No Foreign Tax Credit Where Sisters Couldn't Prove Virgin Island Residency

(Parker Tax Publishing October 2016)

The Tax Court determined that because three sisters were not bona fide residents of the U.S. Virgin Islands, and could not prove that they reasonably relied on advice in claiming they were residents, they could not take a foreign tax credit against their U.S. tax liability for taxes paid to the Virgin Islands. Although the sisters had already paid income tax to the Virgin Islands, they were not required to do so because they did not have any Virgin Island income for the year at issue and thus the amounts for which they were claiming a foreign tax credit were not "taxes paid" within the meaning of Reg. Sec. 1.901-2(e)(5)(i). Vento v. Comm'r, 147 T.C. No. 7 (2016).

Background

In early 2001, Richard and Lana Vento, their three daughters Renee, Gail, and Nicole, and various Vento-controlled entities realized $180 million in capital gains from the sale of a technology company, Objective Systems Integrators, Inc. (OSI). After the sale of OSI was complete, the family took a vacation to the U.S. Virgin Islands. In May, Richard and Lana contracted to buy a home on the islands, and in the fall of 2001 they obtained Virgin Islands driver's licenses and registered to vote there. The three sisters did not follow their parents' lead, and throughout the majority of 2001, they lived in the U.S., where they worked, attended school, or cared for school-age children.

Richard and Lana filed a joint 2001 income tax return with the Virgin Islands Bureau of Internal Revenue (BIR). Although the sisters had previously made estimated federal income tax payments for 2001, they did not file U.S. income tax returns for that year but instead filed their tax returns with the BIR. Each of those returns included a payment of tax. In 2003, because the sisters filed their 2001 returns with the BIR rather than with the IRS, the IRS transferred to the BIR the estimated payments the sisters had made for 2001, along with credits to their accounts from prior years.

In 2005, the family became embroiled in a tax dispute between the U.S. and the Virgin Islands over the taxation of the capital gain from the sale of OSI. The dispute made its way to the Third Circuit, which held in Vento v. Director of Virgin Islands BIR, 2013 PTC 71 (3d Cir. 2013) that Richard and Lana successfully established that they were bona fide residents of the Virgin Islands at the end of the year and thus owed taxes to the Virgin Islands and not the IRS; the court determined the daughters did not similarly establish Virgin Islands residency and held they owed the taxes on the capital gains to the IRS.

Each sister conceded the issue of their residency and also conceded that none of her income for 2001 was sourced in the Virgin Islands and that she did not work in the Virgin Islands or conduct any trade or business there. The sisters subsequently brought suit seeking to credit the payments made on their 2001 Virgin Island returns, along with the estimated taxes the IRS transferred to the BIR, against their U.S. tax liabilities for 2001.

Analysis

Code Sec. 901 allows U.S. taxpayers to credit foreign income tax paid against their U.S. income tax liabilities. Under Reg. Sec. 1.901-2(a)(2)(i), income taxes paid to foreign jurisdictions or U.S. possessions are creditable only to the extent that they are compulsory amounts paid in satisfaction of a legal obligation. Under Reg. Sec. 1.901-2(e)(5)(i), an amount paid is not a compulsory payment to the extent it exceeds the foreign tax liability, and an amount paid doesn't exceed the liability if it is based on the taxpayer's reasonable interpretation of the law.

Code Sec. 904 limits the amount of creditable foreign tax to the portion of the taxpayer's pre-credit U.S. tax liability attributable to foreign source income.

Before the Tax Court, the IRS argued that because the sisters were not bona fide residents of the Virgin Islands for 2001 - nor was any of their income for that year sourced there - they were not legally liable for the Virgin Islands tax at issue, and thus the amounts were not compulsory and were not "taxes paid" for purposes of Code Sec. 901. In addition, the IRS stated that even if the sisters were required to pay taxes to the Virgin Islands, because their Code Sec. 904 limitation was zero, the amounts paid still would not be credited under Code Sec. 901.

The sisters argued that, because in 2001 there was no clear authority on determining residency in the Virgin Islands, the position that they were bona fide residents of the Virgin Islands (and thus required to pay income tax there) for that year was, at the time, a reasonable interpretation of applicable law. The sisters also claimed that the Code Sec. 904 limitation did not apply to taxes paid to the Virgin Islands, citing a conference report on the Tax Reform Act (TRA) of 1986, which coordinated the U.S. and Virgin Islands tax systems.

The Tax Court sided with the IRS, concluding that the taxpayers were not entitled to credit the amounts in issue under Code Sec. 901. The court stated that although during 2001 a highly subjective test governed whether an individual qualified as a bona fide resident of the Virgin Islands, there was no evidence that the sisters, on the basis of advice from competent advisers or otherwise, paid Virgin Islands tax for 2001 in reliance on a reasonable interpretation of the residency requirements. The court also rejected the taxpayers' argument that the Code Sec. 904 limitation did not apply, finding their argument rested on a single sentence pulled out of context from the legislative history of the TRA.

The court recognized that the sisters, having already paid tax to the Virgin Islands on their 2001 income, would as a result of the decision end up paying a second tax on the same income to the U.S. However, the court said, whatever sympathy it might have for the taxpayers could not compel it to allow them a foreign tax credit against their U.S. tax liabilities to which they were not legally entitled. The sisters only redress, the court said, was to apply for refunds from the Virgin Islands BIR.

For a discussion of U.S. taxation of residents of U.S. possessions, see Parker Tax ¶200,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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