EFTA00301255.pdf

ay US, ..... nava ICAIRD tra 'ilwr 1 wagon/A SI CPO I 114TH CONGRESS H. 2D SESSION R. 5039 To amend the Internal Revenue Code of 1986 to provide for economic recovery in the possessions of the United States. IN THE HOUSE OF REPRESENTATIVES Ana 21, 2016 Ms. Phswerr introduced the following bill; which was referred to the Committee on Ways and Means A BILL To amend the Internal Revenue Code of 1986 to provide for economic recovery, in the possessions of the United States. 1 Be it enacted by the Senate and House of Representa- 2 tines of the United States of America in Congress assembled, 3 SECTION 1. SHORT TITLE. 4 This Act may be cited as the "Territorial Tax Parity 5 Act of 2016". 6 SEC. 2. MODIFICATION TO SOURCE RULES INVOLVING PO& 7 SESSIONS. 8 (a) SOURCE RULES.—Section 937(b)(2) of the Inter- 9 nal Revenue Code of 1986 is amended by striking the pe- 10 Hod at the end and inserting the following: "to the extent EFTA00301255  2 1 such income is attributable to an office or fixed place of 2 business within the United States (determined under the 3 rules of section 864(c)(5)).". 4 (b) SOURCE RULES FOR PERSONAL PROPERTY 5 SALES.—Section 865(j)(3) of such Code is amended by 6 adding "932," after "931," and before "933.". 7 (c) EFFECTIVE DATE.—The amendments made by 8 this section shall apply to taxable years beginning after 9 December 31, 2016. 0 .H 6099 EFTA00301256 WtHeNIFCAll, wMAT GPO I 114TH CONGRESS H. R. 20 SESSION 5038 To amend the Internal Revenue Code of 1986 to provide for economic recovery in the territories. IN THE HOUSE OF REPRESENTATIVES Aran.. 21, 2016 Ms. PhasicErr introduced the following bill; which was referred to the Committee on Ways and Means A BILL To amend the Internal Revenue Code of 1986 to provide for economic recovery in the territories. 1 Be it enacted by the Senate and House of Representa- 2 tives of the United States of America in Congress assembled, 3 SECTION 1. SHORT TITLE. 4 This Act may be cited as the "Territorial Tax Equity 5 and Economic Growth Act". 6 SEC. 2. MODIFICATION TO RESIDENCE AND SOURCE RULES 7 INVOLVING POSSESSIONS. 8 (a) BONA FIDE RESIDENT.—Section 937(a) of the 9 Internal Revenue Code of 1986 is amended- 10 (1) by striking the last sentence, and EFTA00301257  2 1 (2) by amending paragraph (1) to read as fol- 2 lows: 3 "(1) who has a substantial presence (deter- 4 mined under the principles of section 7701(b)(3)(A) 5 (applied by substituting `122 days' for '31 days' in 6 clause (i) thereof) without regard to sections 7 7701(b)(3)(B), (C), and (D)) during the taxable 8 year in Guam, American Samoa, the Northern Mar- 9 Tana Islands, Puerto Rico, or the Virgin Islands, as 10 the case may be, and". 11 (b) SOURCE RULES.—Section 937(b) of such Code 12 is amended- 13 (1) by striking "and" at the end of paragraph 14 (1), 15 (2) in paragraph (2) by striking the period at 16 the end and inserting the following: "to the extent 17 such income is attributable to an office or fixed 18 place of business within the United States (deter- 19 mined under the rules of section 864(c)(5)),", and 20 (3) by adding at the end the following. 21 "(3) for purposes of paragraph (1), the prin- 22 ciples of section 864(c)(2), rather than rules similar 23 to the rules in section 864(c)(4), shall apply for pur- 24 poses of determining whether income from sources 25 without a possession specified in subsection (a)(1) is •HR 6098 IH EFTA00301258  3 1 effectively connected with the conduct of a trade or 2 business within such possession, and 3 "(4) for purposes of paragraph (2), income 4 from activities within the United States which are of 5 a preparatory or auxiliary character shall not be 6 treated as income from sources within the United 7 States or as effectively connected with the conduct 8 of a trade or business within the United States.". 9 (c) SOURCE RULES FOR PERSONAL PROPERTY 10 SALEs.—Section 865(j)(3) of such Code is amended by 11 adding "932," after "931," and before "933.". 12 (d) EFFECTIVE DATE.—The amendments made by 13 this section shall apply to taxable years beginning after 14 December 31, 2016. 0 •IIR 6058 III EFTA00301259  Congress should provide two tax incentives needed to attract, promote, and enhance economic development in the Territory. The U.S. Virgin Islands economy has been battered by the economic damage caused by the Great Recession and, more recently, the 2012 closure of the HOVENSA refinery, which had been the Territory's largest private employer and the mainstay of the St. Croix economy for the last half century. Almost 2,000 persons have lost their jobs, annual tax revenue has fallen by over a hundred million dollars, and hundreds of millions more in economic activity have been lost. The Government of the U.S. Virgin Islands respectfully submits that the federal government has a critical role to play in helping our Territory generate robust and sustainable economic growth that can help the Territory improve its long-term fiscal health—and avoid the situation that Puerto Rico is now in. We request that Congress provide for fair and balanced tax rules by including in the omnibus appropriations package two tax incentives related to our Economic Development Commission (EDC) program to attract, promote, and enhance economic development in our Territory. First, Congress should modify the Jobs Act sourcing rule in Section 937(b)(2) of the Internal Revenue Code (IRC) by modifying the U.S. income limitation to exclude only U.S. source (or effectively connected) income attributable to a