Are taxpayers properly paying the federal foreign insurance excise tax?

With the globalization of the insurance market, U.S. risks are often insured by foreign insurance companies. When estimates of insured loss are calculated after a catastrophic event such as a hurricane, it is not unusual to find a significant portion of that loss is ultimately borne by foreign insurance companies. This generally happens through reinsurance contracts, by which an insurance company lays off risk to another insurance company. However, in today's world, buying insurance/reinsurance coverage from foreign insurance/reinsurance companies is not just the domain of insurers. Risk managers, such as manufacturers or those in the service industry, regularly arrange for some insurance coverage from a number of foreign insurance companies. Some businesses have also established domestic or foreign captive insurance companies, which in turn may be purchasing reinsurance from foreign insurance companies. Aside from the Federal income tax issues of these insurance arrangements, it is also important to understand that the premiums paid to a foreign insurer may be subject to Federal excise tax (FET) under Sec. 4371. Recent experience shows that the IRS has been looking closely at the issue of whether businesses have properly paid the tax.

Background

Sec. 4371 imposes a FET on certain premiums paid to a foreign insurer not engaged in a U.S. trade or business. The tax is imposed on the gross amount of the premium. In general, the liability is 4% of the premiums paid for casualty risks wholly or partly within the U.S., and 1% for a life, sickness or accident insurance policy, or an annuity contract on the life of, or hazards to, the person who is a U.S. citizen or resident. The rate is also 1% of the premium paid on a reinsurance policy (insurance purchased by an insurance company) covering those same risks. A premium payment includes any consideration paid for assuming and carrying the risk or obligation, and includes any additional assessment or charge paid under the insurance contract, whether payable in one sum or installments.

Who Is Liable for the Tax?

The FET must be paid by the person who makes the premium payment to the foreign insurer/reinsurer. Under Regs. Sec. 46.4374-1(b), the liability for the FET attaches when the premium payment is transferred to the foreign insurer or reinsurer (including transfers to any bank, trust fund or similar recipient, designated by the foreign insurer or reinsurer), or to any nonresident agent, solicitor or broker. However, if the tax is not paid by the person paying the premium to the foreign insurer/reinsurer, it must be paid by any person who makes, signs, issues or sells any of the documents or instruments subject to the excise tax, or for whose use or benefit such document or instrument is made, signed, issued or sold. Thus, the U.S. insured, for whose benefit the policy is issued, may be liable even if it does not directly pay the premium to the foreign insurer. Controversies sometimes arise as to who should file the FET return when a U.S. insured pays a U.S. broker who then pays the foreign insurer. The insured and the broker should discuss and preferably enter into a written agreement as to their understanding of their respective responsibilities in this regard so that compliance is fostered.

Tax Return

The FET is reported quarterly by filing Form 720, Quarterly Federal Excise Tax Return. The returns are due by April 30, July 31, October 31 and January 3 ! for each respective quarter of a calendar year. A tax deposit is generally required for each semi-monthly period in which tax liability is incurred. The deposit for a semimonthly period is due by the 14th day following that period. Generally, this is the 29th day of a month for the first semi-monthly period and the 14th of the following month for the second semi-monthly period.

Treaty-Based Exemptions from the FET

Many foreign countries have treaties with the U.S. that provide an exemption from the tax. However, these treaties do not typically grant such exemption merely because a foreign insurer is a resident of that foreign country. Generally, the foreign insurer has to meet certain limitation of benefits provided by the treaty. In addition, it must not engage in certain reinsurance arrangements with reinsurance companies in other countries that do not have such an exemption. Thus, it is not enough to know whether a foreign insurer is a resident of a country that has a treaty with the U.S. which exempts the FET; the question is whether the foreign insurer is entitled to the treaty benefits. Foreign insurers that are entitled can enter into a closing agreement with the IRS under Rev. Proc. 2003-78.A person liable for the FET can obtain a copy of such agreement as proof of entitlement, and thus not have to pay the FET. However, without a closing agreement, there is no prescribed method for that person to establish the foreign insurer's entitlement. For example, a U.K. insurer may not actually be entitled to treaty benefits because it does not meet the limitation of benefits under the U.S.-U.K. treaty. If the U.K. insurer does not have a closing agreement with the IRS, a U.S. insured would have to take reasonable steps to determine whether the foreign insurer is indeed entitled to treaty benefits. It could obtain an indemnity from the foreign insurer flit is found later that the insurer was not entitled to the FET exemption.

