A three-judge panel of the D.C Circuit Court is in the process of deciding on whether the 1% IRC § 4371 foreign excise tax (FET) applies to retrocession transactions between foreign entities. The Court heard oral arguments on February 20 in Validus Reinsurance Ltd. v. United States (No. 14-5081) to determine whether to uphold the district court’s holding that the IRC § 4371(3) FET does not apply to retrocession transactions.

Under a retrocession agreement, a reinsurer transfers risk it has reinsured to another reinsurer. In other words, retrocession occurs when a reinsurer buys insurance from another reinsurance company to protect itself from claims. Validus involves a foreign reinsurance company, Validus Ltd., which sells reinsurance policies to other insurance companies and in turn buys reinsurance for a portion of its potential liabilities under the reinsurance contracts it sells. The IRS assessed a $326,340 FET against Validus, arguing that under Treas. Reg. § 46.4371-2(c), section 4371(3) imposes FET upon each policy of reinsurance, which would include retrocession agreements. The district court disagreed with this interpretation by stating that the statute does not mention retrocessions and only applies to reinsurance policies. Rather than considering retrocessions a type of reinsurance agreement, the court held it to be a completely different type of insurance.

The district court did not nullify Rev. Rul. 2008-15, which says that the FET applies to reinsurance premiums paid by one foreign reinsurer to another foreign reinsurer, unless a specific treaty applies. While the court ruled § 4371(3) does not apply to retrocession agreements, it did not address whether the FET could be imposed on a foreign reinsurer purchasing reinsurance from another reinsurer, when both are foreign entities with no U.S. activities. The appellate court will have to go further than the district court to determine whether the FET applies to foreign activities. A favorable ruling for Validus would likely benefit foreign reinsurance companies with retrocessional agreements by exempting them from the FET.

For more information on FET and other emerging international tax issues, please contact alliantNational, alliantgroup’s national practice, for further guidance. Contact us today to learn how your business can benefit from alliantgroup’s tax consulting services.