The Eleventh Circuit Weighs in on the United States Virgin Islands’ Economic Development Tax Credit

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The Eleventh Circuit Weighs in on the United States Virgin Islands’ Economic Development Tax Credit

The Eleventh Circuit Court of Appeals recently remanded a closely-watched case dealing with territorial tax credits under the United States Virgin Islands’ Economic Development Commission Program that involved an important statute of limitations issue. Comm’r v. Estate of Travis Sanders, No. 15-12582 (Aug. 24, 2016). The primary issue in the case was whether the taxpayer, Mr. Sanders (now deceased), qualified as a bona fide USVI resident during the 2002, 2003, and 2004 tax years. If he did, as explained below, the statute of limitations would bar the IRS’s tax assessments at issue in the case. If not, the IRS would not be barred from making the assessments at issue. The Tax Court (in proceedings below) found that the taxpayer was indeed a bona fide USVI resident; on remand, the appellate court directed the Tax Court to reconsider that determination.

I’ll start by noting that I’ve been writing about USVI tax issues for many years now. Here’s an article that I wrote back in 2012 for the Journal of Tax Practice & Procedure, anticipating the very issues involved in the Sanders case. I’ve also been litigating cases dealing with USVI/territorial tax issues for many years as well. The court’s opinion in Sanders has been a much-anticipated opinion, but given its mere remand (not reversal) of a taxpayer-friendly opinion and the extremely fact-intensive nature of its analysis (it really doesn’t break much ground in terms of the analytical/legal framework applicable to the issues) it frankly doesn’t give much final resolution or guidance for those other USVI cases that are currently pending with similar issues.
The United States Virgin Islands (“USVI”) is classified as an unincorporated territory of the United States. 48 U.S.C. § 1541(a) (2006). It is technically not part of one of the 50 States or the District of Columbia, and generally is not considered a part of the United States for tax purposes. See 26 U.S.C. § 7701(a)(9). As a result, the USVI and the United States operate “separate but interrelated tax systems.” Huff v. Comm’r, 743 F.3d 790, 793 (11th Cir. 2014). In tax jargon, the USVI operates under the so-called “mirror code”—an interesting system that largely adopts the United States tax code and applies it to the USVI, generally inserting the phrase “Virgin Islands” where the phrase “United States” appears. Act of July 12, 1921, ch. 44, sec. 1, 42 Stat. 123 (codified as amended at 48 U.S.C. sec. 1397 (2006)). One can imagine that this approach creates all manner of interpretative issues and uncertainties.

Under the established tax system, the USVI grants a tax credit—through its Economic Development Commission Program (“EDP”)—to certain bona fide USVI residents on income derived from USVI sources or that is effectively connected with the conduct of a trade or business within the UVSI. The EDP, which offers a 90-percent reduction on certain USVI-sourced income for such residents, was specifically sanctioned by Congress and is intended to encourage investment in the USVI’s economy. See 26 U.S.C. § 934(b).

At issue in Sanders is whether tax returns filed by the deceased taxpayer with the USVI’s Bureau of Internal Revenue (“VIBIR”) started the statute of limitations against the IRS’s ability to assess taxes against the taxpayer. Generally, unless an exception applies, the IRS must assess a tax liability within three years of the filing of a tax return. 26 U.S.C. § 6501(a). In Sanders, the IRS did not issue a notice of deficiency until 2010—well after three years had passed since Sanders had filed his tax returns with the VIBIR. The question, then, was whether the returns that Sanders filed with the VIBIR were properly filed with the VIBIR or whether he was required to file with the IRS as well. If properly filed, they began the three-year statute of limitations. And this issue turned on whether Sanders was a bona fide resident of the USVI during the years at issue.

