n-04-45.pdf

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Part I – Income Taxes

Meritless Filing Position Based on Sections 932(c) and 934(b)

Notice 2004-45

The Internal Revenue Service is aware that certain promoters are advising
taxpayers to take highly questionable, and in most cases meritless, positions described
below in order to avoid U.S. taxation and claim a tax benefit under the laws of the
United States Virgin Islands (USVI). Promoters may also be advising taxpayers to take
similar positions with respect to other U.S. possessions. This notice alerts taxpayers
that the Service intends to challenge these positions in appropriate cases. The Service
may impose civil penalties on taxpayers or persons who participated in the promotion or
reporting of these positions. In addition to being subject to other penalties, any person
who willfully attempts to evade or defeat tax by means of an arrangement such as the
one described in this notice, or who willfully counsels or advises such evasion or defeat,
may be guilty of a criminal offense under federal law.
Background

Section 934, which was enacted in 1960, provides that the USVI may reduce its
territorial income tax only in certain limited cases. The USVI may not, however, reduce
the tax liability of U.S. citizens or residents who are not bona fide residents of the USVI.
In the case of U.S. citizens or residents who are bona fide residents of the USVI, it may
reduce their tax liability only with respect to income from sources in the USVI or income
effectively connected with the conduct of a trade or business within the USVI.

The legislative history of § 934 indicates that the statute was enacted in part
because of concerns that certain local income tax programs, which were intended to
provide incentives to corporations and USVI residents that made new investments in the
USVI, were having the effect of reducing the tax liability attributable not only to income
from sources within the USVI but also to income from sources within the United States.
While recognizing the goal of encouraging economic development in the USVI through
appropriate income tax reductions, the legislative history to § 934 indicates that in no
case should this [goal] be attained by granting windfall gains to taxpayers with respect
to income derived from investments in corporations in the continental United States, or
with respect to income in any other manner derived from sources outside of the Virgin
Islands.

S. Rep. No. 1767, 86
th
Cong., 2nd Sess. 4 (1960).

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Typical Promotion

The highly questionable positions described in this notice may be promoted to
taxpayers in a variety of forms. The Service is aware, however, that they have
frequently been promoted in the following manner:

Promoters typically approach a taxpayer (Taxpayer) living and working in the
United States and advise Taxpayer to (i) purport to become a USVI resident by
establishing certain contacts with the USVI, (ii) purport to terminate his or her existing
employment relationship with his or her employer (Employer) and (iii) purport to become
a partner of a Virgin Islands limited liability partnership (“V.I.LLP”) that is treated as a
partnership for U.S. tax purposes. V.I.LLP then purports to enter into a contract with
Employer to provide Employer with substantially the same services that were provided
by Taxpayer prior to the creation of this arrangement. Typically, after entering into the
arrangement, Taxpayer continues to provide substantially the same services for
Employer that he or she provided before entering into the arrangement, but Taxpayer is
nominally a partner of V.I.LLP instead of an employee of Employer.

Under this arrangement, Employer makes payments to V.I.LLP for Taxpayer’s
services and no longer treats the payments as wages paid to Taxpayer subject to the
withholding and payment of employment taxes and reporting on Taxpayer’s Form W-2.
V.I.LLP, in turn, makes payments to Taxpayer for his or her services to Employer.
V.I.LLP typically treats these payments for tax accounting purposes either as
guaranteed payments for services or as distributions of Taxpayer’s allocable share of
partnership income. Under this arrangement, the promoter may be a general partner in
V.I.LLP and may retain a percentage of the fees received from Employer.

V.I.LLP either has or secures a reduction, up to 90 percent, in USVI income tax
liability under the Economic Development Program (EDP) of the USVI. Taxpayer takes
the position that the EDP benefits granted to V.I.LLP provide a corresponding reduction
in the income tax liability that Taxpayer reports on his or her USVI income tax return
with respect to guaranteed payments from the partnership or distributive shares of the
partnership’s net income, or both. Taxpayer pays tax to the USVI in an amount
approximately equal to 10% of the U.S. income tax liability that otherwise would be
imposed on Taxpayer’s income from performing the services. Taxpayer claims that, for
purposes of computing his or her U.S. income tax liability, gross income does not
include guaranteed payments received from V.I.LLP or Taxpayer’s distributive share, if
any, of the partnership’s net income, or both.