U.S. office or fixed place of business. A copy of a March 31, 2011 memorandum to Michael Mundaca, then Assistant Secretary of the Treasury for Tax Policy, explaining the need for the request is attached. Under the long-standing rules governing the tax relationship between the Virgin Islands and the United States, a bona fide resident of the Virgin Islands (L e., a tax resident) may satisfy his or her U.S. income tax obligations by filing in, and paying the applicable tax to, the Virgin Islands. Under Section 934 of the U.S. Internal Revenue Code, the Virgin Islands is authorized to reduce the otherwise applicable tax on "V.I. source income" and "income which is effectively connected with the conduct of a V.I. trade or business," regardless of source ("V.I. ECI"). This provision is a potentially powerful incentive for attracting investment to the Virgin Islands by allowing certain qualified U.S. source income (which would otherwise be subject to U.S. income tax rates under the V.I. mirror tax code) to be eligible for the concessionary tax rates under the EDC program. The Jobs Act, however, sharply limited the scope of this incentive by adding new IRC Section 937, which provides that no U.S. source income can qualify as V.I. ECI (the "U.S. income limitation") unless specifically permitted under rules promulgated by the Treasury. To date, Treasury has permitted only inventory sales of Virgin Islands manufactured goods in the U.S. market (which would constitute U.S. source income) to qualify as V.I. ECI, based on the Department's constrained interpretation of an express legislative statement in the Jobs Act that Congress expected that the rules would continue the historic rule regarding inventory. We understand that Treasury believes a statutory change or Congressional clarification would be needed to address the issue, and that it would not oppose such a change or clarification. This limitation has resulted in unjustified and sometimes illogical restrictions on the EDC program, and it has hindered the growth and development of high tech and knowledge-based EFTA00301260 industries in the Territory. For example, royalty income earned through licensing of a software created by a Virgin Islands company to clients in foreign countries may qualify as V.I. ECI under the Jobs Act rules and thus eligible for EDC tax incentives, while licensing of the same software to U.S. customers would not, thus incentivizing Virgin Islands high tech companies to look to foreign markets rather than the U.S. market. Similarly, a Virgin Islands captive insurer which insures foreign risks would qualify for EDC tax incentives, while the insurance of U.S. risks would not, ironically putting V.I. companies at a competitive disadvantage compared to companies in Bermuda and other Caribbean countries. We therefore request that Congress modify the sourcing rules in the Jobs Act by adopting the model income tax treaty rules for determining effectively connected income and modifying the U.S. income limitation to exclude only U.S. source (or effectively connected) income attributable to a U.S. office or fixed place of business. Proposed language that would amend• Subsection (b)(2) of IRC Section 937 is attached. Second, Congress should ensure parity of treatment among the Territories with respect to the treatment of capital gains, by clarifying in IRC Section 865(j)(3) that capital gains income earned by V.I. taxpayers should be deemed to constitute V.I. source income regardless of the tax rate imposed by the V.I. government (to maintain eligibility of certain capital gains income for EDC tax incentives). This change would correct an apparent drafting oversight by conforming the sourcing of capital gains of V.I. EDC beneficiaries with the rules already applicable to Puerto Rican resident tax benefitted capital gains. Providing such parity would make our EDC economic growth program even more effective in attracting and retaining V.I. resident beneficiaries with capital gains. Attached are a May 1, 2014 letter to Mark Mazur, Assistant Secretary of the Treasury for Tax Policy and a background paper that explain the need for the request. Treasury has indicated that there is no apparent tax policy for this V.I.-PR capital gains sourcing distinction and that it would not oppose such a provision. Proposed language that would amend Subsection (j)(3) of IRC Section 865 is also attached. Attachments: March 31, 2011 Memo. to Michael Mundaca, Ass't Secr. of Treasury for Tax Policy (re Modifying the U.S. Income Limitation) May 1, 2014 Letter to Mark Mann, Ass't Secr. of Treasury for Tax Policy; and Background Paper (Addressing the Capital Gains Sourcing Distinction) Proposed Language to Amend IRC §§ 937(bX2) and 865(1)(3) "*1 -2- EFTA00301261  1700 K Street, N.W. WINSTON Washington, D.C. 20006-3817 T: +1 & STRAWN North America Europe Asia F: +1 LLP wvAv.winston.00m External Memorandum Pews N. Hicbcrt To: The Honorable Michael F. Mundaca Assistant Secretary of the Treasury for Tax Policy From: Peter N. Hiebert Barry J. Hart Counsel to the of the U.S. Virgin Islands Date: March 31, 2011 Re: Determination of "Bona Fide Residency," "Source of Income," and "Effectively Connected Income" for U.S. Virgin Islands Taxpayers Thank you for the opportunity to address the important question of the Treasury Department's treatment of "bona fide residency," "source of income," and "effectively connected income" under the provisions of Section 937(a) and (b) of the Internal Revenue Code of 1986, as amended ("Code"), as