Under the U.S. Tax Code, United States taxpayers who receive income related to the USVI are subject to different reporting requirements depending on their residency status. Bona fide residents of the USVI are only required to file tax returns with the USVI VIBIR; they are not required to file a tax return with the IRS. 26 U.S.C. § 932(c)(2). A bona fide USVI resident who files a tax return with the VIBIR sets the statute of limitations running on the IRS’s ability to assess additional tax against him. Taxpayers who are not bona fide residents of the USVI, however, but who have USVI-sourced income, are required to file tax returns with both the VIBIR and the IRS. 26 U.S.C. § 932(a)(2). If a U.S. taxpayer who is not a bona fide resident of the USVI does not file a U.S. tax return, the taxpayer arguably never sets the limitations period running. The IRS takes the position that it can assess additional taxes against such a taxpayer at any time in the future—even, say, a decade or more later. Clearly, then, much hinges on one’s status as a bona fide USVI resident in this context. And, to complicate matters even more, during the years at issue in this case, the meaning of that phrase was not entirely clear.

Sanders, a successful Florida businessman, was a partner in a USVI-based consulting firm. He claimed bona fide USVI resident status in 2002, 2003, and 2004—a position that, if upheld, entitled him to a 90-percent tax reduction on a substantial portion of his income reported to the USVI. During the years at issue, he filed tax returns with the VIBIR, but not with the IRS (a position that was consistent with his claim of bona-fide-USVI-resident status).

In 2010, the Service issued a notice of deficiency against Sanders, assessing taxes going back to 2002. It challenged Sanders’s claimed status as a bona fide USVI resident during those years, asserting that Sanders was not entitled to the EDP tax reduction that he claimed and that the returns that he filed with the VIBIR did not start the statute of limitations because he was not a bona fide resident.

The estate argued that if a taxpayer filed a return with the VIBIR, but not the IRS, in the good faith belief that he was a USVI resident, the limitations period should start even if the taxpayer was not, in fact, a bona fide USVI resident. The focus, under this argument, would be placed on the subjective belief of the taxpayer, not the objective reasonableness of that belief. The circuit court, however, rejected this argument, holding that a taxpayer’s mere good faith belief regarding his USVI residency is insufficient to cause a return filed with the VIBIR to start the statute of limitations period. Instead, on the court’s reading, the term “bona fide” requires both the resident’s good faith intention to be a resident and objective indicia of genuine residency.

The circuit court went on to address the estate’s second argument: that, regardless of any good faith belief, on the factual record Sanders was in fact a bona fide USVI resident. This issue, which the appellate court characterized as a “conclusion of law or at least a determination of a mixed question of fact and law,” is a fact-intensive one. The court found that that the facts the Tax Court relied on were insufficient—as a matter of law—to establish bona fide residency, necessitating that the trial court make further factual findings on remand.

The meaning of residency in this context has been the subject of some scrutiny and uncertainty. The circuit court, acknowledging that it had never set out a comprehensive test for bona fide residency, looked to existing guidance in the case law as to its meaning. Residency, it found, demands that one be more than a transient or a sojourner, but requires “far less than domicile[,] which requires an intent to make a fixed and permanent home.” In addition, it noted, while a person may have only one domicile at a time, cases have recognized the possibility that one person may have multiple residences simultaneously.

Canvasing the relevant case law, the circuit court noted that courts generally look to the eleven so-called Sochurek factors in analyzing residency. Those factors are set forth below:

(1) intention of the taxpayer;
(2) establishment of his home temporarily in the foreign country for an indefinite period;
(3) participation in the activities of his chosen community on social and cultural levels, identification with the daily lives of the people and, in general, assimilation into the foreign environment;
(4) physical presence in the foreign country consistent with his employment;
(5) nature, extent and reasons for temporary absences from his temporary foreign home;
(6) assumption of economic burdens and payment of taxes to the foreign country;
(7) status of resident contrasted to that of transient or sojourner;
(8) treatment accorded his income tax status by his employer;
(9) marital status and residence of his family;
(10) nature and duration of his employment; whether his assignment abroad could be promptly accomplished within a definite or specified time;
(11) good faith in making his trip abroad; whether for purpose of tax evasion.

