By Marjorie Rawls Roberts, Law Offices of Marjorie Rawls Roberts, US Virgin Islands
On 15 November 2007, Senator Charles E. Grassley (R-Iowa), the Ranking Minority Member on the US Senate’s Finance Committee, released a document that should alarm everyone who is concerned about governmental abuse of power. It is a 9 November 2007 letter to Senator Grassley from Kathy Petronchak, Commissioner, Small Business/Self-Employed Division, providing tremendous detail and accompanying misinformation about its ongoing audits of US Virgin Islands (USVI) residents.
As indicated in the Petronchak letter, on 24 May 2007, Senator Grassley sent a letter to the IRS requesting information on the effect of a proposal to amend Section 932(c) of the Internal Revenue Code (IRC) to provide that the same statutes of limitation applied for returns filed with the Virgin Islands Bureau of Internal Revenue (BIR) as for returns filed with the IRS. US citizens and resident aliens who are bona fide residents of the USVI have been instructed to file their returns with and pay their Federal taxes to the BIR, not the IRS, since 1922. They calculate their taxes under the IRC, just as other US taxpayers do. The USVI has also been authorised by Congress for almost 50 years to enact economic incentives available on USVI source or effectively connected income to diversify its economy and create jobs, and it has done so.
Generally the statute of limitations that applies to all taxpayers under the IRC is three years, measured from the filing date of the return, but no limitation exists where a return is fraudulent or shows a wilful attempt to evade tax. The amendment to Section 932(c), sponsored by House Ways and Means Committee Chair Charles Rangel (D-NY), would confirm that this same statute of limitations applies to protect taxpayers filing returns with the BIR as exists with the IRS. USVI filers would be treated as all other US persons filing in accordance with the IRC – including US filers receiving economic benefits such as farm subsidies and GO-Zone tax credits.
The Rangel Amendment, passed by the full House of Representatives on 9 November as part of the Temporary Tax Relief Act of 2007, applies to taxable years after 1986. Its legislative history states, simply, “[t]he Committee believes it is unfair to apply different statute of limitations rules to U.S. citizens who claim to be bona fide USVI residents and who file USVI income tax returns than to other U.S. citizens who file income tax returns with the IRS. The 1986 Tax Reform Act provided that residents of the USVI are required to file income tax returns only with the USVI. The Committee believes that the guidance issued by the IRS in 2006 and 2007 represents a misapplication of present law.”
Incredibly the Petronchak letter reiterates the falsehood that clarifying the statute of limitations rules “could allow a significant number of individuals currently under examination to avoid paying income tax for years prior to 2004.” In fact, the individuals and entities referenced in the Petronchak letter filed returns with the BIR and paid taxes to the BIR – and both the BIR and the IRS had the full three years to audit whomever they wished, the same as elsewhere in the US. Some taxpayers under IRS examination have received no-change letters from the BIR for the years under joint BIR-IRS review. After all, the BIR has ten revenue agents conducting civil examinations, the letter notes. Even with the Rangel clarification, USVI taxpayers will be subject to audits by two, not one, independent tax authorities on the same return.
The Petronchak letter also gives a glimpse into the massive resources that the IRS has thrown into the USVI since 2002, and the lack of any appreciable results. It states that 30 IRS agents are conducting civil income tax examinations on 279 individuals and 16 entities, and that 260 of the individual cases involve taxable years prior to 2004 that would be affected by a statute of limitations clarification.
The Petronchak letter provides a timeline showing that investigations into USVI tax issues started in 2002 and civil examinations started in 2004 – so taxpayers have been under audit for three years and years from 2001 forward were open when the audits started. (The IRS Manual requires that auditors proceed reasonably quickly and points out that timely action reduces the burden on taxpayers, but apparently the IRS doesn’t think that applies in the USVI either.)
In February 2005, the Deputy Associate Chief Counsel issued administrative advice to the Program Manager for Small Business/Self Employment, concluding that the statutes of limitation didn’t apply to USVI filers. This directly contradicted the position that the IRS had taken in Field Service Advice (FSA) 199906031, issued 12 February 1999, which acknowledged that the limitations period protected USVI filers. The administrative advice, however, conveniently didn’t mention the FSA. The IRS didn’t publish the administrative advice until the middle of 2006 – more than a year after it was issued internally – and never allowed for any public comment or USVI government input. The Petronchak letter doesn’t address the reasons for the delay in publicising this dramatic policy change and why the IRS hasn’t completed the USVI audits on a timely basis as they must do everywhere else in the US.
The author of the 1999 FSA, W. Edward Williams, an IRS attorney and Senior Technical Reviewer, pointed correctly to the Third Circuit’s finding in the case of Danbury v. Olive, where the court found that “the taxpayer’s returns to the Virgin Islands satisfied its filing obligations under the Internal Revenue Code for the purpose of considering time bars.” However, the 2005 Chief Counsel advice stated that “it is our view that the issues with respect to the statute of limitations on assessment in Danbury … are distinguishable from the issue under discussion” – but it doesn’t distinguish Danbury in any meaningful way.
For the IRS to intentionally let three years of statutes expire – 2001, 2002, and 2003 – and then cry foul when Congressmen indicate that the statute applied all along is frankly unfathomable. Even in cases when the IRS is confident that it has a six-year statute (for substantial omission of income), it normally issues the notice of deficiency within the three year statute.
Apparently some people within the IRS didn’t place their faith in the administrative advice. Instead, in some cases IRS agents, acting as though the three-year statute applied, have sent letters advising taxpayers that the statute would soon expire and have requested and received extensions from USVI taxpayers.
