United States Virgin Islands Tax Law and Litigation
Virgin Islands of the United States (also includes Saint Thomas, Saint John, Saint Croix) was acquired from Denmark in 1971. It’s one of the most distinctive areas to engage in tax litigation, the reason being, not only does it raise highly complex taxation issues mainly because it’s a territory(not a state) but also of importance is the Virgin Islands Economic Development Program.
The United States Congress wanted to inspire more development of the economy in the Virgin Islands which significantly brought about a rush of litigation between the program participants, IRS, and Virgin Islands Bureau of Internal Revenue. In 1921 congress made Income tax laws of the United States applicable to the Virgin Islands that brought about the similarity in these laws with the only difference being that residents of Virgin Islands pay tax to the Virgin Islands and not the United States. See Naval Service Appropriation Act of July 12, 1921, 48 U.S.C. § 1397; see also Chase Manhattan Bank, N.A. v. Gov’t of the Virgin Islands, 300 F.3d 320, 322-23 (3d Cir. 2002), overruling 173 F.Supp.2d 386 (D.V.I. 2001). 48 U.S.C. § 1397 states: Despite other provisions of law, the legislature of the Virgin Islands is allowed to impose a surtax on all taxpayers as long as the amount does not surpass 10% of their annual income tax obligation. See 48 U.S.C. § 1397
To execute Naval services Appropriation Act, the courts legally established the “Mirror Code” where one replaces the words “United States” with “Virgin Islands”, under the mirror system, any changes on regulations and revenue rulings on court interpretation of the substantive tax provision of the Internal Revenue Code is relevant to the Virgin Islands tax cases provided the provision is not conflicting with a separate territorial income tax, Chicago Bridge & Iron Co. v. Wheatley, 430 F.2d 973, 976 (3d Cir. 1970), rev’g 295 F.Supp. 240 (D.V.I. 1969), cert. denied 91 S.Ct. 873 (1971), the treasury regulations apply in the Virgin Islands in ways that may be appropriate under the International Revenue Code (IRC) however though some provisions in the IRC are not mirrored since they are fully effective in the Virgin Islands which applies to its residents. Abramson Enters. v. Government of the Virgin Islands, 994 F.2d 140, 142 (3d Cir. 1993), Broderick v. Bank of America, 17 V.I. 594 (D.V.I. 1987); see also Chase Manhattan Bank, supra. See I.R.C. §§ 932, 934, 7654
The income tax laws effective to the Virgin Islands include; The Internal Revenue Code sections 932(“coordination of united states and virgin islands income taxes”) and 934(“Limitations on reductions in income Tax liability incurred in the Virgin Islands”). These sections determine who is a resident of the Virgin Islands, who should file returns, the amount owed to the Islands, and how much the Islands can reduce tax liability owed to it. With the Tax reform act of 1986, 99 P.L No. 514 (October 22, 1986), congress approved I.R.C. § 932 that gives a proper distinction between those who are bona fide Virgin Islands residents and those who are not. A resident of the United States who gets income from the Virgin Islands, but is not a bona fide Virgin Islands resident, must file two tax returns (one with the IRS, the other with the Virgin Islands). I.R.C. § 932(a). Such individuals pay source income tax to the Virgin Islands and source income tax on Non-virgin Island to the IRS. I.R.C. § 932(b). Contrary, a bona fide Virgin Islands resident-only files returns with the BIR and pays tax on all income, regardless of its source, to the Virgin Islands. I.R.C. § 932(c). By paying the BIR the tax on all worldwide income, a bona fide Virgin Islands resident is relieved of any income tax liability to the United States, even on non-Virgin Islands source income. Id.; see also Abramson Enters., supra.
By approving I.R.C. § 932, Congress examined that the BIR would give IRS information regarding Virgin Islands residents reporting on non-Virgin Islands income:
[a] Virgin Islands resident getting gross income from outside sources will report all items of such income on his/her Virgin Islands returns. This information will be compiled by the Virgin Islands Bureau of Internal Revenue and sent to the Internal Revenue Service to enable enforcement assistance. Rep. 99-313, at 482.
