SOURCE: Foreign Insurance Excise Tax - Audit Technique Guide, April 2008, as found at http://www.irs.gov/businesses/small/art ... 63,00.html NOTE: This document is not an official pronouncement of the law or the position of the Service and can not be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Chapter 7 - Cascading Insurance
Internal Revenue Code Section 4371 imposes a tax of 1 cent on each dollar or fractional part thereof of the premium paid on a policy of reinsurance. Therefore, as long as the underlying risk insured is a United States risk, the tax on reinsurance may be imposed on premiums paid to a reinsurer residing in a taxable foreign country. The issue of cascading takes the above definition one-step further by applying the reinsurance excise tax to each instance of taxable reinsurance.
The Issue of Cascading
An insured pays a premium to a foreign insurance company for either direct insurance or reinsurance, where the initial premium payment is subject to tax. The foreign insurer then reinsures all or part of the risk with another taxable foreign insurance company. In turn, that foreign insurer may reinsure with yet another taxable foreign insurer.
Example: Domestic Corporation A insured its casualty risks located in the United States with Foreign Insurer B, who is a taxable insurer. Foreign Insurer B in turn, reinsured the same risks with Foreign Reinsurer C, a taxable reinsurer. Foreign Reinsurer C reinsured these same risks again with Foreign Reinsurer D, who is also a taxable reinsurer.
In this case, the premiums paid from Domestic Corporation A to Foreign Insurer B would be subject to the 4% tax rate on casualty insurance. The premiums reinsured from Foreign Insurer B to Foreign Insurer C would be subject to the 1% tax rate on reinsurance. In addition, the premiums reinsured from Foreign Insurer C to Foreign Insurer D would also be subject to the 1% tax rate on reinsurance.
The issue is whether each of the transactions of reinsurance, subsequent to the initial taxable premium payment, is subject to the 1% foreign insurance tax. In general, each level of reinsurance with a taxable foreign reinsurer is a taxable event for imposition of the 1% excise tax on the foreign reinsurance. For the tax to be imposed, the insurance must be on a United States risk, the reinsurer must reside in a foreign country, and the reinsurer must not have a valid exemption from the excise tax as discussed in Chapter 5.
As can be expected, the insurance industry does not agree with the imposition of the tax each time a taxable transaction occurs. The remainder of this chapter will review both sides of the controversy as well as present scenarios where imposition and assessment of the tax will be applicable.
Position of the Internal Revenue Service
Revenue Ruling 2008-15
Revenue Ruling 2008-15 directly addresses the issue of cascading foreign insurance excise tax as it applies to foreign insurers and foreign reinsurers. Rev. Rul. 2008-15 contains the following four scenarios:
(1) A non-U.S. insurance company, incorporated in a country that has no income tax treaty with the United States, issues direct insurance policies to a U.S. corporation with respect to risks located wholly or partly within the United States. The non-U.S. insurer then purchases reinsurance, covering all or part of the loss that the non-U.S. insurer may sustain on its policies issued to the U.S. corporation, from a non-U.S. reinsurer that is incorporated in a country that has a U.S. income tax treaty that does not contain an FET waiver. Neither the non-U.S. insurer nor the reinsurer is engaged in a U.S. trade or business. Rev. Rul. 2008-15 holds that the FET will apply to (a) the premium paid by the U.S. corporation to the non-U.S. insurer (the 1st leg FET) at a 4% rate and (b) the premium paid by the non-U.S. insurer to the non-U.S. reinsurer (the 2nd leg FET) at a 1% rate.
The Non-US insurer then reinsures the US risk to another Non US reinsurer that has no FET waiver. The premium paid in this second leg is subject to 1% FET
(2) A non-U.S. reinsurance company, incorporated in a country that has a U.S. income tax treaty that does not contain an FET waiver, issues reinsurance policies to a U.S. insurer with respect to policies the U.S. insurer has issued to insureds (as defined in section 4372(d)), i.e., that cover U.S. risks. The non-U.S. reinsurer then cedes some or all of those risks to another non-U.S. reinsurance company, incorporated in a different country that has a U.S. income tax treaty that does not contain an FET waiver. Rev. Rul. 2008-15 holds that the FET will apply to (a) the premium paid by the U.S. insurer to the first non-U.S. reinsurer at a 1% rate and (b) the premium paid by the first non-U.S. reinsurer to the second non-U.S. reinsurer at a 1% rate.
(3) A non-U.S. insurance company, entitled to the benefits of a U.S. income tax treaty containing a qualified FET waiver issues direct insurance policies to a U.S. corporation with respect to risks located wholly or partly within the United States. The non-U.S. insurer then purchases reinsurance, covering all or part of the loss that the non-U.S. insurer may sustain on its policies issued to the U.S. corporation, from a non-U.S. reinsurer that is incorporated in a country that has a U.S. income tax treaty that does not contain an FET waiver. Neither the non-U.S. insurer nor the reinsurer is engaged in a U.S. trade or business. Since the anti-conduit provision of the qualified FET waiver was violated by the first non-U.S. insurance company with the reinsurance of the U.S. risks to the second non-U.S. reinsurer, the premium paid by the U.S. corporation to the first non-U.S. insurer is subject to excise tax. Rev. Rul. 2008-15 holds that the FET will apply to (a) the premium paid by the U.S. corporation to the non-U.S. insurer (the 1st leg FET) at a 4% rate and (b) the premium paid by the non-U.S. insurer to the non-U.S. reinsurer (the 2nd leg FET) at a 1% rate.