added by the American Jobs Creation Act of 2004 ("Jobs Act") and as it applies to taxpayers in the U.S. Virgin Islands ("USVI" or "Territory"). The scope and content of those provisions are critically important to USVI tax policy, and to the economic development program that relies heavily upon it. We believe that the current Treasury regulations implementing these provisions of the Jobs Act (the "Treasury Regulations"), particularly the "physical presence" test for establishing Territorial residency and the treatment of "effectively connected income" cEcn, set forth at Treas. Reg. §§ 1.937-1(c) and 1.937-2 and -3, are unnerassarily restrictive, and have resulted in severe harm to the USVI's most promising economic development efforts. The purpose of this Memorandum is to explain the USVI's objections to the current Treasury Regulations and provide alternative approaches that we believe would give effect to Congressional intent, be consistent with Treasury's commitment to preventing abusive schemes, and help restore the USVI's economic development program to its former promise. INTRODUCTION The USVI remains a developing economy with per capita income barely half that of the United States and a poverty rate three times the national average. The USVI Government ("Government") is committed to transforming its economy from one based heavily on tourism to a diversified one that includes high-value service businesses—the kind of businesses that attract not only investment but also entrepreneurial and intellectual capital. To that end, the Government has committed significant resources to its Economic Development Commission ("EDC") program, which relies upon Congressionally-authorized tax incentives in order to attract new and dynamic service businesses to the USVI and create jobs and economic opportunity for its people. EFTA00301262 WINSTON & STRAWN LLP Honorable Michael F. Mundaca March 31, 2011 Page 2 The tax benefits administered by the EDC are essential to the economic growth and prosperity of the USVI: in 2004, service businesses associated with the EDC program contributed nearly 20% of the USVI's total General Pond revenues and supported 8% of the USVI's total employment. But since the imposition of more stringent residency and income sourcing requirements by the American Jobs Creation Act of 2004 ("Jobs Act") and subsequent Treasury Regulations, the EDC program has all but fallen into disuse: applications to the program have fallen from 74 in 2003 to just 12 in 2009. The resulting decline in tax revenues, employment, and commercial growth has harmed the entire USVI economy and the people who depend on it. This blow to the USVI's economic prospects was not Congress' intent The purpose of the Jobs Act revisions to the possessions' residency and income rules was simply to prevent a small number of abusive tax-avoidance schemes, which the IRS had condeinned as unlawful even under the old law. Congress certainly did not intend to cripple the EDC program. And to ensure that any such effect could be remedied, Congress conferred on Treasury broad authority to promulgate regulations defining possession "bona fide residency," "source of income", and "effectively connected income." We take this opportunity to urge Treasury to exercise that authority to revisit and revise its approach to determining Territorial residency, source of income, and ECI in terms that will restore viability to the EDC program as an important engine for job creation, revenue generation and economic growth, while continuing to prevent opportunities for taxpayer abuse. BACKGROUND A. The USVI's Economic Challenge The USVI is an island Territory, geographically removed from the U S mainland and larking in both natural resources and a significant manufacturing base. Subject to U.S. minimum wage laws and federal labor, environmental and other regulatory requirements, the USVI is also vulnerable to industrial and commercial competition from lower-wage, non-U.S. jurisdictions nearby and throughout the hemisphere. Historically, its economy has been based heavily oh tourism—an industry of limited scalability and growth potential—which accounts for approximately 80% of both Territorial GDP and private sector employment' The result is an economy that struggles even in good times: for USVI families with young children, the poverty rate erns% 40%, and the overall poverty rate is nearly double that of Mississippi, the poorest U.S. State. The perceived lack of economic opportunity in the USVI has led to a "brain drain" of the USVI's most promising young people, who typically emigrate to the United States after college to pursue employment and professional opportunities. 3 Source: CIA World Factbook, Field Listing: Population Below Poverty Line, available at htsprfivivewicia.govilibrarylpul the-world-factbookineos/waronl EFTA00301263 WINSTON &STRAWN I.LP Honorable Michael F. Mundaca March 31, 2011 Page 3 B. The USVI Economic Development Program Like most developing economies, the USVI has long used tax incentive programs to attract business and investment Historically, the USVI's EDC program focused on tourism and manufacturing: it provided tax benefits to companies in traditional categories like rum and dairy production, oil refining, watch manufacturing, transportation, hospitality, and utilities.2 With the decline of the manufacturing sector in the face of tariff liberalization and increased foreign competition, those efforts, by the turn of the century, had become largely outpaced by globalization