Judge Amy Jackson clearly sided with Validus Re in her February 5 opinion in Validus Re’s closely followed lawsuit in US federal district court in Washington, DC. Validus won a refund of the federal excise tax (FET) it had paid on nine reinsurance policies it purchased in retrocession transactions in which Validus obtained protection on US risks that Validus had previously insured.

The case was closely followed by the offshore insurance industry because it was the first legal challenge to the Internal Revenue Service’s (the Service) 2008 position that FET should be paid each time a US-based risk is transferred to a foreign insurer or reinsurer by insurance, reinsurance, retrocession or any level of re-retrocession. A tax refund suit was the only avenue open to the industry to mount a judicial challenge to the so-called “cascading FET” theory that the Service announced in Revenue Ruling 2008-15. So Validus paid the FET based on the retrocession policies it purchased, filed a claim for refund of that tax and sued in US federal district court for a refund.

The Service has systematically audited offshore reinsurers of US insurers and collected FET whenever it has found that the offshore reinsurer retransferred the US risks to another offshore reinsurer subject to FET. Many offshore insurers have just as systematically paid the tax, filed “protective” claims for refund and generally waited for the results of the Validus case before determining how vigorously to pursue their refund claims.

Validus and the Department of Justice had filed cross motions for summary judgment. In their respective briefs in support of their motions, the parties had addressed such complex topics as whether Congress intended to impose FET extraterritorially and whether the Service had the authority to impose the tax on a wholly foreign transaction under international law or the US Constitution.

The answer to these intriguing questions will have to wait for another day. Judge Jackson decided the case on the simplest of all possible grounds. She said that the plain language of section 4371(3) of the Internal Revenue Code applies the FET to “reinsurance” transactions. Because the nine Validus transactions in the case were “retrocession” transactions, that is, reinsurance of reinsurance, Judge Jackson concluded that they were not “reinsurance” transactions as that term is used in section 4371(3). While the Code specifies a 4 percent FET on direct P&C insurance premiums and a 1 percent tax on reinsurance premiums, the Code does not specify a tax rate for retrocession premiums. Judge Jackson notes in a footnote that “The lack of a provision setting rates for retrocessions reinforces the Court’s conclusion.”

The government finds itself in perhaps a worse position than it was in before it adopted the “cascading” theory in 2008. At that time most taxpayers probably took the position that the 1 percent FET applied to all reinsurance of US risks to foreign reinsurers, regardless of whether the transaction was technically “reinsurance” or “retrocession.” The district court opinion in Validus now makes a clear and sharp distinction between “reinsurance” and “retrocession.” Not only is Validus’ retrocession of a US risk to another Bermuda reinsurer not subject to FET, under Judge Jackson’s reasoning, a retrocession of US risk from a US reinsurer to a foreign reinsurer is not subject to tax.

The government is likely to appeal this decision. Perhaps the DC Circuit Court of Appeals will not be persuaded by the “plain language of the statute” argument that persuaded the District Court. And perhaps the Appeals Court will weigh in on those complex questions of international and constitutional law. Those offshore reinsurers who paid FET and filed “protective” tax returns may have to wait a little longer for the final resolution of the Validus case and a determination of the legality of the Service’s “cascading FET” theory.