The court further drew on the Third Circuit’s analysis of the Sochurek factors, grouping them into four broad categories to provide a framework to facilitate the analysis: (1) the taxpayer’s intent to remain in the place of residency for “an indefinite or at least substantial period of time;” (2) the taxpayer’s physical presence; (3) the taxpayer’s social, family, and professional relationships; and (4) the taxpayer’s own representations. The court noted that there is particular emphasis on the taxpayer’s time spent at the alleged place of residency and the nature of that time.

On remand, the Tax Court will further develop the factual record. It is unclear whether the outcome will be the same. Stay tuned for future developments.

 

Note: Post 2004, § 932 reads as follows:

(a) Treatment of United States residents

(1) Application of subsectionThis subsection shall apply to an individual for the taxable year if—

(A) such individual—

(i) is a citizen or resident of the United States (other than a bona fide resident of the Virgin Islands during the entire taxable year), and
(ii) has income derived from sources within the Virgin Islands, or effectively connected with the conduct of a trade or business within such possession, for the taxable year, or
(B) such individual files a joint return for the taxable year with an individual described in subparagraph (A).

(2) Filing requirement

Each individual to whom this subsection applies for the taxable year shall file his income tax return for the taxable year with both the United States and the Virgin Islands.

(3) Extent of income tax liability

In the case of an individual to whom this subsection applies in a taxable year for purposes of so much of this title (other than this section and section 7654) as relates to the taxes imposed by this chapter, the United States shall be treated as including the Virgin Islands.

(b) Portion of United States tax liability payable to the Virgin Islands

(1) In general

Each individual to whom subsection (a) applies for the taxable year shall pay the applicable percentage of the taxes imposed by this chapter for such taxable year (determined without regard to paragraph (3)) to the Virgin Islands.

(2) Applicable percentage

(A) In general

For purposes of paragraph (1), the term “applicable percentage” means the percentage which Virgin Islands adjusted gross income bears to adjusted gross income.

(B) Virgin Islands adjusted gross income

For purposes of subparagraph (A), the term “Virgin Islands adjusted gross income” means adjusted gross income determined by taking into account only income derived from sources within the Virgin Islands and deductions properly apportioned or allocable thereto.

(3) Amounts paid allowed as credit

There shall be allowed as a credit against the tax imposed by this chapter for the taxable year an amount equal to the taxes required to be paid to the Virgin Islands under paragraph (1) which are so paid.

(c) Treatment of Virgin Islands residents

(1) Application of subsectionThis subsection shall apply to an individual for the taxable year if—

(A) such individual is a bona fide resident of the Virgin Islands during the entire taxable year, or
(B) such individual files a joint return for the taxable year with an individual described in subparagraph (A).

(2) Filing requirement

Each individual to whom this subsection applies for the taxable year shall file an income tax return for the taxable year with the Virgin Islands.

(3) Extent of income tax liability

In the case of an individual to whom this subsection applies in a taxable year for purposes of so much of this title (other than this section and section 7654) as relates to the taxes imposed by this chapter, the Virgin Islands shall be treated as including the United States.

(4) Residents of the Virgin Islands In the case of an individual—

(A) who is a bona fide resident of the Virgin Islands during the entire taxable year,
(B) who, on his return of income tax to the Virgin Islands, reports income from all sources and identifies the source of each item shown on such return, and
(C) who fully pays his tax liability referred to in section 934(a) to the Virgin Islands with respect to such income,
for purposes of calculating income tax liability to the United States, gross income shall not include any amount included in gross income on such return, and allocable deductions and credits shall not be taken into account.

(d) Special rule for joint returns

In the case of a joint return, this section shall be applied on the basis of the residence of the spouse who has the greater adjusted gross income (determined without regard to community property laws) for the taxable year.

(e) Special rule for applying section to tax imposed in Virgin Islands

In applying this section for purposes of determining income tax liability incurred to the Virgin Islands, the provisions of this section shall not be affected by the provisions of Federal law referred to in section 934(a).

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