and resulted in stagnant economic growth. Beginning in 2001, the Government embarked on a new economic development strategy that promised not only to increase revenues, but to effect structural improvements in the USVI economy itself. That year, the Government reorganized and expanded the EDC program by refocusing it on "designated service businesses" ("DSBs")—companies that can leverage modem telecommunications technologies to service an international clientele from a USVI base. Indeed, by USVI law, a DSB may only provide its services "to customers located outside the Virgin Islands."3 Although the category of DSBs is potentially broad, in practice the DSB program consists largely of very high-income services businesses—typically, hedge funds, asset management, investment services, and consultancies. Under the program, a DSB's qualified USVI income is eligible for a 90% tax exemption if certain conditions are met, including (1) proof of the company's physical presence in the USVI; (2) completion of an extensive application process; (3) due diligence by the EDC's professional staff; (4) public hearings; and (5) specific authorization from the Governor. A qualified applicant must then satisfy continuing requirements involving the investment of capital, employment of at least 10 full-time employees (a substantial number of whom must be local resident), provision of health and retirement benefits and training to those employees, and contributions to local charities or other job-training programs. Each beneficiary receives a compliance orientation conducted by the EDC's Director of Compliance and, thereafter, is assigned a compliance officer who ensures that the beneficiary's continuing obligations are satisfied. The development focus on DSBs had an immediate impact on the USVI economy. In 1999, there were only 7 DSBs operating in the USVI, with gross sales of $113 million.4 By 2003, there were 44 such entities, generating gross sales of $643 million—an increase of 470%.5 By 2004, just three 'PricewaterhouseCoopers, "Economic Impact of [the Jobs Act] on U.S. Virgin Islands," Jan. 12, 2005 ("PwC Report") at 14-15. The PwC Report was provided to both the Treasury Department and the Department of the Interior in connection with their implementation of the Jobs Act in January 2005. 29 V.LC. § 703(g). 4 PwC Report, Table 12. 5 Id EFTA00301264 WINSTON 8(STRAWN LLP Honorable Michael F. Mundaca March 31, 2011 Page 4 years into the program, DSBs were responsible for 29% of all USVI income tax receipts.6 Moreover, because DSBs provide the kind of high-paying, high-qualification jobs that are otherwise lacking in the USVI economy—and because DSBs are required by law to employ 80% USVI residents—those jobs provide a dynamic counterweight to the historical problem of "brain drain." The DSBs thus provide an essential resource for the human and intellectual capital that are critical to the USVI's developing economy. The direct financial and employment benefits of the EDC program, however, were only part of an even larger economic success story. The infusion of DSBs into the USVI economy also had a significant multiplier effect.? Successful DSBs and their employees pour money back into the local economy by purchasing homes, services and goods. Those pure. sqrs in turn generate yet more local employment, which further stimulates the local economy in a virtual cycle of growth. . Based on the growth rate of the DSB program from 2001-2004, the number of qualified DSBs was projected to rise from 49 in 2004 to 79 in 2007, with the income tax revenue generated by the program rising from $114 million to $227 million in those three years. Those additional tax revenues would have funded a significant portion of the USVI's annual budget during that period—to say nothing of the additional jobs, consumer spending, real estate investments, and other benefits that increased use of the program would have brought. But, as explained below, none of that happened. C. The Jobs Act of 2004: Restricting Territorial Residency and Income Rules In early 2004, in the wake of media coverage describing certain abuses of the EDC program, the IRS issued Notice 2004-45, warning certain EDC beneficiaries and tax promoters against taking "questionable" tax positions with respect to USVI residency and source of income. In particular, Notice 200445 warned against U.S. persons falsely claiming bona fide USVI residency and EDC benefits while continuing to live and work in the U.S. It also warned against U.S. persons claiming as USVI source income monies received for services performed in the United States, or claiming that non- • USVI source income could be treated as "effectively connected" with the conduct of a trade or business within the USVI. At the same time, the Senate Finance Committee investigated the EDC program and concluded that, under the subjective "facts arid circumstances" test then applicable in determining residency under Section 932, some U.S. taxpayers (encouraged by unscrupulous promoters) were able to gain EDC benefits by falsely claiming USVI residency based on such flimsy.evidence as a driver's license or voter registration card. 6 id., Table B. I Id. at 24-26 and Table 20. EFTA00301265 WINSTON & STRAWN LLP Honorable Michael F. Mundaca March 31, 2011 Page 5 1. Section 937(a): Congress enacts a newly restrictive approach to Territorial residency but provides broad discretion to Treasury to promulgate "appropriate" implementing rules. In response to such abuses, the Senate