Feb. 28, 2007 -- The Internal Revenue Service ("IRS") released Notice 2007-19 on February 21, 2007, providing interim rules on the statute of limitations on assessment for bona fide residents of the United States Virgin Islands ("USVI") by the IRS. The Notice also announced that the Treasury Department and the IRS intend to issue regulations under Sections 932(c) and 7654(e) of the Internal Revenue Code of 1986. The impact of this Notice is far reaching. It does not just affect business people or persons who have taken benefits under the Territory's various economic incentive programs. It affects, for example, all fifteen senators, the Governor and Lieutenant Governor, and countless other government officials and private citizens.
This Notice appears to be in furtherance of the IRS position that USVI residents previously had no statute of limitations for purposes of the IRS, which was first articulated by the IRS in 2006. As discussed in more detail below, USVI Delegate to Congress Donna Christian Christensen and Congressman Charles Rangel, Chair of the House Ways and Means Committee, have articulated in testimony and in letters to the Treasury Department respectively that they disagree with the IRS position that no statute of limitations existed for USVI resident taxpayers vis-à-vis the IRS prior to issuance of the Notice.
This Notice asserts that there is now in fact a statute of limitations on assessment by the IRS of bona fide residents of the USVI. Unlike the treatment accorded to U.S. residents who file with the IRS, where the statute of limitations starts automatically upon filing, certain bona fide residents of the USVI must take additional steps to start the statute of limitations with respect to a taxing authority to which they previously had no filing obligation under the Internal Revenue Code as long as they filed their returns with and paid full tax to the USVI.
The issuance of this Notice is ironic in that for a number of years some bona fide residents of the USVI have been filing copies of their Forms 1040 with the IRS as duplicative or protective filings. The filings were made in the event the IRS determined that taxpayers filing as bona fide residents of the USVI did in fact have a filing obligation to the U.S. Upon receipt of these protective filings however, it is the experience of taxpayers and tax practitioners that the IRS either processed the returns, resulting in a notice of payment due to the taxpayer and potential double taxation, or sent the return to the Virgin Islands Bureau of Internal Revenue ("BIR") and notified the taxpayer that his or her return was misfiled with the IRS.
Under the IRS position as discussed in the Notice, a USVI resident does not start the statute of limitations for purposes of IRS assessment of tax (as opposed to the BIR) by filing his or her return with the BIR despite that being required by the Internal Revenue Code and IRS Publication 570, among other sources. The IRS is, accordingly, conducting audits of persons who filed returns with the BIR and these audits are covering years as far back as 1998 in some cases. If the IRS determines that a person owes tax to the U.S., that person may now be subject to double taxation if the three-year period for requesting a refund from the BIR has passed and the matter cannot be resolved through appropriate competent authority procedures.
Under the terms of Notice 2007-19, USVI residents are divided into two classes, which are "covered persons" and "non-covered persons" based on a person's gross income in a certain year. A "covered person" is a U.S. citizen or resident alien who takes the position that he or she is a bona fide resident of the USVI, files Form 1040 with the BIR, and has less than $75,000 gross income for the taxable year. A "non-covered person" is a person who would otherwise be a "covered person" but has gross income of $75,000 or greater.
Treatment of "Covered" Persons -- Those with Gross Income Under $75,000
Once a covered person has filed a Form 1040 with the BIR, assuming the absence of fraud, the three-year statute of limitations begins to run for purposes of both the BIR and the IRS according to the Notice. As explained by the IRS in the Notice, assume C, who takes the position he is a USVI resident and has gross income of less than $75,000, files a Form 1040 for the tax year 2006 on March 12, 2007 with the BIR. Since C is a "covered person" he does not have a filing obligation with the IRS and the three-year statute of limitations on assessment for both the IRS and the BIR would expire on April 15, 2010.
The Notice does not deal with a number of issues in its definition of "covered" person. First, the IRS does not state whether it takes the position that it can audit persons who report gross income of less than $75,000 beyond the three-year statute to determine whether in fact they had gross income of less than $75,000. For example, if a person filed an income tax return with the BIR showing gross income of $74,000 but failed to report $2,000 in dividend earnings, could the IRS audit that person beyond the three-year statute of limitations?