U.S. Corporations with Captive Insurers

Many U.S. corporations have established captive insurance companies (captives) for risk management purposes. Due to the hardening of the insurance market, captives have become quite prevalent. Many have been established in foreign jurisdictions. An insurance arrangement with a captive may or may not qualify as insurance for Federal income tax purposes. Neither the statute nor the regulations provide a definition of insurance in this regard. In Helvering v. Le Gierse, 312 US 531 (1941), the Supreme Court stated, "insurance involves risk-shifting and risk-distributing" The concept of risk-shifting and risk-distribution has become the basis of most court opinions considering whether a contract is an insurance contract for Federal tax purposes. Any insurance arrangement with a captive should be carefully evaluated as to whether it should be treated as insurance for such purposes. For example, a foreign captive may insure the risks of only its parent corporation, and thus the arrangement may not be treated as insurance for Federal tax purposes. If that is the case, the excise tax treatment for that arrangement should follow the Federal income tax treatment. In other words, the premium payments to such a captive should not be subject to the FET. The answer is more complicated if that captive then turns around and purchases reinsurance. The IRS has taken the position that in such a situation the U.S. insured is treated as having purchased insurance from the reinsurer directly--such that a 4% FET would apply.

If the insurance arrangement with a foreign captive is properly treated as insurance for Federal income tax purposes, the premiums paid with respect to such an insurance arrangement are subject to the FET. Generally though, a U.S.-owned captive situated in a foreign jurisdiction would elect to be taxed as a domestic insurance company under Sec. 953(d). If the election has been properly made, no FET applies to premiums paid to the captive. However, reinsurance premiums paid by the captive to a foreign reinsurer would be subject to the FET.

Foreign-parented captives are not eligible to make the election under Sec. 953(d).As a result, the FET consequences of such arrangements should be evaluated. Foreign-parented U.S. businesses should also be aware that if their foreign parent purchases insurance on their behalf from a foreign insurer, those premiums may also be subject to the FET. Sometimes such charges are hidden in intercompany chargebacks that are bundled with other items and may be difficult to determine.

Of course, in any situations in which a foreign insurer is involved, consideration should be given to whether a treaty exemption applies.

Cascading Nature of the FET

Although insurance premiums paid to a foreign insurer are subject to the FET, a second FET applies if the foreign insurer purchases reinsurance. This is due to the "cascading" nature of the tax. In fact, all subsequent reinsurance (retrocession) arrangements with foreign reinsurers theoretically are subject to the FET.

Generally, a U.S. insured need not worry about cascading tax liabilities that arise through subsequent reinsurance and retrocession arrangements. This is because those arrangements are not for the benefit of the U.S. insured; rather, they are for the benefit of the insurance/reinsurance company. However, to the extent the captive purchases reinsurance, the FET consequence of that transaction is of interest to the U.S. insured because the captive is a related party.

Nonprofit Organizations with Captive Insurers

Many nonprofit organizations have in the past treated captive insurance arrangements as failing to qualify as insurance arrangements for Federal income tax purposes. These captives are often established in foreign jurisdictions. Since the IRS reversed its position on the economic family theory on captives in Rev. Rul. 2001-31 (see also Rev. Ruls. 2002-89, 2002-90, 2002-91 and 2005-40), such captive insurance arrangements may in fact qualify as insurance arrangements for Federal income tax purposes. Accordingly, the FET consequences of these arrangements should be evaluated.

Records Required for Foreign Insurance Policies

Under Regs. Sec. 46.4371-4, each person who is required to remit the FET has certain recordkeeping requirements. Such a person has to keep, or cause to be kept, accurate records of all policies or other instruments subject to the FET that premiums have been paid on. Such records must identify each such policy or other instrument in such a manner as to establish clearly:

1. The gross premium paid;

2. Whether such policy or other instrument is (i) a policy of casualty insurance, (ii) a policy of fife, sickness or accident insurance or an annuity contract or (iii) a policy of reinsurance;

3. The identity of the insured;

4. The identity of the foreign insurer or reinsurer; and

5. The total premium charged and, if the premium is to be paid in installments, the amount and anniversary date of each such installment.

The records must be kept on file at the place of business or at some other convenient location for a period of at least three years from the date any part of the tax became due or the date any part of the tax is paid, whichever is later.

Conclusion

There are many issues that may arise when dealing with the FET. U.S. businesses purchasing insurance from foreign insurers should evaluate whether the FET is being properly paid. If they are engaging a U.S. broker to make such purchases, it may be in the interest of all parties to enter into a written agreement as to who will assume responsibility for the FET; however, this agreement would not protect a U.S. business from an IRS assessment if the FET has not been paid. U.S. businesses that enter into foreign captive insurance arrangements should not lose sight of the FET, both when paying premiums to the captive and when the captive purchases reinsurance.

FROM SURJYA MITRA, CPA, J.D., LL.M., AND RUTH HOFFMAN, J.D., WASHINGTON, DC