Finance Committee, during its consideration of the Jobs Act, adopted an amendment to the Code that would have repealed the subjective "facts and circumstances" test then in effect in favor of a more objective analysis employing a test "similar to" the "substantial presence" test set forth in Section 7701(b)(3)—the test used to determine whether foreign nationals are .USVI (and U.S.) "residents" for U.S. income tax purposes.g Under the latter test, a foreign taxpayer would have qualified as a U.S. resident for U.S. income tax purposes if he (1) was present in the United States on at least 31 days in the cakndar, year; and (2) was present in the United States for a minimum weighted average of 122 days in the current year and the two preceding years, unless for a given year he was present for less than 183 days, and had both a "tax home" in and a "closer connection" to another country. Consistent with that test, the Government submitted a proposal to the Joint Committee on Taxation ("Joint Committee" or "MT') under which a USVI taxpayer could claim USVI residency if he was physically in the USVI (1) at least 183 days in any one tax year, or (2) a weighted average of 122 days a year for any three-year period, or if (failing those tests) the taxpayer could establish that he had a "closer connection" to the USVI than to the United States. Following discussions with Joint Committee staff, the USVI then modified its proposal by making the "closer connection" test a mandatory addition to the 3-year weighted average test. Treasury, however, submitted an alternative proposal during the House-Senate Conference Committee deliberations on the Jobs Act that defined residency much more restrictively. Under Treasury's proposal, a USVI (or other U.S. possession) taxpayer was required to establish that he (1) was physically present in the territory for at least 183 days in any tax year; (2) had no "tax home" other than the USVI; and (3) had a "closer connection" to the USVI than to the United States or any other jurisdiction. Treasury's proposal made no reference to the 122-day three-year weighted average test borrowed from Section 7701(b)(3)—thus, on its face, making it more difficult for a U.S. citizen to claim USVI (or other possession) residency than for a foreign national to be deemed a USVI (or U.S.) resident. The Conference Committee adopted Treasury's more restrictive test, which ultimately became Code Section 937(a).9 Importantly, however, in enacting the more restrictive residency test, Congress made clear that Treasury had broad discretion to make "exceptions" by regulation to that test "as appropriate.s10 The legislative history explains that such exceptions should be made for, "in particular, persons whose presence outside [the Virgin Islands or other possessions] for extended periods of time lacks a tax avoidance purpose." S. 1637, 108th Cong. § 497 (as passed by Senate, May I I, 2004). 9 See H.R. REP. No. 108-755 (2004) (Conf. Rep.), as reprinted in 2004 U.S.C.C.A.N., 1341, 1830-31. tO EFTA00301266 WINSTON &STRAWN LIP Honorable Michael F. Mundaca March 31, 2011 Page 6 2. Section 937(b): Congress enacts a newly restrictive approach to Territorial income rules but also provides broad discretion to Treasury to promulgate "appropriate" implementing rules. Neither the Senate nor the House versions of the Jobs Act contained any provisions with respect to the possessions'• source of income or ECI rules." Treasury, however, included in its alternative proposal a new statutory framework, not included in either the Senate- or House-passed bills, which severely limits the amount of USVI ECI that can qualify for EDC benefits. The Treasury substitute generally provided that rules "similar to" the .rules for determining whether income is income from sources within the United States or effectively connected with the conduct of a trade or business within the United States shall apply for purposes of detepnining whether income is USVI source income or USVI ECI. However, the Treasury proposal also provided that, unless otherwise excepted in regulations, U.S. source income and ECI would generally not be treated as income from within the USVI or as USVI ECI (the "U.S. income limitation rule"), thus limiting, without the benefit of legislative hearings, the scope of USVI tax incentives and the opportunities to develop a modem and' diversified economy. The Conference Committee adopted Treasury's more restrictive source of income and ECI rules, which are now codified in Code Section 937(bX1) and (2).12 The effect of the U.S. income limitation rule under Section 937(b)(2) is, perversely, to discourage USVI companies from doing business in the United States. For example, if a USVI-based software company licenses $40 million in software products, developed and produced in the USVI, to U.S. customers and $40 million to European customers, the $40 million in European royalties will qualify as USVI ECI—but the substantively identical $40 million in U.S. royalties will not However, as it did with the residency requirements, Congress also made clear that Treasury had broad discretion to make "exceptions" by _regulation "as appropriate" which would allow some categories of U.S. source income (and U.S. ECI) in certain circumstances to be treated as USVI source income or USVI ECI.13 The legislative history explains, illustratively, that such exceptions should be made "to continue the existing treatment of income from the sale of goods manufactured in a possession.s14 This exception would protect the EDC manufacturing sector, including rum distilling, watch and jewelry manufacturers and other manufacturing industries in the Virgin Islands which might otherwise be harmed by. the new sourcing and ECI limitations. It would not, however, extend to income generated by the kinds of information-ageor other high-value service businesses that are now the focus of the USVI's economic development efforts. S. 1637, 108th Cong. § 497 (as passed by Senate, May 11, 2004); H. R. 4520 108th Cong. (as passed by House, June 17, 2004). 