(4) A non-U.S. insurance company, entitled to the benefits of a U.S. income tax treaty containing an FET waiver subject to a conduit arrangement limitation issues direct insurance policies to a U.S. corporation with respect to risks located wholly or partly within the United States. The non-U.S. insurer then purchases reinsurance, covering all or part of the loss that the non-U.S. insurer may sustain on its policies issued to the U.S. corporation, from a non-U.S. reinsurer that is incorporated in a country that has a U.S. income tax treaty that does not contain an FET waiver. Neither the non-U.S. insurer nor the reinsurer is engaged in a U.S. trade or business, and it is assumed that the non-U.S. insurer has not issued the policies to the U.S. corporation as part of a conduit arrangement. Rev. Rul. 2008-15 Revenue Ruling holds that the FET (a) will not apply to the premium paid by the U.S. corporation to the non-U.S. insurer, but (b) will apply to the premium paid by the non-U.S. insurer to the non-U.S. reinsurer (the 2nd leg FET) at a 1% rate.
It should be noted that the cascading effect of the FET is not limited to the 1st and 2nd legs, but continues with each subsequent retrocession involving underlying U.S. risks.
Voluntary Compliance Initiative
In connection with Revenue Ruling 2008-15, Announcement 2008-18 lays out a voluntary compliance initiative regarding the 2nd leg FET. Pursuant to the Announcement, with respect to those taxpayers otherwise complying with this procedure, the IRS will not examine issues arising under the situations described in Revenue Ruling 2008-15 in respect of premiums paid from one non-U.S. insurer to another non-U.S. reinsurer before October 1, 2008. For these purposes, all premiums relating to a U.S. risk will be treated as received on or after October 1, 2008, if any transaction described in Revenue Ruling 2008-15 occurs with respect to such risk on or after such date.
To participate in the initiative, an eligible non-U.S. person must timely file an applicable Form 720 return and pay any FET due with respect to premiums paid or received on or after October 1, 2008, or timely disclose that it is claiming a treaty-based return position that it is entitled to an exemption with respect to such premiums. The top of such Form 720 must bear in red print the statement: “Election to participate in FET Voluntary Compliance Initiative pursuant to Announcement 2008-18.” If an eligible non-U.S. person is not otherwise required to file a Form 720 return with respect to this quarter, a blank Form 720 bearing the above legend must be filed to participate in the initiative. Participating non-U.S. persons are required to conform to the recordkeeping requirements of Treas. Reg. § 46.4371-4 with respect to premiums paid or received on or after October 1, 2008.
Persons eligible to participate in the initiative include any non-U.S. insurer or reinsurer or any other non-U.S. person liable for the FET that has failed to file timely one or more Form 720 returns and pay or remit any 2nd leg FET due or to timely disclose that it is claiming a treaty based return position that it is entitled to an exemption with respect to premiums paid or received during any quarterly tax period ending before October 1, 2008.
Failures of a non-U.S. person to file or pay the 1st leg FET will not fall within the scope of the initiative. More specifically, if a non-U.S. person that has entered into an FET closing agreement with the IRS fails to pay the 1st leg FET due on premiums it received covering U.S. risks as required under such agreement because either (i) the non-U.S. person is entitled to a qualified FET waiver and such non-U.S. person has reinsured the U.S. risks with an unprotected reinsurer or (ii) the non-U.S. person is entitled to an FET waiver subject to a conduit arrangement limitation and the policies underlying the U.S. risks were entered into by the non-U.S. person as part of a conduit arrangement, such failures will not be covered by the initiative.
Prior Sources of Support for the Cascading Theory
There are three prior sources which support the position that cascading of premiums is subject to the reinsurance excise tax. The sources are discussed in detail and are as follows:
Technical Advice Memorandum 9621001, December 18, 1995
United States v. Northumberland Insurance Co, Ltd, 521 F. Supp. 70 (D. N.J. 1981)
Revenue Ruling 58-612, 1958-2 C.B. 850
Technical Advice Memorandum 9621001
The current position of the Internal Revenue Service is contained in Technical Advice Memorandum 9621001. While this TAM may not be used or cited as precedent, pursuant to I.R.C. § 6110(k)(3), it is a useful source of reference on the issue of cascading tax. The TAM discusses whether reinsurance premiums paid by a foreign insurer to other foreign insurers on U.S. risks are subject to the 1% excise tax on reinsurance. The TAM concerns premiums paid from Corporation A, a domestic company, to Foreign Insurer E, located in Bermuda. Foreign Insurer E subsequently reinsured the risks with other taxable foreign insurers. The premium payment from Corporation A to Foreign Insurer E is subject to the 4% excise tax for direct insurance.
