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Global Scale by Coletta Kemper When It Reigns, It Cascades

Sovereign calls for cascading excise taxes for foreign insurance and reinsurance policies on U.S. risks—and brokers could be left holding the bag.

By  Coletta Kemper

It’s often repeated that nothing’s certain in life except death and taxes. U.S. revenuers are leaving no stone unturned to find every bit of tax they believe is due them, even if it means stepping on the toes of U.S. trading partners.

You really can’t blame them. Their job is to fill the federal coffers so government can spend our hard-earned tax dollars. With the economy in turmoil, a huge deficit, an expensive war and the presidential hopefuls calling for tax cuts, you’d better believe every penny counts.

Of course, it’s better if the tax is so obscure and complicated that the average person isn’t aware of it. If it were a tax on gasoline or income, there would be a public outcry. And believe me, raising taxes in an election year is political suicide.

So who’s pocket is the IRS looking to pick? You guessed it—the insurance industry’s. In March, the IRS clarified that the Federal Excise Tax (FET) on foreign insurance and reinsurance policies is a “cascading tax.” In a nutshell that means the tax is not due just on the primary transaction covering a U.S. risk, but also could be due on subsequent reinsurance, retrocessions, etc.—as far as the risk is spun out.

The FET is not a new tax. IRS Code Sec. 4371 imposes a 4% tax on casualty policies and indemnity bonds issued by non-U.S. insurers and reinsurers. A 1% tax is levied on life and health policies as well as on reinsurance policies by foreign insurers. There are some exceptions. The FET does not apply to premiums that are connected with the conduct of a trade or business within the U.S. and subject to federal income tax.

The U.S. has a number of tax treaties with other countries that may exempt all or part of the tax along the reinsurance chain. But the treaties vary country to country on what’s exempt. The treaties don’t necessarily exempt the taxes on the cascading aspect of the taxation.

For example, the U.S.-British tax treaty waives the FET as long as the UK insurance or reinsurance policy issued for a U.S. risk isn’t part of a so-called conduit arrangement. Simply put, it is a conduit arrangement if it meets two tests: If all or substantially all of premium income from a policy is paid (directly or indirectly) to an entity in another jurisdiction that doesn’t have a similar (or better) tax treaty with the U.S.; and if the main purpose of the transaction is to avoid the tax.

A fronting arrangement that is run through the UK to an insurer in another country for the purpose of avoiding the FET is most likely not acceptable under the IRS scenario.

This is just one example where the FET is owed. There are numerous variations on this theme, which makes it fairly complicated to figure out.

The interpretation of “cascading” raises a number of sticky issues. The first is the question of whether non-facultative reinsurance and retrocessions really cover U.S. risks. Just figuring out what those cessions cover is mind-boggling.

Who pays the tax—the insurer, reinsurer or broker? According to the IRS, it can collect the FET from any party involved in the transaction, including someone outside the U.S. The IRS also believes it can levy fines on the U.S. assets of a non-U.S. company for non-payment.

What jurisdiction does the IRS have to collect taxes from a non-U.S. person? Cleverly, the IRS has set out a voluntary compliance scheme that explains how taxpayers can voluntarily comply with the cascading FET. By agreeing to the voluntary plan, companies are also agreeing to U.S. tax authority, albeit limited, even if they are outside U.S. borders.

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