12 See H.R. REP. NO. 108-755, at 1830. 13 Id. 14 Id. EFTA00301267 WINSTON &STRAWN LLP Honorable Michael F. Mundaca March 31, 2011 Page 7 D. Treasury's Possessions Regulations: Implementing the Provisions of the Jobs Act 1. Residency Regulations: Treas. Reg. § 1.937-1. In April 2005, Treasury promulgated Proposed Regulations pursuant to Code Section 937(a). The Final Treasury Regulations, issued in November 2006, provide that to establish "bona fide residency" in the USVI (or other possession), a taxpayer must meet a physical presence test, a tax home test, and a "closer connection" test. The physical presence test may be satisfied in relevant part either by demonstrating physical presence in the USVI (1) "for at least 183 days during the taxable year," or (2) "for at least 549 days during" the relevant three-year period, provided that he was "also present . . . for at least 60 days during each [of those three years]".15 This three-year averaging test is computed on a non-weighted basis. In other words, the Final Regulations—which remain in effect—take the three-year weighted averaging method of Section 7701(b)(3) and substantially lengthen it, from a required average of 122 days of physical presence over a three-year period to a required (non-weighted) average of 183 days over a three-year period, while also imposing the additional "tax home" and "closer connection" requirements mandated by Section 937(a)(2). The result is a possession residency determination for U.S. citizens that is substantially harder to satisfy, not only than the old "facts and circumstances" test that preceded Section 937(a), but also the Section 7701(b)(3) "substantial presence" test that applies to USVI (and U.S.) residency determinations for foreign nationals.16 2. Possession Source Income and ECI Regulations: Treas. Reg. §§ 1.937-2 and -3. In Section 937(b), Congress authorized Treasury to create by regulation appropriate exceptions to the U.S. income limitation set forth in Section 937(b)(2). But Treasury has largely declined to do so. The Final Regulations governing possessions' source income and ECI, Treas. Reg. §§ 1.937-2 and -3, respectively, both include a blanket rule that possession source income and ECI shall not include income that is either U.S. source income or U.S. ECI.17 The lone exception applieS narrowly to "sale[s] of inventory property" under Treas. Reg. § 1.863-3(f), which refers to inventory "produced (in whole or in part) ...within the United States and sold within a possession, or produced (in whole or in part) .. .in a possession and sold within the United States."I8 Such sales may be treated as possession ECI even if such income is also determined to constitute U.S. source income or U.S. ECI. But the USVI, in particular, lacks a significant manufacturing base; and the inventory exception does not extend to 15 See Treas. Reg. § 1.937-1(cX1Xi), Tress. Reg. § 1.937-1(c)(1)(iii), (iv), and (v) provide additional tests for physical presence. The Government understands that these additional tests are rarely able to be satisfied by EDC participants. 16 See Treas. Reg. § 1.937-1(c)(2).' 17 See Treas. Reg, § 1.937-2(c), -3(c). 16 See fleas. Reg. §§ L937-2(d), -3(d) and 1863-3(f). EFTA00301268 WINSTON &STRAWN up Honorable Michael F. Mundaca March 31, 2011 Page 8 income generated by modem industries like finance, consulting, and software development—the industries most critical to the USVI's future growth and prosperity. As a result of these limitations, the USVI (and other U.S. possessions) will be forced to rely on legacy industries of limited scalability, such as manufacturing and tourism, for its economic development, or to focus on foreign markets rather than the United Stain. E. Consequences of the Treasury Regulations for USVI's Economic Development Program The effects of Section 937 and the Final Treasury Regulations on the USVI's economic developinent efforts were immediate and devastating. At least seven EDC beneficiaries dropped out of the program within a few months of the new law taking effect.19 New EDC applications dropped from 74 in 2003 to 21 in 2005, and to just. 12 in 2009.2 The job opportunities created by new EDC beneficiaries fell from 1,660 in 2004 to 798 in 2005, to just 282 in 2009.21 Worse, of just eight new Certificates of Benefit issued by the EDC program in 2009, only two were issued to DSBs. The resulting impact on tax revenues and employment has been severe. It is fair to say that Treasury's highly restrictive regulations governing residency and ECI have all but crippled the USVI's most successful economic development program. PROPOSED REVISIONS TO THE SECTION 937 RESIDENCY AND ECI REGULATIONS The Government is grateful to you and to the Treasury Department for your willingness to revisit the Territorial residency and ECI regulations. We believe that an accommodation can be reached that would both serve Congress' and Treasury's purpose of preventing fraud and abuse of the USVI's EDC program and permit the revitalization of that essential part of the USVI's (and other possessions') ongoing economic development efforts. A. Proposed Revisions to the Physical Presence Test for Determining Bona Fick V.I. Residency The Government's proposed solution is essentially a return to the principles of the original 2004 Senate bill: A Treasury regulatory regime that is similar to the "substantial presence" tat of Section 7701(b)(3).23 The Government's proposal would leave the existing alternative physical presence tests 19 See Letter from USVI Gov. Charles W. Turnbull to The Hon. John W. Snow, Secretary of the Treasury, April 28, 2005. 