United States Virgin Islands Tax Law and Litigation
The United States Virgin Islands (including Saint Thomas, Saint John and Saint Croix) is one of the most unique jurisdictions in the United States to practice tax law or engage in tax litigation.
Why is the Virgin Islands such a unique jurisdiction for tax litigation? For starters, it is a territory and not a state, and this alone raises highly complex issues of taxation. But even more unique to the Virgin Islands is the Virgin Islands Economic Development Program, which was intended by the United States Congress to inspire “economic development” in the Virgin Islands, and has led to a deluge of litigation between program participants, the IRS and the Virgin Islands Bureau of Internal Revenue.
The United States acquired the Virgin Islands from Denmark in 1917, and in 1921 Congress made the income tax laws of the United States applicable to the Virgin Islands, under which the United States income tax laws represent the Virgin Islands income tax laws, with the only difference being that Virgin Islands residents pay tax to the Virgin Islands rather than to 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:
The income-tax laws in force in the United States of America and those which may hereafter be enacted shall be held to be likewise in force in the Virgin Islands of the United States, except that the proceeds of such taxes shall be paid into the treasuries of said islands: Provided further, that, notwithstanding any other provision of law, the Legislature of the Virgin Islands is authorized to levy a surtax on all taxpayers in an amount not to exceed 10 per centum of their annual income tax obligation to the government of the Virgin Islands.
48 U.S.C. § 1397.
In order to effectuate the Naval Service Appropriation Act, the courts have judicially constructed the “Mirror Code” where one substitutes the words “Virgin Islands” to replace “United States” in the Internal Revenue Code. Abramson Enters. v. Government of the Virgin Islands, 994 F.2d 140, 142 (3d Cir. 1993). Further, the Treasury Regulations, to the extent they may be applicable under the Internal Revenue Code as it applies in the Virgin Islands, are also “mirrored.” Broderick v. Bank of America, 17 V.I. 594 (D.V.I. 1987); see also Chase Manhattan Bank, supra. However, there are some provisions of the Internal Revenue Code that are not “mirrored” because they apply in full to the Virgin Islands and its residents. See I.R.C. §§ 932, 934, 7654. By definition, Internal Revenue Code Sections 932 (“Coordination of United States and Virgin Islands Income Taxes”) and 934 (“Limitations on Reduction in Income Tax Liability Incurred to the Virgin Islands”) are “the income tax laws applicable” to the Virgin Islands as the two operative sections determine who is a resident of the Virgin Islands, directs who is required to file a return with the VIRGIN ISLANDS, the amount owed to the Virgin Islands, and how much, if any, the Virgin Islands can reduce the tax liability owed to it.
Under the mirror system “any changes to, interpretations of, regulations and revenue rulings on and court interpretations of the substantive tax provisions of the Internal Revenue Code are applicable to Virgin Islands tax cases as long as the particular provision at issue is not manifestly inapplicable or incompatible 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).
With the Tax Reform Act of 1986, 99 P.L. No. 514 (October 22, 1986) (“TRA”), Congress enacted I.R.C. § 932, which draws a clear distinction between individuals who are bona fide Virgin Islands residents and those who are not. A United States resident who derives income from the Virgin Islands, but who is not a bona fide Virgin Islands resident, must file two tax returns, one with the IRS and the other with the Virgin Islands. I.R.C. § 932(a). Such individuals pay tax on Virgin Islands source income to the Virgin Islands and tax on non- Virgin Islands source income to the IRS. I.R.C. § 932(b). In contrast, a bona fide Virgin Islands resident files a return only 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 enacting I.R.C. § 932, Congress contemplated that the BIR would provide the IRS with information regarding Virgin Islands residents that report non-Virgin Islands income:
[a] Virgin Islands resident deriving gross income from sources outside the Virgin Islands will report all items of such income on his or her Virgin Islands return. Information contained on these returns will be compiled by the Virgin Islands Bureau of Internal Revenue and transmitted to the Internal Revenue Service to facilitate enforcement assistance.
- Rep. 99-313, at 482.
Consistent with this understanding, the United States and the VIRGIN ISLANDS entered into an agreement “for the exchange of information and mutual assistance with respect to taxes in order to prevent the evasion or avoidance of 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” to the Virgin Islands with “copies of reports of individual, partnership, corporate, and employment audit changes that disclose 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 applicable to the Virgin Islands have also permitted the VIRGIN ISLANDS to reduce the tax liability of certain Virgin Islands taxpayers. Since 1921 the policy has stood in order to promote investment in, and the economic development of, the Virgin Islands. This policy was again congressionally endorsed 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 provides the Virgin Islands law making authority to reduce the tax owed to it.
