IRS Backs Down On USVI Tax Returns

by Mike Godfrey, for LawAndTax-News.com, Washington

27 February 2007

The IRS has responded to criticism over its continuing attack on residents of the US Virgin Islands, after it required them to file tax returns directly, rather than just through the local tax agency, suspending the 3-year Statute of Limitations that would normally apply.

Representative Charles Rangel (DEM - NY) Chairman of the House Ways and Means Committee had written to Treasury Secretary Henry Paulson, in January, saying: "Situations have been brought to my attention that involve individuals who, in good faith, filed the return with the Virgin Islands and fully paid their liability. The IRS has taken the position that those individuals should have filed their returns with the United States. As a result, the IRS is now asserting deficiencies for the full liability even though many have already paid their share -- although perhaps to the wrong government."

Last week, however, the IRS said it would set a three-year limit on audits of island residents with worldwide income exceeding US$75,000 who immediately provide federal tax returns for the past 20 years.

The cause of the problem is an IRS program for the USVI, instituted in 1986 and extended in 2001, which allows certain types of business with investment of at least US$100,000 and at least 10, mostly local employees, a 90% income tax deduction. 49 hedge funds took advantage of the program.

In 2004, the IRS and Congress clamped down on abuse of the program by US citizens falsely claiming to be resident in the USVI in order to claim the tax break on income received from local businesses, or on income attributed to them because of their ownership of such companies. Under the new rules, incorporated in the American Jobs Creation Act of 2004 (AJCA) a person has to be resident for at least six months of the year in order to claim the tax break.

The IRS's clamp-down on abuse of US Virgin Islands tax incentive legislation has claimed some possibly unintended scalps as nearly half of the locally-registered hedge funds have jumped ship.

23 hedge funds have left the USVI since 2004, fearing an attack from the IRS, hedgie William Mosler told the International Herald Tribune. Said Mosler: "It's kind of like what happens to a community when a big company or an army base pulls out but on a smaller scale. Unfortunately, the fear is causing a case of running away from the police when you're not guilty."

The Treasury Department and IRS issued a comprehensive package of proposed and temporary regulations under the AJCA in April of 2005; final regulations were issued in September incorporating many of the comments received on the proposed and temporary regulations, including a number of revisions intended to better reflect the realities of life in the US possessions.

Confusingly, Bloomberg reported that the US Virgin Islands is trying to encourage investment in high-tech companies after the Treasury extended the Islands' 90% tax break to businesses dealing in intellectual property in September.

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