Had the IRS requested extensions from all 279 taxpayers under audit, presumably some would have granted extensions – at least for a while – and others would have declined. Then the IRS would have done what it does in every other audit of US citizens – decide that the taxpayer’s filing position was correct or issue a notice of deficiency. A taxpayer getting such a notice can decide to pay-up or go to appeals and then possibly to court upon disagreement with the appeals officer’s findings. Cases would be in litigation, appeals officers would be considering facts, and the USVI audit programme would now be well towards conclusion with clarity as to what constituted bona fide residency in the USVI before 2005 (when the law changed) and what constituted USVI source or effectively connected income. After all, the average audit lasts about six months, not more than three years.
The Petronchak letter further seeks to provide some explanation of why, despite the IRS’s overwhelming deployment of resources, it has failed to move any audits to conclusion, stating that the IRS has not yet issued a single notice of deficiency because “the tax issues involved are technically complex and factually intensive, requiring significant audit activity. Each case required factual development of residency and an income sourcing determination as well as coordination of examinations with the BIR.”
However, no one challenges that, before 2005, the test for USVI residency was that a person had to be a bona fide resident as of the last day of the tax year under the “facts and circumstances” principles of Section 871 of the IRC. Under that section, Treasury Regulation Section 1.871-2(b) defines “residence”. It is one paragraph in length and states that an alien “who is not a mere transient or sojourner is a resident” 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.” For decades, the IRS and courts have been applying precisely those standards, without complaining about “technical complexity.” Commerce Clearing House annotations list nine cases and three IRS revenue rulings under Section 871 dealing with “resident or non-resident” factual analysis. Many more analogous cases and rulings are found under IRC Section 911, which determines whether US citizens are bona fide residents of a foreign country. If so, taxpayers can exclude foreign earned income from US taxation.
Indeed, the very case selected by the IRS as its primary audit standard, based on materials received pursuant to a Freedom of Information Act request and materials provided to IRS agents in USVI audit prep classes, demonstrates that these issues aren’t complex. In that case, Howard J. Sochurek vs. Commissioner, the Seventh Circuit Court of Appeals reversed the determination of the Tax Court that Mr. Sochurek was not a resident of Singapore (and thus not able to take the foreign earned income exclusion). In its decision, the Tax Court had affirmed the IRS determination that Mr. Sochurek was not a bona fide resident of Singapore for all of 1954 for purposes of IRC Section 911. (It is worth noting that no limitations issues arose precisely because the IRS had sought, and received, timely extensions from Mr. Sochurek.)
The Seventh Circuit reviewed the facts to determine whether Mr. Sochurek – a photographer for Life Magazine covering South-East Asia – was indeed a foreign resident. For the year under audit, 1954, Mr. Sochurek was physically present in Singapore for about 25 days during the year, regularly stayed at the Raffles Hotel when he was there (although he shared a cheap rental with another reporter paying about USD600 a month in today’s dollars), attended church during the three weekends he was in Singapore that year, and travelled extensively throughout the region and back to the US to see his aging parents. The Seventh Circuit then set out eleven factors as bearing on its determination that Mr. Sochurek was a Singapore resident such as “the intention of the taxpayer”. The Seventh Circuit concluded that Mr. Sochurek “was not a transient or sojourner but, as a matter of law, was a bona fide resident of a foreign country” so he got to exclude his wages from Life Magazine from US taxation.
Like residency, the issues of income sourcing and effectively connected income haven’t been difficult for the courts to develop. The Tax Court dealt with such issues in the case of Francisco v. Commissioner, examining whether income earned by Mr. John Francisco for personal services performed on a fishing boat in international waters was American Samoan source or effectively connected income or US source income – and ruled against the taxpayer in 2002. The case took five years from last filing year (1997) to Tax Court opinion (2002), precisely the five year period that the IRS has already spent investigating USVI tax filers – with no results to date. (The Tax Court opinion was affirmed by the Federal Court of Appeals in D.C. in 2004.) Mr. Francisco may have not liked the result, but he got his day in court – and quickly.
Finally, the Petronchak letter discussed the IRS efforts to provide some semblance of fairness, namely by announcing in Notice 2007-31 that, for years starting with 2006, a statute of limitations will apply for USVI filers. The letter indicates that “the IRS will receive complete copies of income tax returns filed with the BIR by individuals who take the position that they are bona fide USVI residents and qualify for the U.S. exemption in section 932(c)(4).”
However, the IRS has had the ability to examine the returns for USVI filers for more than 20 years. On 24 February 1987, a Tax Implementation Agreement was signed in Washington by J. Roger Mentz, then Assistant Secretary (Tax Policy), Department of Treasury, Alexander Farrelly, then USVI Governor, and Anthony Olive, then BIR Director. This Agreement provides for the extensive exchange of information and mutual assistance with respect to taxes to prevent the evasion or avoidance of US or USVI taxes. Among other things, it requires the BIR to provide the IRS with information about any first-time filer with the BIR who claims USVI residency yet has non-USVI source income. It isn’t taxpayers’ faults (and they shouldn’t bear the burden through endless audits) if the IRS and the BIR chose to ignore the Agreement’s extensive exchange of information requirements, literally for decades.
At the outset, I indicated that the IRS audit stance should concern everyone who opposes governmental abuses of power. This group of concerned citizens includes, apparently, Senator Grassley. He stated in 1998 in hearings on the IRS Restructuring and Reform Act that “I have learned over the years … that oversight of the IRS is a step-by-step process, a long-term commitment. … [H]istory teaches the need for constant vigilance over the IRS.” In those hearings he also focused on the mind set of the management culture of the IRS that “if allowed to persist” leads to “arrogance, unresponsiveness, [and] disregard of one’s rights.” That appears to sum up the IRS attitude towards the USVI in the past few years – where the IRS has attempted to strip USVI residents of the fundamental taxpayer rights that all other US taxpayers enjoy without question.
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