30 Declaration of Percival Clouden, Appleton v. Comm 'r, No. 7717-10 (Tax Ct. Aug. 18,2010), at 911. 11 See US Virgin Islands Economic Development Commission, FY 2009 Annual Report, ("EDC Annual Report') at 13 (available at httpd/www.usvieda.org/ecla_report2009/index.html). • n .14 at 14, Table 1. See H.R. REP. N0.108-755, at 1831. EFTA00301269 WINSTON &STRAWN LLP Honorable Michael F. Mundaca March 31, 2011 Page 9 for U.S. citizens set forth in Treas. Reg. § 1.937-1(c)(1) intact, but for one change: It would revise the "physical presence" test of Treas. Reg. § 1.937-1(c)(1)(ii) to adopt the 122-day three-year weighted average test of Section 7701(b)(3), rather than the 183-day non-weighted average test required by the current Treas. Reg. § 1.937-1(c)(1)(ii), and add a minimum annual physical presence requirement of 90 days (rather than the current 60 days). The "tax home" and "closer connection" tests of Treas. Reg. § 1.937-1(d) and (e) would remain unaltered. Thus, a U.S. citizen could claim bona fide USVI residency by showing that (1) he or she was physically present in the USVI for 183 days in the current tax year, or for a weighted average of 122 days over the last three tax years, together with a minimum of 90 days of physical presence in each year (or one or more of the other physical presence tests), (2) his or her "tax home" is in the USVI, and (3) he or she did not have a closer connection to the United States or a foreign country than to the USVI during the taxable year.24 As we explain below, such a compromise would be consistent with Congress' intention to prevent the exploitation of EDC benefits by "individuals who continue to live and work in the United States," and would serve both Treasury's interest in administrability and the USVI's interest in revitalizing its once-promising economic development efforts. 1. The proposed substantial presence test is consistent with Congress' wish to prevent exploitation of EDC tax benefits by U.S. persons and to "rationalize" the law of Territorial residency. As explained above, the impetus for Congress' decision to abandon the old "facts and circumstances" residency test in favor of the more stringent requirements of Section 937(a) was its "understand[ing]" that "certain U S citizens and residents are claiming that they are exempt from U.S. income tax . . . based on a position that they are bona fide residents of the Virgin Islands," despite continuing "to live and work in the United States," and that some of those "same individuals" were able to "secure a reduction of up to 90 percent of their Virgin Islands income tax liability" under the EDC program.23 The express purposes of Section 937(a) were, first, to give effect to Congress' belief "that the various exemptions from U.S. tax provided to residents of possessions should not be available to individuals who continue to live and work in the United States"; and second, to ensure that "the special U.S. income tax rules applicable to residents in a possession" would be "rationolized " that is, made more objective than the old "facts and circumstances" test.26 Consistent with those purposes, Congress also gave Treasury broad authority to "create exceptions to" the Section 937(a) regime "as appropriate . . . to cover, in particular, persons whose presence outside a possession for extended periods of time lacks a tax avoidance purpose.a27 That is, Congress explicitly provided the Treasury 24 We note that under Treat Reg. § 1.937-1(cX2), foreign nationals would continue to be deemed USVI residents under the Section 7701(bX3) physical presence test, which requires only a 31-day minimum physical presence each year. 25 See H.R. REP. N0.108-755, at 1830-31. 26 /c/ 27 See RR_ REP. N0.108-755, at 1832. EFTA00301270 WINSTON &STRAWN LLP Honorable Michael F. Mundaca March 31, 2011 Page 10 • with authority to create less stringent residency rules for persons who are genuinely resident in the USVI, but are required to travel extensively outside the Territory for purposes other than tax avoidance. The Government's proposed "substantial presence" test is entirely consistent with both of Congress' goals. First, a taxpayer who "continues to live and work in the United States" (and so receives the benefits of public services funded by U.S. tax revenues) likely could not satisfy the proposed 122-day three-year weighted average USVI presence requirement, and almost certainly could not satisfy both the "tax home" and "closer connection" requirements. For that reason, the potential for abuse—in the form of U.S. persons claiming USVI residency and EDC benefits on the basis of tenuous connections to the Territory—is very low, if not non-existent. This is particularly true in light of the rigorous EDC application process and the mandatory compliance reviews that are now conditions of EDC participation. In 2009, EDC's compliance personnel completed 