Five decades ago, the U.S. Congress and the Virgin Islands created the Economic Development Program (“Development Program”) to attract businesspeople to establish new businesses in the Virgin Islands. See generally 29 V.I.C. § 701, et seq. The Virgin Islands then created the Economic Development Commission (“EDC”) to oversee the Development Program. See generally 29 V.I.C. § 704, et seq. The Economic Development Program presents an opportunity for approved beneficiaries to receive an income tax credit, pursuant to I.R.C. § 934.
The U.S. Department of the Interior together with the VIRGIN ISLANDS, through the EDC, have promoted the Virgin Islands as a preferred location to establish businesses because of the tax and other incentives offered by the Virgin Islands. Advancements in modern telecommunications, the internet, and improvements in the Virgin Islands’ infrastructure, have permitted taxpayers to work remotely from the Virgin Islands. With these improvements, the Virgin Islands actively solicited individuals and business to move to the Virgin Islands to take advantage of the congressionally authorized tax incentives. Numerous taxpayers have moved to the Virgin Islands to participate in the Development Program, and many have come under heightened IRS scrutiny as a result. Mr. DiRuzzo and the other seasoned tax attorneys at Fuerst Ittleman David & Joseph routinely represent clients in matters involving tax law and tax litigation against the IRS and Virgin Islands resulting from the Virgin Islands Economic Development Program.
The Treasury Department’s Failure to Issue Regulations
The Tax Reform Act of 1986 (TRA) modified the system of taxation in effect in the Virgin Islands since 1921. In particular, the TRA modified the treatment of persons with residency in the U.S. and the Virgin Islands. The TRA provided that the 1954 Revised Organic Act of the Virgin Islands (“ROA”), codified at 48 U.S.C. § 1541, et seq., was treated as if it were enacted before the Internal Revenue Code. The TRA generally continued the tax treatment of Virgin Islands individuals provided under the ROA. However, under I.R.C. § 932, as added by the TRA, 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 or her worldwide income to the VIRGIN ISLANDS, is relieved of the obligation to file and pay tax to the United States, including tax on U.S. source income and U.S. effectively connected income. 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 amended I.R.C. § 934 to expand the categories of income eligible for tax reduction and other tax incentives enacted by the VIRGIN ISLANDS. Prior to the enactment of the TRA, the VIRGIN ISLANDS was authorized to reduce the tax liability on corporations only with respect to non-U.S. source income; similarly, the VIRGIN ISLANDS was authorized to reduce the tax liability of an individual who is a “bona fide resident of the Virgin Islands” only with respect to 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.
The TRA, however, did not define “bona fide Virgin Islands resident,” “Virgin Islands source income,” or “Virgin Islands effectively connected income,” and the legislative history of the TRA does not provide any guidance with respect to 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 Virgin Islands effectively connected income under I.R.C. § 934. However, the Treasury Department never did.
It is against this backdrop of a lack of regulatory guidance that 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. Prior to 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 actually 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. Whether he is a transient is determined by his intentions with regard to the length and nature of his stay. A mere floating intention, indefinite as to time, to return to another country is not sufficient to constitute him a transient. If he lives in the United States and has no definite intention as to his stay, he is a resident. One who comes to the United States for a definite purpose which in its nature may be promptly 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 make [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 consummated or abandoned. An alien whose stay in the United States is limited to a definite period by the immigration laws is not a resident of the United States within the meaning of this section, in the absence of exceptional circumstances.
Although Treasury Regulation § 1.871-2(b) applies to the determination of whether an individual is a resident of the United States, this same definition is applicable to the determination of whether an individual is a resident of the Virgin Islands under the income tax laws applicable to the Virgin Islands by operation of the substitution scheme of the Mirror Code. Accordingly, a person actually 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 an Development Program tax credit, and whether 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:
[A]n income tax return filed with the U.S. Virgin Islands by a U.S. citizen or resident alien (USVI Form 1040) will be deemed 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 seemingly interminable periods of time. 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. A copy of the Appleton decision may be read here. The threat of the statute of limitations issue lingers for all other program participants.
Mr. DiRuzzo and the tax litigators of Fuerst Ittleman David & Joseph have been at the forefront of the longstanding dispute between the IRS and the participants in the Virgin Islands Economic Development Program. For more information, please contact us at email@example.com or call us directly at 305-350-5690.