A US district court judgement in an early case to test US Federal excise tax on insurance (FET) has been hailed in Bermuda as a “common sense decision”.

While the US District Court judge found that the excise tax law did not apply to retrocessions of reinsurance placed with a foreign reinsurer by a US policyholder, parties with an interest in this case are cautioned to await the results of an almost certain appeal of the finding before celebrating.

The decision that exempts offshore retrocession deals from the US tax was made in the case of Validus Reinsurance Ltd versus United States of America, and was adjudicated on February 5 by Judge Amy Jackson of the US District Court for the District of Columbia.

Brenda Viehe-Naess, an attorney with industry lobbying group Washington Advocates Group, had praise for Brad Kading of The Association of Bermuda Insurers & Reinsurers, and Frank Nutter, president of the Reinsurance Association of America, for keeping the issue alive and in front of industry members until Validus Re launched the legal challenge that resulted in last week’s victory.

Validus Re challenged the federal excise tax on insurance (FET) under Section 4371 of the Internal Revenue Code that taxes insurance and reinsurance purchased from a foreign insurer or reinsurer. Under the law, the tax is applied at the rate of one percent on life insurance and reinsurance premiums, and four percent on property-casualty insurance premiums.

In 2008, the IRS announced a new position — the tax applies not only to the US-to-foreign insurance premiums, but also to a subsequent reinsurance transaction between the foreign insurer/reinsurer and another foreign reinsurer. The ruling provided that the FET may be collected twice — first on the US-to-foreign transaction, and then on a foreign-to-foreign transaction. Retrocessional arrangements — reinsurance between two companies that specialise in reinsurance — were impacted.

Legal arguments were made that the 2008 ruling announcing the ‘cascade tax’ is contrary to long-standing IRS interpretations of the FET.

An industry professional who did not wish to be named said the impact of the February 5 decision is small in terms of percentages.

However the industry commonly deals in sums that are numbered in hundreds of millions of dollars, with, for example, Bermuda-based XL insurance announcing $1 billion in profits for 2013 and reinsurance giant Munich Re announcing profits in the region of $5 billion for the same period.

Professionals say that on average, ten percent of an insurance premium is ceded to reinsurers, although it varies dramatically by class of business and by company.

On average, ten percent of reinsurance then would be retroceded, so one percent of the original insurance premium would be subject to retrocession.

Described as “a crude measure” it does show the impact the ultimate Court of Appeal judgment will have, on average, on a small amount of premium and a small segment of the business — though with volumes fluctuating depending on market conditions. The professional stated: “It’s an opportunistic market.”

While Validus Re declined to comment for this story, fellow reinsurer Allied World, which is located in the same Pembroke Parish building as the successful litigant, did comment.

Wesley Dupont, executive vice-president and general counsel, stated: “We believe the recent ruling in Validus Re’s favour is very encouraging. However, we recognise there is more work to be done as it is likely that the US justice department will appeal the ruling. We will wait and see. Ultimately, if there is a final positive outcome, it will be beneficial to the Bermuda market.”

Mr Kading also welcomed the result. He said: “The judge wrote a straightforward statutory construction decision — a common sense conclusion.”

However, he too added: “We do expect the IRS to appeal.”

A story in the online publication Business Insurance quoted Joseph Sieverling, senior vice-president and director of financial services for the Reinsurance Association of America commenting about the case: “From the beginning, it has been the RAA’s position that the initial design of the Federal Excise Tax was as a stamp tax, which meant when the premium went offshore in the first instance. So, it was only intended to be applied one time to the transaction and not on a cascading basis.”

In the “olden days,” said Mr Sieverling, one actually had to go to the post office and buy a special stamp showing that the tax had been paid.

Another industry lawyer, David Miller, a New York-based tax attorney with Cadwalader, Wickersham & Taft LLP, said: “This is a great result for foreign insurers because now, if they write retrocession policies, they’re not subject to the excise tax.”

Ms Viehe-Naess said: “The industry has always thought that the cascade theory was wrong — it doesn’t make sense, applying the tax twice has never made sense. The extraterritorial application of the tax has never made sense.”

“The industry is delighted with this decision. They’re very pleased,” Ms Viehe-Naess added.

“I think that many insurance and reinsurance companies have already filed for refunds when they had to pay the tax, and should expect to get refunds,” said Mr Sieverling.

The US Government has 60 days to file a notice of appeal, so that the industry should know by April 7 whether it has decided to appeal.

Many insurers have paid the cascade tax under protest, and filed claims for refund. IRS will not process refunds before the Court of Appeals decision is released.