Further, the Notice does not explain how the IRS can firmly assert that there is no applicable statute of limitations in the law, and then develop by Notice a statute of limitations for bona fide USVI residents.
Finally, the Notice did not indicate that the income number of $75,000 was selected as being the appropriate cut-off for a statute of limitations.
Treatment of "Non-covered" Persons -- Those with Gross Income of $75,000 or More
The requirements that the Notice sets out for starting a statute of limitations are very different for those persons deemed to be "non-covered persons." In order to start the statute of limitations with respect to the IRS, the Notice requires that a non-covered person must file a Form 1040 with the IRS on which the non-covered person reports no gross income and no taxable income. In addition, each non-covered person must complete and submit a new form titled "Bona Fide Residence-Based Return Position." Until this form is issued (and the Notice gave no indication of when the form would be issued) a non-covered person must meet the information reporting requirement by attaching a statement to his or her U.S. Form 1040 titled "Bona Fide Residence-Based Return Position" and setting forth the following information:
(1) the taxpayer's name, social security number and address;
(2) a statement affirming the facts upon which the taxpayer's bona fide residence is based as defined in Treas. Reg. Section 1.937-1(b);
(3) an affirmation that the taxpayer has properly filed a USVI individual income tax return (generally Form 1040), a statement of total tax liability reported on the USVI Form 1040 and the amount of gross income reported in such return; and
(4) a declaration under penalties of perjury that the taxpayer has examined the statement and attachments and that they are true and correct to the best of the taxpayer's knowledge.
Taxpayers filing joint returns may file a joint Form 1040 with the IRS but each must file a separate Bona Fide Resident Return Position statement, if each is a "non-covered person."
Required Contents of Statement Affirming Residency
The statement affirming the facts upon which the taxpayer's bona fide residence is based is a reference to the new test for bona fide residency under Section 937 of the Internal Revenue Code and regulations promulgated thereunder. Every bona fide resident of the USVI who is a non-covered person must submit a statement to the IRS indicating that they meet the three tests for bona fide residency: (1) the physical presence test; (2) the closer connection test; and (3) the tax home test. Providing information addressing these three tests will require that each taxpayer analyze and provide extensive information to the IRS. These tests are summarized below for persons who do not have ready access to Treasury Regulations.
Physical Presence Test: Under the physical presence test, a person must spend all or part of 183 days in the USVI or average 183 days a year over a rolling three-year period or meet one of three alternatives. One alternative requires spending no more than 90 days in the U.S. during a taxable year. A second alternative requires that an individual spend more days in the USVI than in the U.S. and have no more than $3,000 in earned income from the U.S. "Earned income" doesn't include dividends, interest, or pensions. Finally, if a person does not have a significant connection to the U.S., then no day counting is required. To meet this test, a person's spouse and dependents cannot live in the U.S. (but no limitations exist for grown children or children for which a taxpayer does not have custody), a person must not be registered to vote in the U.S., and a person must not have a home available for full-time use in the U.S. (with special rules for rental properties).
Closer Connection Test: The "closer connection test" requires that a taxpayer be able to demonstrate that he or she does not have a "closer connection" to the U.S. or a foreign country than to the USVI (or another possession if relevant). The regulations list ten factors to be considered in determining whether a "closer connection" exists and also indicate that the list is not exclusive.
The enumerated "closer connection" factors are (1) location of the individual's permanent home; (2) location of the individual's family; (3) location of personal belongings, such as automobiles, furniture, clothing, and jewelry owned by the individual and family members; (4) location of social, political, cultural or religious organizations in which the individual has a current relationship; (5) location of the individual's personal bank accounts; (6) location where the individual conducts business activities other than those that constitute the individual's principal business; (7) type of driver's license held by the individual; (8) country of residence designated by the individual on forms and documents; (9) types of official forms and documents filed by the individual; and (10) where the individual votes.