In line with this understanding, the United States and VIRGIN ISLANDS went into an agreement “for the exchange of information and mutual assistance with taxes to prevent avoidance of the United States or Virgin Islands taxes.” ( Tax Implementation Agreement Between the United States of America and the Virgin Islands, p. 1 Feb. 24, 1987, 1989-1 C.B. 347 “TIA”). The United States agreed to “routinely supply” the Virgin Islands with “copies of reports of individual, partnership, corporate, and employment audit changes that showcase information relevant to the Virgin Islands” and “copies of Schedule K-1 of Form 1065 (U.S. Partnership Return of Income) and audit results when the partnership return is examined and it appears the examination will affect returns of Virgin Islands taxpayers.” Id., Art. 4, § 2(a)(i)-2(a)(iii). JA-0575. The Virgin Islands agreed to “routinely supply” the United States with “information about any taxpayer subject to Virgin Islands tax with non-Virgin Islands source income who files an income tax return with the Virgin Islands claiming for the first time to be a Virgin Islands resident.” Id., Art. 4, § 2(b)(iii). JA-0577.
The Virgin Islands Economic Development Program
The tax laws relevant to the Virgin Islands have also allowed VIRGIN ISLANDS to lower the tax liability of certain Virgin Islands taxpayers. The policy has stood from 1921 to promote investments and economic development of the Virgin Islands. It was again congressionally countersigned with the enactment of I.R.C. § 934 in 1960, (Pub. L. No. 86-779 (1960)). See also S. Rep. No. 1767, 86th Cong., 2d Sess. (1960); H.R. Rep. No. 1131, 86th Cong., 1st Sess. (1959)), which gives the Virgin Islands law-making authority power to reduce the tax owed to it.
The U.S. Congress and the Virgin Islands came up with the Economic Development Program five decades ago to entice businesspeople to open new businesses in the Virgin Islands. See generally 29 V.I.C. § 701, et seq. The Virgin Islands then started the Economic Development Commission (“EDC”) to oversee the Development Program. See generally 29 V.I.C. § 704, et seq. which presents an opportunity for approved beneficiaries to receive an income tax credit, related to I.R.C. § 934.
Through the EDC, the U.S. Department of the Interior and the VIRGIN ISLANDS, have promoted the Virgin Islands as the preferred location to open businesses due to tax and other incentives offered by the Virgin Islands. Improvement of modern telecommunications, the internet, and infrastructure growth, has allowed taxpayers to work remotely from the Virgin Islands. With these advancements, the Virgin Islands actively
individuals and businesses to move to the Virgin Islands and take advantage of the congressionally authorized tax incentives. Many taxpayers have moved to the Virgin Islands to take part in the Development Program, and many have undergone heightened IRS scrutiny as a result. Mr. DiRuzzo and other experienced tax attorneys at Fuerst Ittleman David & Joseph customarily represent clients in matters involving tax law and tax litigation against the IRS and the Virgin Islands resulting from the Virgin Islands Economic Development Program.
The Treasury Department’s Failure to Issue Regulations
Since 1921, the system of taxation in the Virgin Islands was modified through the Tax Reform Act (TRA) of 1986. TRA changed the treatment of people with residency in the U.S. and the Virgin Islands in particular. It provided that the 1954 Revised Organic Act of the Virgin Islands (“ROA”), codified at 48 U.S.C. § 1541, et seq. be treated as if it were approved before the Internal Revenue Code. The tax imposition of Virgin Islands persons provided under the ROA was normally continued by the TRA. However, an individual who is a “bona fide resident of the Virgin Islands” at the close of the taxable year and who reports income from, and pays tax on, his/her worldwide income to the VIRGIN ISLANDS, is relieved of the obligation to file and pay tax to the United States, including the tax on U.S. source income and United states effectively connected income as stated under I.R.C. § 932, added by the TRA. Under the TRA, to determine the tax liability of residents, the United States is treated as including the Virgin Islands for purposes of calculating U.S. tax liability, and the Virgin Islands is treated as including the United States for purposes of calculating Virgin Islands tax liability. I.R.C. §§ 932(a)(3); 932(c)(3) (1986).
The TRA also revised I.R.C. § 934 to broaden categories of income eligible for tax reduction and other tax incentives sanctioned by the VIRGIN ISLANDS. Before validation of the TRA, the VIRGIN ISLANDS was allowed to reduce the tax liability on corporations about non-U.S. source income; similarly, the VIRGIN ISLANDS was allowed to reduce the tax liability of an individual who is a “bona fide resident of the Virgin Islands” with his or her Virgin Islands source income. As amended by the TRA, I.R.C. § 934(b)(1) authorizes the VIRGIN ISLANDS to reduce the tax on income which is (1) Virgin Islands source income, or (2) income which is “effectively connected” with the conduct of a Virgin Islands trade or business regardless of the source of such income. The TRA also provided in new I.R.C. § 934(b) (2) that the expanded authority in I.R.C. § 934(b) (1) is not available to reduce the tax liability of U.S. citizens or residents who are not bona fide residents of the Virgin Islands.
