Tax Litigation Update: IRS Commits to Prevent Double Taxation in Virgin Islands Economic Development Program Case

May 28, 2013   
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Disclosure: Joseph A. DiRuzzo, III of Fuerst Ittleman David & Joseph represented the taxpayers before the District Court of the Virgin Islands and before the Third Circuit Court of Appeals.

On May 17, 2013, the United States Court of Appeals for the Third Circuit issued its opinion in the case of Cooper v. Comm’r of Internal Revenue, ___ F.3d ____, 2013-1 U.S. Tax Cas. (CCH) P50,331. A copy of the precedential opinion is available here. The opinion is a consolidated one, and decided the cases of four separate taxpayers (Cooper, McGrogan, McHenry, and Huff) who had availed themselves of the Virgin Islands Economic Development Program (EDP).

The Court of Appeals began its opinion by aptly noting the following: “This case is about Taxpayers’ attempt to lawfully reduce their income tax liability by claiming certain tax benefits afforded exclusively to bona fide residents of the United States Virgin Islands.”

The facts of the case are as follows:

Between 2001 and 2004, the Taxpayers claimed that they were bona fide residents of the Virgin Islands and therefore eligible for the tax benefits granted by the EDP. (For more information about the EDP, including a history of the litigation between and among U.S. taxpayers, the IRS and the Virgin Islands Bureau of Internal Revenue, please review our prior blog entries here, here, here, here, here and here.) Consequently, the Taxpayers filed tax returns with the Virgin Island Bureau of Internal Revenue (VIBIR) and paid their taxes only to the Virgin Islands government. However, the Taxpayers did not file federal income tax returns with the IRS. Consequently, in late 2009 and early 2010, the Taxpayers were issued statutory notices of deficiency by the IRS challenging their claims of bona fide residency in the Virgin Islands. The Taxpayers challenged the deficiency notices in the District Court of the Virgin Islands. The District Court granted the IRS’s motion to dismiss on the grounds that the Tax Court was the only proper forum for the Taxpayers’ suits against the IRS and therefore the District Court of the Virgin Islands lacked subject matter jurisdiction to adjudicate the dispute.

After receiving a deficiency notice from the IRS in late 2009, McGrogan, in an effort to avoid double taxation, filed suit in the District Court of the Virgin Islands seeking a refund of taxes paid to the VIBIR. The District Court granted the VIBIR’s motion to dismiss McGrogan’s refund petition because McGrogan filed his claim outside the statute of limitations pursuant to I.R.C. § 6511(a) (statute of limitations for a refund petition expires either three years after the time of filing an income tax return or two years after the time of payment of the tax owed, whichever expires last).

On appeal, the Third Circuit noted that the mitigation provisions in the Internal Revenue Code allow qualifying taxpayers to bring refund claims that would otherwise be barred by the statute of limitations. See I.R.C. § 1311(a). However, according to the Third Circuit, the mitigation provisions did not afford relief to McGrogan because he could not show that a “circumstance of adjustment” had occurred. In short, although McGrogan claimed a circumstance of adjustment for the double inclusion of income, the Internal Revenue Code permits mitigation for the double inclusion of income only if the taxpayer’s claim involves “an item which was erroneously included in the gross income of the taxpayer for another taxable year or in the gross income of a related taxpayer.” I.R.C. § 1312(1). Such a double inclusion did not occur in this case. McGrogan did not allege that he erroneously paid taxes in an incorrect tax year and did not claim to have erroneously paid taxes for a related taxpayer. Rather, McGrogan’s overpayment of taxes is a situation not contemplated by the mitigation statute: payment to the wrong taxing entity.

The Court then went on to discuss the Court of Appeal’s concern “about the possibility of double payment of taxation to the IRS and to the VIBIR in cases such as the ones at issue here. The IRS assured us at oral argument it was willing to participate in the administrative procedure set up by the Tax Implementation Agreement:

[Counsel for the IRS]: At this point I don’t believe there’s any sign that there would be double taxation. We’ve indicated ”” the IRS has indicated its willingness to participate in competent authority once it is determined how much taxes are owed.

Obviously, if a particular taxpayer wins on their challenge, if they prove that they’re bon[a] fide Virgin Islands residents and they prove that the income in question was Virgin Islands income, there won’t be any double taxation because there won’t be any residual U.S. tax liability. But if, instead, there is determined that, yes, there is U.S. tax liability here because these were not Virgin Islands residents, or their income was not Virgin Islands income and, therefore, not subject to the EDP benefits, then we’ve indicated, as shown in the record cites I gave you for the Cooper notices of deficiency, that we’re willing to go in a competent authority at that point to determine which tax authorities should be getting the money.

“The IRS then qualified the above statement:

[Counsel for the IRS]: I’m not entirely certain what the remedy would be in a situation where someone, unlike the Coopers, failed to do a protective refund claim, failed to take that step to protect their right to go and get money back from the Virgin Islands BIR if, in fact, it is determined that they should have instead paid all of their taxes to [the IRS].

“Counsel for the Taxpayers replied to the IRS’s argument by pointing out that the protective mechanism of a refund claim was set up in 2006, after the time to file a protective income tax return for calendar years 2001 and 2002 had already closed. Therefore, McHenry and McGrogan could not have taken the protective actions advocated by the IRS.

“In view of the statement by the IRS that negotiation would be initiated to prevent double taxation ”” in the situation we could envisage if, for instance, McGrogan lost his pending case in the Tax Court ”” we trust that the IRS will live up to its commitment to prevent double taxation.”

Slip op. at p. 19-20, fn.6; (emphasis added).

A copy of the transcript of the oral argument is available here:

So, while this decision was resolved unfavorably for the named taxpayers, the decision has far reaching implications for all taxpayers who are litigating the issue of whether they were bona fide USVI residents. The IRS has now made the affirmative commitment to the Third Circuit that there will be no double taxation. This has effectively removed one of the bargaining chips that the IRS has had in its litigation position. Previously, the standard operating procedure of the IRS was that a taxpayer should settle, and upon settlement the IRS would give the taxpayer credit for taxes paid to the VIBIR. However, if the taxpayer wanted to litigate the residency issue (in the Tax Court for example) then the IRS would not give credit for taxes paid to the VIBIR. Further, based on the IRS’s representation to the Third Circuit, there is no longer the need to sue the VIBIR in an attempt to recoup the taxes paid to the VIBIR in an attempt to remit the previously paid taxes to the IRS.

This case, taken with the Third Circuit’s decision in Vento, see here, and the Tax Court’s decision in Appleton, see here, show that the federal courts have been willing to rebuff the IRS and its litigation position for those who have claimed to be bona fide USVI residents and therefore able to participate in the Virgin Islands Economic Development Program.

The attorneys at Fuerst Ittleman David & Joseph are actively litigating against the IRS, the United States, and the Virgin Islands Bureau of Internal Revenue in Virgin Islands residency cases in the District Court of the Virgin Islands, the U.S. Tax Court, the Third Circuit Court of Appeals, and the U.S. Court of Federal Claims. Additionally, Joseph A. DiRuzzo, III, is licensed to practice in the Virgin Islands and lived on St. Thomas for years before relocating to South Florida. Mr. DiRuzzo is actively litigating federal tax cases (both civil and criminal) on St. Thomas and St. Croix.

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