Tax Home Test: For the "tax home test" an individual's tax home is generally considered to be located at his or her regular place of business. If an individual has more than one place of business, then the tax home is the principal place of business. For persons without a regular or principal place of business, the tax home is their regular place of abode.
As explained by the IRS, if N, a U.S. citizen asserting bona fide residency in the USVI, has at least $75,000 of gross income, in addition to filing a Form 1040 with the BIR, he must also file a Form 1040 with the IRS taking the position that he does not have any gross income or taxable income for U.S. tax purposes. N must also file a Bona Fide Residence-Based Return Position statement. As a result of these filings by N the three-year statute of limitations on assessment for both the BIR and the IRS will expire on April 15, 2010 and in the absence of fraud or other activity that would extend the statute of limitations, neither the IRS nor the BIR can make any further assessment of income tax for the 2006 taxable year after April 15, 2010.
Effective Dates for New Filings Requirement
According to the Notice, the new filing requirement is applicable to tax years ending on or after December 31, 2006.
For years prior to 2006, non-covered persons (that is, persons with gross income of $75,000 or more) may choose to file U.S Form 1040 with the IRS as provided in this Notice. Although a Bona Fide Residence-Based Position statement does not need to be filed for a taxable year ending before December 31, 2006, the non-covered person must note on the first page of U.S. Form 1040 the applicable taxable year and that U.S. Form 1040 is being filed in accordance with Notice 2007-19. However, the Notice states that the statute of limitations will only start to run from the date the additional return is filed with the IRS. As explained by the IRS, assume on March 16, 2007, J, a U.S. citizen and calendar year taxpayer with at least $75,000 of gross income for taxable year 2003 files Form 1040 with the IRS, taking the position that for taxable year 2003 she did not have any gross or taxable income for U.S. income tax purposes and clearly marks the Form 1040 as applying to her taxable year 2003 and as being filed in accordance with Notice 2007-19. Under these circumstances, the three-year period of limitation for the taxable year 2003 will expire on March 16, 2010 and the IRS will make no further assessment after that date except as otherwise authorized under law.
Covered persons may also apply this Notice to years prior to 2006 by providing documentation upon examination that establishes to the satisfaction of the IRS Commissioner that the taxpayer is a covered person. Once that is done, the statute of limitations will be deemed to have begun on the date of the filing with the BIR. In effect, this means that if the IRS determines during an examination that a person had less than $75,000 in gross income for a given year, then the person will be determined to have a three-year statute of limitations for that year.
The Notice does not discuss the effect on the statute of limitations of the receipt of the actual return by the IRS for a given year prior to the issuance of the Notice either by way of duplicate or protective filing or as may have actually been provided to the IRS by the BIR.
A non-covered person's failure to file the Form 1040 and the Bona Fide Residence-Based Position statement with the IRS for tax years commencing with 2006 may result in the imposition of a $1,000 penalty for failure to file by the IRS.
The Notice is noticeably silent on a number of points regarding non-covered persons. For example, it does not state whether dependents of non-covered persons who file separate returns must also complete the requirements for non-covered persons or can simply file their returns with the BIR assuming gross income of each dependent of less than $75,000.
Further, it does not address the fact that many bona fide residents of the USVI have not retained records for 20 plus years and thus are at an extreme disadvantage in the event of an IRS audit for years beyond the three-year statute of limitations. The IRS is essentially taking the position now that no statute of limitations on assessment has ever been in effect for any year in which a bona fide resident of the USVI did not file a return with the IRS. This is so notwithstanding the fact that the statute of limitations on taxpayer refunds expired prior to any notice that the IRS had changed its position on its ability to assess tax. Upon audit a USVI resident would be required to substantiate all aspects of his or her return regardless of the normal discarding of records, the death or retirement of return preparers, or the destruction of records by hurricane or other natural disasters.
The Notice does not clearly indicate what is meant by "gross income reported in such return." Is it the same as total income as reported on line 22 of Form 1040? If not, do taxpayers have to add back tax-exempt interest? If a taxpayer is a partner in a partnership, is the taxpayer required to report his or her gross income from the partnership?
