ltd., 786 F.3d at 1043.

12. See id. at 1045 (citing EEOC v. Arabian Am. Oil Co., 499 U.S. 244, 248 (1991) (internal citations omitted)).

13. Morrison v. National Australia Bank, 561 U.S. 247 (2010).

14. Id. at 255.

15. Morrison, 561 U.S. at 248.

16. Validus Reinsurance, Ltd. v. United States, 786 F.3d 1039, 1044 (D.C. Cir. 2015).

17. See id. at 1041.

18. Morrison, 561 U.S. at 255.

19. Validus Reinsurance, Ltd, 786 F.3d at 1045.

20. See id.

21. See 28 U.S.C.A. § 1346; 28 U.S.C.A. § 1402.

22. See 28 U.S.C.A. § 1402.

23. See id.

24. See id.

25. IRS Instructions for Form 720, Quarterly Federal Excise Tax return (2015).

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