However the TRA did not describe “bona fide Virgin Islands resident,” “Virgin Islands source income,” or “Virgin Islands effectively connected income,” and its legislative history does not provide any guidance with those terms. Rather, Congress required the Treasury Department to promulgate regulations for determining Virgin Islands residency under I.R.C. § 932 and Virgin Islands source and the Virgin Islands effectively connected income under I.R.C. § 934. However, the Treasury Department never did.
Following this backdrop of a lack of regulatory guidance, one must view Notice 2004-45, 2004-2 C.B. 33 (2004) and the subsequent enactment of the American Jobs Creation Act of 2004, Pub. L. No. 108-357 § 908 (2004), codified at I.R.C. § 937. Before the enactment of I.R.C. § 937, without a regulatory definition of a “bona fide Virgin Islands resident,” and without a regulatory definition of “Virgin Islands sourced income” or “income effectively connected with a Virgin Islands trade or business,” taxpayers participating in the EDC relied on the then existing definition of a bona fide resident and source of income by referring to I.R.C. §§ 871 and 864 and the Treasury Regulations thereunder.
Treasury Regulation § 1.871-2(b) states as follows:
An alien present in the United States who is not a mere transient or sojourner is a resident of the United States for purposes of the income tax. His intentions regarding the length and nature of his stay will determine whether he is a transient. But if he intends to return to another country, regardless of the time it takes then he does not qualify to be a transient. If he lives in the United States and has no sure intention as to his stay, he is a resident. One who comes to the States for a definite purpose that may be accomplished is a transient; but, if his purpose is of such a nature that an extended stay may be necessary for its accomplishment, and to that end, the alien made [sic] his home temporarily in the United States, he becomes a resident, though it may be his intention at all times to return to his domicile abroad when the purpose for which he came has been achieved. An alien whose stay in the United States is limited to a stated period by the immigration laws is not a resident of the United States within the meaning of this section, unless there are exceptional circumstances.
Treasury Regulation § 1.871-2(b) is used to determine whether a person is a resident of the United States, this also applies to the Virgin Islands under the income tax laws applicable by operation of the substitution scheme of the Mirror Code. Accordingly, a person present in the Virgin Islands “who is not a mere transient or sojourner” is a resident of the Virgin Islands for income tax purposes.
In late 2003 or early 2004, the IRS began auditing United States citizens who resided in the Virgin Islands and filed income tax returns with BIR to determine if they were bona fide Virgin Islands residents, whether the taxpayers had properly claimed development Program tax credit, or the taxpayers’ income was sourced in or effectively connected with a Virgin Islands trade or business. In its battle against program participants, the IRS’s weapon of choice has been a questionable construction of the applicable three-year statute of limitations under I.R.C. § 6501(a). On March 12, 2007, the IRS issued Notice 2007-19; 2007-1 C.B. 689; 2007-11 I.R.B. 689 (2007) (“Statute of Limitations on Assessment Concerning Certain Individuals Filing Income Tax Returns with the U.S. Virgin Islands”).
Notice 2007-19 stated that:
An income tax return filed with the U.S. Virgin Islands by a U.S. citizen or resident alien (USVI Form 1040) will be taken to be a U.S. income tax return of that individual for purposes of section 6501(a), provided that the individual is a covered person. The term “covered person” means a U.S. citizen or resident alien who takes the position that he or she is a bona fide resident of the U.S. Virgin Islands, files USVI Form 1040 with the U.S. Virgin Islands and has less than $75,000 of gross income for the taxable year.
Notice 2007-19 at § 2. With this newfound weapon in the IRS’ arsenal, the IRS proceeded with its Virgin Islands project by auditing program participants for a seemingly interminable period. Although the IRS was unsuccessful in Appleton and the Government of the United States Virgin Islands v. Commissioner of Internal Revenue, 140 T.C. No. 14 in persuading the United States Tax Court that its application of the statute of limitations was correct, the Tax Court’s decision was limited to cases where the IRS conceded the bona fide residency of the taxpayer. The threat of the statute of limitations issue lingers for all other program participants.