The Notice also does not set out a clear due date for the filing with the IRS. The Notice does not state whether the filing date is April 15 or whether it is the date that the taxpayer's Form 1040 is filed with the BIR, including applicable extensions.
Finally, under applicable law a person who is not a bona fide resident of the USVI but who has a spouse who is a bona fide resident of the USVI with a higher income can file a joint return with his or her spouse in the USVI as a bona fide resident of the USVI. The Notice does not indicate whether such persons must file returns with the IRS as "non-covered persons" if they have gross income above $75,000 since they are not taking the position that they individually are bona fide residents of the USVI.
Impact of Notice on USVI
The IRS estimates that this new filing requirement will affect approximately 8,500 USVI bona fide residents and will take each taxpayer approximately 5 hours to complete each year. The estimated total annual reporting burden is 42,500 hours that must be spent by USVI residents in meeting this new requirement.
However, the new filing requirement does not affect any other territories since the Notice and its requirements only apply to USVI residents.
Notice 2007-19 Conflicts with Law and IRS Practice
The IRS position set forth in the Notice conflicts with prior guidance that affirmed that filing a return with the BIR started the statute of limitations for all purposes. This Notice may have been issued in response to concerns have been raised by Congresspersons Rangel and Christensen, by USVI taxpayers being audited beyond three years, by tax professionals, and by others that the IRS was ignoring significant case law, statutes, and practices that indicated that a return filing by a USVI resident with the BIR started the statute of limitations for both the BIR and the IRS. Congresswoman Christen, testifying before the Committee on Ways and Means on September 26, 2006, stated in pertinent part that "[t]he IRS tactics ... go far beyond intrusive and burdensome data requests. In the course of these audits, the IRS has reversed its long-standing administrative practice and published position, and now claims that the statute of limitations never runs for V.I. taxpayers who reasonably and in good faith file their tax returns with, and pay their tax to, the Virgin Islands Bureau of Internal Revenue, as the law requires them to do."
In recent years the IRS has embarked on an extensive examination of USVI residents, both persons who were owners of entities granted benefits by the Economic Development Commission and residents of the USVI who were not affiliated with an EDC entity. Concerns have been raised in particular when the IRS began examining filings of USVI residents for years that were otherwise closed by the three-year statute of limitations based on filing with the BIR.
In response to these concerns, the IRS issued Chief Counsel Advice (CCA) 200624002, which indicated that the IRS position was that the filing of a return by a bona fide resident with the USVI, as required by Section 932(c) of the Internal Revenue Code as applicable in the USVI and the U.S., did not start the statute of limitations with respect to an examination of a taxpayer by the IRS. Congressman Rangel sent a letter on September 19, 2006 to Nina Olson, National Taxpayer Advocate, characterizing the issuance of the CCA as a reversal of longstanding practice "without notice and without any mention of the prior administrative practice" of requesting that USVI taxpayers sign a waiver of the statute of limitations to extend the statute.
The position taken in the CCA also directly conflicts with the position of the Third Circuit taken in Danbury, Inc. v. Anthony Olive [820 F.2d 618 (3d Cir.), cert. denied, 484 U.S. 964 (1987)] and the position taken by the IRS in Field Service Advice 199906031, issued by the IRS on February 12, 1999. It also conflicts with the actions taken by the IRS over decades and even with recent requests in some of the ongoing IRS audits for extensions of the statute to permit the IRS to continue its audits.
FSA 199906031 examined the issue of whether the statute of limitations remained open with respect to a taxpayer who was a U.S. citizen and also a bona fide resident of the USVI, and who timely filed a USVI tax return, but failed to report on that return income from U.S. sources. The IRS concluded that, absent an exception, it could not assess additional tax because the statute of limitations imposed by Section 6501(a) of the Internal Revenue Code had expired for IRS purposes as well as BIR purposes. FSA 1999906031 relied in large part upon the determination of the Third Circuit Court of Appeals in Danbury. The Third Circuit held in that case that "[the Taxpayer's] returns to the Virgin Islands satisfied its filing obligations under the [Code] for the purpose of considering time bars" [Danbury, 820 F.2d at 627], irrespective of the Taxpayer's failure to report income in accordance with Code Section 932(c)(4)(B). Since more than three years had passed since each of the filings, the court ruled that the IRS was precluded from assessing deficiencies for those tax years pursuant to Section 6501(a) of the Code. FSA 199906031 clearly states that it is the position of the IRS that this analysis also applies to individual taxpayers. A Field Service Advice is guidance provided to an IRS agent by an IRS attorney.
