Why US Federal Excise Tax matters to Europe

Tax burden

The US Internal Revenue Service is keen to combat tax evasion and is tightening its federal excise tax enforcement procedures. Asher Harris looks at affect FET has on European insurers doing business with US firms and the resultant cascading effect.

In the current corporate governance climate, clients are placing increasing levels of pressure on insurers and brokers to deliver assured international tax compliance. Clients know that the regulations are complex, complexity can lead to uncertainty, uncertainty can lead to fear and clients want reassurance.

In Europe, acquiring the knowledge and administrative resources to keep up with the European Union's 21 different insurance premium tax regimes, varying widely in terms of business classes liable and methods of payment, is challenging enough. But insurers globally need to be aware that the US is serious about significantly intensifying tax collection procedures and closing tax loopholes.

Combating tax evasion
The ‘Hire Act', for example, enacted into law in March 2010, gives the US Internal Revenue Service broad powers to combat tax evasion by forcing non-US financial institutions to reveal the identities of any Americans who may have assets outside the US banking system. In related activity, the IRS is tightening federal excise tax enforcement procedures and has sent a number of information document requests and notices of deficiency to non-US insurers and reinsurers.

Of course, the US talking tough about tax collection and tax havens is not new. Nonetheless, when President Obama says the IRS needs to crack down on international tax abuse, major players believe him. Many companies that use captives organised in one or more low-tax countries are now reviewing the structure of their captive network in the light of the ongoing surge in political opposition to tax havens.

 

"The US is serious about significantly intensifying tax collection procedures and closing tax loopholes."

 

Meeting FET requirements
Insurers must ensure that tax on both sides of the Atlantic is properly calculated. As well as financial penalties, failure to meet the requirements of international tax compliance can damage the reputations of insurers, brokers and clients.

Despite the intensifying political pressure, a non-US captive insuring US operations generally remains an effective tax-planning tool for companies with significant operations in the US. However, an important factor in this analysis is the cost of FET.

FET exemption
The US imposes FET of 4% on non-life insurance premiums and 1% on reinsurance premiums, paid with respect to US risks to reinsurers outside the US. FET does not apply if the insurer is a qualified resident of a country that has a tax treaty with the US that includes a FET exemption. Increasing attention is being focused on ways in which overseas insurers can secure an exemption from FET.

The jurisdictions that are currently the leading captive domiciles do not have tax treaties with the US that include FET exemptions - locations such as Bermuda, Barbados, the Cayman Islands, the British Virgin Islands, the Channel Islands, the Isle of Man and Gibraltar.

For this reason, many insurance businesses are migrating to countries with a tax treaty that includes a FET waiver. Insurance companies such as Ace Europe, Flagstone and United America Indemnity have already moved from Bermuda - and the Caymans - to Switzerland and Ireland. While those companies that have kept their headquarters in countries with no treaty protection are continually re-examining their corporate structures to ensure they are operating in a manner as tax-effective as possible.


"Increasing attention is being focused on ways in which overseas insurers can secure an exemption from FET."

 

Insurers wishing to qualify for the exemption from FET typically enter into a closing agreement with the IRS confirming that the non-US insurer qualifies under the relevant tax treaty. However, the definition of ‘qualified resident' is complex and varies from treaty to treaty. As a result, before applying for a closing agreement, the insurer may need to go through a detailed analysis of its corporate structure and operations to determine whether the FET exemption will actually be available.

Cascading FET
A fundamental challenge for insurers and reinsurers exposed to the US is to understand and comply with FET, which applies to the premium paid to a non-US insurance company on contracts covering risks located in the US, as well as to reinsurance premiums paid when any programme covering risks located in the US are ceded to a non-US reinsurance company.

With the globalisation of the insurance market, such risks are often covered by non-US insurance companies through reinsurance contracts. A key point to remember is that the IRS considers FET applicable to multiple transactions in which the same underlying US risks are insured and reinsured. The IRS states that FET is due each time a US risk is reinsured or retroceded, even to a party affiliated with the cedant - although some courts may not support the IRS on this point. Some commentators consequently refer to FET as a ‘cascading excise tax'.

 

"The IRS states that FET is due each time a US risk is reinsured or retroceded."

 

Miscalculation issues
The complexity of cascading FET, like IPT and other parafiscal taxes, means there is ample scope for miscalculation. Many insurers and brokers, therefore, incur major costs trying to build proprietary systems that still fail to reassure.

So how do the complexities of cascading FET take effect in practice? An illustration may help to make this clearer. Where a US entity buys insurance from an Irish captive, which qualifies for FET exemption under the US/Ireland tax treaty, and the Irish captive reinsures the risk with a Bermuda affiliate, which receives no FET exemption through a tax treaty with the US, because the Irish insurer reinsured the risk with a reinsurer not qualified for treaty protection, the initial insurance transaction is subject to 4% FET. As the reinsurance transaction involves a US risk, and no tax treaty applies, this second transaction is subject to 1% FET, leading to a total excise tax cost of 5% of the premium paid. Therefore, the insured and the insurer may both be held liable for the tax payment.

The latest IRS activity on FET has been to request information on amounts and sources of insurance and reinsurance premiums ceded and assumed - apparently an attempt to match the FET paid by US insureds and cedants with the FET liability of insurers or assuming companies.

 

"There is no forum to contest FET prior to its assessment; the only remedy is to pay the tax and then sue for a refund."

 

No right to contest
Most industry participants have complied with the IDRs and are paying tax as there are no perceived realistic alternatives. There is no forum to contest FET prior to its assessment; the only remedy is to pay the tax and then sue for a refund. However, some participants are developing FET strategies that tighten compliance and transactional practices: crucially they are structuring policies so that US risks are centralised in one policy.

The extreme complexities of cascading FET help nobody. The industry would be best served if a global standard for managing insurance tax compliance could be set. Insurers would then be able to focus on doing what they do best, rather than being forced individually to establish uncertain solutions to achieve compliance. Insurers are advised to check each aspect of their possible exposure through reputable third-party expertise or face the consequences.

Asher Harris is a lawyer for Asher Harris, New York, and a consultant with Fiscal Reps

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