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Positions Promoted

In situations such as those described above, as well as in other situations, the
following highly questionable positions are being promoted:

--“You can continue to live and work in the United States and, nevertheless,
be a bona fide resident of the USVI.” The concept of a “bona fide resident of
the Virgin Islands” was an integral part of the predecessor to § 934(b), and as
such, its meaning has been well established. See
§ 934(c) as enacted by P.L.
86-779, §4(a) (1960). When Congress enacted the current versions of §§ 932
and 934(b), it retained this concept, but noted that Treasury has the authority to
modify its meaning when necessary to prevent abuse. See
H.R. Rep. No. 99-
426 (1985) and General Explanation of the Tax Reform Act of 1986, JCS-10-87
(1987) (“Similarly, where appropriate, the Secretary may treat an individual as
not a bona fide resident of the Virgin Islands.”) The determination of whether an
individual is a bona fide resident of the USVI turns on the facts and
circumstances and, specifically, on an individual’s intentions with respect to the
length and nature of his or her stay in the USVI. See § 1.934-1(c)(2) (generally
applying the principles of §§ 1.871-2 through -5). Promoters typically represent
that a taxpayer need not make major lifestyle changes in order to become a bona
fide resident of the USVI, and may represent that the taxpayer need only spend a
few weeks or less out of the year in the USVI to become a resident for income
tax purposes. These representations, however, have no basis in the well-
established meaning of the term “bona fide resident of the Virgin Islands.”
Accordingly, a claim of USVI residency for income tax purposes may be
considered without merit or fraudulent when the taxpayer continues to live and
work in the United States.

--“USVI source income includes income from services performed in the
United States.” The principles that generally apply for determining gross and
taxable income from sources within and without the United States (in particular,
the rules of §§ 1.861-1 through 1.863-5) also generally apply in determining
gross and taxable income from sources within and without a possession of the
United States. See
§ 1.863-6 and Francisco v. Commissioner, 119 T.C. 317
(2002) aff’d, No. 03-1210 (D.C. Cir. June 18, 2004). With certain limited
exceptions, compensation for labor or personal services performed in the United
States is gross income from sources within the United States. See
§ 861(a)(3)
and § 1.861-4(a)(1). The result does not change if the compensation is received
in the form of a guaranteed payment from a partnership rather than in the form of
a fee for services under an employment contract. See
Miller v. Commissioner,
52 T.C. 752 (1969), acq
. 1972-2 C.B. 2. Promoters typically claim that taxpayers
are free to argue, under a variety of theories, that income from services
performed in the United States constitutes income from USVI sources because

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“no rules exist under section 934” for determining whether income is from USVI
sources. Based on the foregoing discussion, however, such arguments are
without merit.

--“For purposes of determining the source of income, USVI includes the
United States.” Section 932 provides coordination rules for filing of returns for
U.S. and USVI income taxes by bona fide residents of the USVI and U.S. citizens
and residents who have income derived from sources within the USVI or income
effectively connected with the conduct of a trade or business within the USVI. To
facilitate this coordination, § 932(c)(3) states that the USVI includes the United
States for certain tax purposes. Section 932(c)(3) was modeled after § 935(c),
which was enacted fourteen years earlier and which provides an equivalent rule
with respect to Guam. For an illustration of the types of purposes for which
these provisions apply, see
§ 1.935-1(c)(1)(ii). Notably, these provisions do not
apply for purposes of determining the source of income. See H.R. Rep. No. 92-
1479, 92d Cong., 2d Sess. 5 (Oct. 2, 1972) (“In determining the source of income
for purposes of the special tax system provided in the bill (new code sec. 935),
the principles contained in secs. 861-863 are to be applied without reference to
sec. 935(c).”) Based on an incorrect reading of § 932(c)(3), promoters may claim
that compensation for services performed in the United States is considered for
tax purposes to be compensation for services performed in the USVI. This claim
is without merit. Section 932 does not apply to determine the source of income
on which the USVI tax liability of bona fide residents may be reduced under §
934(b)(1). Thus, § 932(c)(3) does not operate to transform compensation from
the performance of personal services in the United States into income from
sources in the USVI.