25 compliance reviews, 12 of which identified one or more instances of noncompliance with program requirements—including noncompliance with the USVI residency requirement? Failure to remedy noncompliance with the USVI residency requirement results in expulsion from the EDC program. In addition, it bears repeating that the Government's proposal retains both the "tax home" and "closer connection" requirements of the existing Treasury Regulations. As you know, an individual's "tax home" is considered to be "located at the individual's. regular or principal (if more than one regular) place of business," except that a taxpayer is not "considered to have a tax home in a foreign country for any period for which [his] abode is in the United States.i29 As the IRS Office of the Associate Chief Counsel recently explained, this "abode" limitation has meant that taxpayers with "strong familial, economic and personal ties in the United States and only transitory ties in the foreign county where the taxpayers worked" are deemed to have a "tax home" in the United States.3° The "tax home" requirement has been employed to prevent U.S. tax avoidance by, for example, contractors who alternate blocks of time working abroad with blocks of time at home in the United States?' Similarly, an individual seeking to demonstrate USVI residency must also satisfy the "closer connection" test of Treas. Reg. § 1.937-1(e), which requires that he or she "did not have a closer connection to the United States or a foreign country than to the [USVI] during any part of the taxable • year." Such a "closer connection" to another jurisdiction exists where the individual "has maintained more significant contacts with the foreign country [or the United States] than with the [USVI]," based on, but not limited to, facts and circumstances, such as the location of the individual's permanent home; his or her. family; his or her personal belongings and those of his or her family; personal banking institution; business activities (aside from those constituting the individual's "tax home"); driver's 28 See EDC Annual Report at 15. Treas. Reg. §.§ 1.937-1(d)(1) and 1.911-2(b). so See AM 2009-03 (Feb. 13, 2009). 31 See, e.g., LeMay Y. Comm 'r, 837 F.2d 681 (5th Cir. 1988). EFTA00301271 WINSTON &STRAWN LLP Honorable Michael F. Mundaca March 31, 2011 Page 11 license; voter registration; and social, political, cultural, or religious organizations with which the individual has a current relationship?' Thus, the existing "tax home" and "closer connection" tests provide a potent merhanism for ensuring that U.S. citizens claiming USVI residency are genuinely based in the USVI. The continuing vitality of those requirements should greatly mitigate any lingering Treasury reservations about the potential for abuse under the modified physical presence test proposed by the Government. Second, the proposed "physical presence" test would amply fulfill Congress' wish to "rationalize" the law of Territorial residency. The difficulty of the pre-2004 "facts and circumstances" test was its subjectivity: it was difficult for both taxpayers and tax authorities to know ex ante how a particular residency determination would come out.-13 "Rationalizing" the residency rules required a more objective standard, which both the straightforward 183-day minimum-presence test of Section 937(a)(1) and the more flexible 183-day three-year average test of Treas. Reg. § 1.937-1(c)(1Xii) provide. But the modified "physical presence" test proposed here—with its 122-day three-year weighted average test—is equally objective, and would in fact "rationalize" the law of taxpayer residency in ways that the existing Treasury Regulations do not. Specifically, the use of a modified "physical presence" test in a revised Treas. Reg. § 1.937- 1(c)-1(iii) would more closely align the principles of Territorial residency for U.S. citizens with the principles of U.S. (and USVI) residency as applied to foreign nationals. The current Treasury Regulations already provide that residency of nonresident aliens is detennined using the 122-day weighted-average test of Section 7701(bX3).34 For decades, Territorial residency and U.S. residency were both governed by the subjective "facts and circumstances" test. But in 1984, Congress abandoned the "facts and circumstances" test for foreign nationals. As the Mint Committee then explained, "Congress believed that the tax law should provide a more objective definition of residence for income tax purposes.'05 The resulting "objective definition" was the substantial presence test of Section 7701(b)(3).36 In adopting that test, Congress explained its view that the 122-day three-year weighted average presence requirement "meets. the criteria of objectivity and establishing nexus with" the taxing jurisdiction, such that subjecting the taxpayer to tax in that jurisdiction was "appropriate." 37 So too 32 See 26 U.S.C. § 7701(b)(3)(BXii); Treas. Reg. §§ 301.7701(b)-2(b), (d)(1)(1)-(viii), (d)(2). 33 See H.R. REP. No. 108-755, at 1829-30 (describing the "subjective facts-and-circumstances test" and proposing "rationalizing" amendment). 36 Treas. Reg. §§ 1.937-1(cX2), (g), Example 4. 33 STAFF OF JOINT COMM. ON TAXATION, 98TH CONG., GENERAL EXPLANATION OF TEE REVZIUE PROVISIONS OF THE DEFICIT REDUCTION ACT OF 1984, at 463 (Comm. Print 1984); see also H.R. REP. No. 98-432, pt. 1, at 222. 96 See H.R. REP. No. 98-861, at 188-189, 967 (1984) (Conf. Rep.) (setting forth text of § 7701(bX3) and describing the new substantial presenc