The TAM held that the 1% tax did apply to the reinsured premiums ceded from Foreign Insurer E to the other foreign insurers. However, the TAM noted that the tax must be collected from Foreign Insurer E, since Foreign Insurer E is the entity for whose use or benefit the reinsurance policy was obtained.
United States v. Northumberland Insurance Co, Ltd.
The holding in TAM 9621001 is based, in part, on the case of Northumberland Insurance Co, Ltd. Northumberland, an Australian insurance company was licensed only as a surplus lines insurer in New Jersey. It was not licensed to perform general insurance business within the United States. Northumberland reinsured a portion of its risk with a Swiss insurance company also not licensed to do business in the United States.
The Service asserted the 1% reinsurance tax on the premiums ceded by Northumberland to the Swiss insurance company. Northumberland objected, noting the following reasons:
It did not qualify as an "insured" under IRC Section 4372(d), and
The assessment would result in multiple taxation on the same risk, a consequence Congress could not have intended.
The Court determined the following:
Northumberland did not have to qualify as an insured so long as the underlying primary policies were issued to insureds.
Northumberland did qualify as an insured because it was a foreign corporation engaged in a trade or business in the United States. NOTE: The judge differentiated between "authorized to do business" per § 4373(1) and "engaged in a trade or business" per § 4372(d).
Internal Revenue Code § 4371 imposes the tax for reinsurance on each policy of reinsurance issued by foreign reinsurers.
Reimposing the excise tax on the underlying premiums accords with the aforementioned legislative intent, namely, eliminating the competitive advantage afforded foreign insurance companies.
Revenue Ruling 58-612
Revenue Ruling 58-612 also supports the cascading theory. The ruling holds, "a policy of reinsurance issued by a foreign insurer covering [a risk subject to tax under Section 4371(1) or (2)] is subject to the tax imposed on reinsurance policies by Section 4373(3), regardless of whether the primary insurer was a domestic or foreign insurer."
The ruling involved a policy issued by a domestic insurer which in turn, is reinsured with a foreign insurer. Using the wording of the ruling, when a foreign insurer insured a United States risk giving rise to tax under § 4371(1) or (2), and then reinsures the risk with another foreign insurer, the reinsurance would be taxable under § 4371(3). Therefore, a cascading of the tax has occurred.
The industry's position is that the doctrine of cascading was invalidated by the case of SDI Netherlands B.V. v. Commissioner, 107 TC 161 (1996). Although that case involves royalties, as opposed to insurance premiums, the industry believes the same logic applies.
The SDI case involved royalties paid from a U.S. company to a Netherlands company (SDI Netherlands), which were combined with other, non-U.S. royalties. The total royalties were then paid to a Bermuda company (SDI Bermuda). The IRS argued that the royalties paid from SDI Netherlands to SDI Bermuda retained their character as "U.S. sourced income" and were subject to withholding under IRC §§ 1441 and 1442.
SDI Netherlands, on the other hand, argued that its payments to SDI Bermuda were made on a separate and independent basis pursuant to a worldwide licensing agreement between two foreign corporations, and therefore did not constitute U.S. sourced income.
The Tax Court found that the royalties from SDI Netherlands to SDI Bermuda were separate payments and not U.S. sourced income. With regards to the cascading issue, the decision states:
We find support for our conclusion herein that respondent's view of the law could cause a cascading royalty problem, wherein multiple withholding taxes could be paid on the same royalty payment as it is transferred up a chain of licensors.… We are not disposed to conclude, in the absence of any legislative expression on the subject, that Congress intended the statutory provisions to permit “cascading” with the question of relief left to the mercy of the respondent.
Who is the Taxpayer?
As discussed in Chapter 3, the liability for the foreign insurance excise tax is joint and several. The tax may be imposed on the insured, the policyholder, the insurance company, or the broker. The problem with cascading tax arises when tax would be imposed on a foreign entity. When reinsurance occurs, a new “contract” is created. Thus, the original domestic entity is replaced by the foreign insurer. The foreign insurer is now the policyholder and the insured on the new contract. The original foreign insurer is replaced by the reinsurer as the insurance company.
Practical Situations with Cascading
As a practical matter, the tax due on cascading premiums will be difficult to detect and collect from a foreign entity. However, the greatest opportunity for the detection and development of this issue will occur in the following situations:
The insurer or reinsurer is a related entity of a United States entity. An example of such an insurer, would be a captive insurance company.
The insurer or reinsurer is a resident of a qualified treaty country and has violated the anti-conduit provision of such treaty. In this case, the tax can be obtained via the letter of credit with a closing agreement filed by the insurer with the United States.
The insurer or reinsurer has made and received an election to be treated as a United States entity for purposes of income tax. An example would be an election under § 953(c) or (d).
A foreign insurer or reinsurer is under examination by an International Excise Agent who is able to request and review the foreign insurer or reinsurer’s reinsurance activities.