--“Non-USVI source income can be treated as effectively connected with
the conduct of a trade or business within the USVI even if, under equivalent
circumstances, such income would not be considered effectively
connected with the conduct of a trade or business within the United
States.” As noted above, § 934(b)(1) grants limited authority to the USVI to
reduce the USVI tax liability with respect to income from USVI sources or income
effectively connected with a trade or business within the USVI. The use of the
term “effectively connected with the conduct of a trade or business” in § 934
indicates that Congress generally intended for the rules under § 934 to follow the
well-established rules that apply for purposes of determining the taxation of
nonresidents, such as the definition of effectively connected income under §
864(c). Section 934(b)(4), however, provides Treasury with the authority to issue
regulations providing an alternative definition of the term. The legislative history
of § 934 makes clear that this grant of regulatory authority was for the purpose of
preventing abuse, and that Congress anticipated that it would be used to provide
further limitations on the type of income that would be treated as from USVI

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sources or as effectively connected with the conduct of a trade or business within
the USVI. S. Rep. No. 99-313, at 484, 1986-3 C.B. (vol. 3) 484. Taxpayers have
no legal basis for claiming that the scope of the term “income effectively
connected with the conduct of a trade or business” is broader under § 934 than it
is under § 864. In particular, taxpayers have no legal basis for disregarding the
rules of § 864(c)(4), which generally limit the amount of foreign source income
that is treated as effectively connected with a U.S. trade or business to certain,
very narrow categories of income. Accordingly, with the exception of those
narrow categories, and in the absence of regulations to the contrary, income,
gain, or loss from sources without the USVI cannot be treated as effectively
connected with the conduct of a trade or business within the USVI for purposes
of § 934. For example, income from the performance of personal services
without the USVI cannot under any circumstances be treated as effectively
connected with the conduct of a trade or business within the USVI. Promoters
typically interpret the phrase “effectively connected to the conduct of a trade or
business within the USVI” broadly, and inconsistently with § 864(c)(4), in order to
claim a tax reduction with respect to income from non-USVI sources. As
indicated above, however, these interpretations have no merit.
The IRS intends to challenge these positions and other similar claims that disregard
the statutory and regulatory provisions concerning the limitations on the reduction of
USVI income tax. Where taxpayers in order to make these claims enter into
arrangements such as the one described in this notice, the Internal Revenue Service
may disregard such arrangements on the grounds that they lack economic substance or
that they have no purpose other than tax avoidance or evasion. The Service also may
assert that the arrangement does not serve to terminate the employment relationship
between a taxpayer and Employer for federal employment tax purposes, with the result
that Employer remains liable for employment taxes and applicable penalties and
interest.
In addition to liability for tax due plus statutory interest, taxpayers that claim to
have no requirement to file a federal income tax return or pay federal income tax liability
based on the positions described herein may be subject to penalties including, but not
limited to, the accuracy-related penalty under § 6662, failure to file or pay penalties
under § 6651 and civil fraud penalties under § 6663. Further, persons who participate
in the promoting or reporting of these positions may be subject to aiding and abetting
penalties under § 6701. In addition to other penalties, any person who willfully attempts
to evade or defeat tax by taking the positions described in this notice, or who willfully
counsels or advises such evasion or defeat, may be guilty of a criminal offense under
§§ 7201, 7203, 7206, or 7212(a) or other provisions of federal law. Promoters and
others who assist taxpayers in taking these positions also may be enjoined from doing
so under § 7408.

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The principal author of this notice is W. Edward Williams of the Office of
Associate Chief Counsel (International). For further information regarding this notice
contact W. Edward Williams at (202) 622-3295 (not a toll-free call).