Interestingly, the IRS did not acknowledge the issuance of FSA 199906031 in issuing Chief Counsel Advice 200624002 although it tried to distinguish the Danbury case basically by pointing out that that case dealt with years not affected by the Tax Reform Act of 1986.
Furthermore, the Notice did not discuss how the IRS can reconcile its position that there is no statute of limitations absent a special filing with the IRS for USVI taxpayers with gross income of at least $75,000 with a reasonable reading of the Internal Revenue Code as applied in the USVI through use of the substitution scheme known as the "mirror" system. Pursuant to the mirror system the words "Virgin Islands" are substituted for the words "United States" wherever they appear in the Internal Revenue Code. [See Naval Service Appropriation Act of July 12, 1921, 48 U.S.C. § 1397 (popularly known as the Naval Service Appropriation, 1922).] 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 USVI 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, 7 V.I. 555, 562; 430 F.2d 973, 976 (3d Cir. 1970).] Consequently, the normal statute of limitations provision in Code Section 6501(a)(i) (3 years) should be mirrored in the USVI. A bona fide resident of the USVI is statutorily required to file his income tax return with the USVI in accordance with Code Section 932(c)(2), and pursuant to Code Section 6501(a), any examination of the taxpayer must be begun prior to the expiration of the three-year statute of limitations.
Finally, the Notice conflicts with prior practice of the IRS. By way of example, Anthony P. Olive, who worked at the BIR from 1965 to 1991 and who served as BIR Director from 1984 until 1991, states that during his term as Director, in the event the IRS was auditing a USVI taxpayer, the IRS would ask for the assistance of the BIR in obtaining an extension of the statute beyond three years when necessary. "It was clear from my numerous discussions with IRS personnel over decades of working together that the position of the IRS was that the three-year statute applied to USVI residents unless this extension was obtained," Mr. Olive adds. Reports are that at least some IRS agents still take this position since some agents are asking for extensions in audits being conducted by the IRS of USVI taxpayers who did not file returns with the BIR.
The Notice did announce that the Treasury Department and the IRS are studying the feasibility of an automatic exchange of information program with the BIR concerning income tax information of individual taxpayers as well as the issuance of regulations. The Notice did not indicate that the BIR was part of the study at this point. The Notice indicated that such a program for the timely exchange of equivalent data in a form compatible with IRS systems may eliminate the reporting requirements set forth in the interim rules. The Notice did not indicate why the information exchange provisions set out in the Tax Implementation Agreement Between the United States of America and the Virgin Islands, signed on February 24, 1987 by then-Director Olive, then-Governor Alexander Farrelly, and then-Assistant Secretary of the Treasury Department J. Roger Mentz, were not sufficient or whether the Treasury is in fact considering an amendment to or renegotiation of that Agreement.
Further, on January 24, 2007, Congressman Rangel, now Chair of the House Ways and Means Committee, sent a letter to Secretary of the Treasury Henry Paulson affirming that the intent of the 1986 Act was to coordinate the two systems, not to repeal procedural rights. The position taken by the IRS prior to issuance of the CCA "was consistent with the law that was in effect before the 1986 Act and was consistent with my understanding of the intent of the 1986 Act." Congressman Rangel has not yet commented publicly on the issuance of Notice 2006-19.
In the absence of further direction from the IRS or the implementation of the information exchange provision, USVI residents with $75,000 or more in gross income must commence preparing to file a return with the IRS for 2006 or face penalties and the possibility of IRS audits commencing more than three years after filing with the BIR.
The information provided in this article is not legal advice. Readers should consult with their professional advisors to determine how this information may apply to their specific circumstances.