Marjorie Rawls Roberts and Lawrence Roos Barusch
from Offshore Investment magazine

United States citizens pay tax on their worldwide income regardless of residency or source of income. Limited exclusions may apply and opportunities to use entities to temporarily defer realisation of income may exist. However there are only three places in the world where United States citizens can take full advantage of tax incentives to reduce their Federal income tax liability: the United States Virgin Islands (the Virgin Islands), Guam, and the Commonwealth of the Northern Mariana Islands (the Northern Marianas). These are sometimes referred to as the possessions.

The possessions currently offer some exciting tax incentives.

The Virgin Islands is authorised under Section 934 of the Internal Revenue Code of 1986, as amended, to reduce or remit the tax liability otherwise imposed on income that is derived from sources within the Virgin Islands or effectively connected with the conduct of a trade or business within the Virgin Islands . Under this Federal "umbrella" the Virgin Islands has enacted economic incentive legislation that provides, among other tax benefits, a tax credit equal to 90 percent of the tax that would otherwise be due on income from the business for which benefits are granted . This credit also applies to distributions made by the business ? whether a corporation, limited liability company, or partnership ? to its individual owners who are bona fide residents of the Virgin Islands.

The Northern Mariana Islands taxes its residences not more than 24% on ordinary income and not more than 14.5% on capital gains if the income is Northern Marianas source. Gain from the sale of securities, including stock of a US corporation, by a Northern Marianas resident is Northern Marianas source income. The Northern Mariana Islands will rebate 100% of all taxes (including income taxes otherwise due to the United States of America) for 25 years on certain businesses and industries established in the Northern Marianas. The Northern Mariana Islands will also rebate 100% of all taxes to certain businesses located in Tax Free Trade Zones.

Guam will rebate 100% of the income tax of Guam-based trusts for 20 years with respect to income earned outside of Guam and the USA. Guam will rebate 75% of income taxes for 20 years on income from qualifying Guam businesses. If the business is conducted as an "S" corporation, the rebate is available to shareholders.

This article does not further discuss tax incentives. However to take full advantage of these incentives a US citizen must establish residency in the applicable possession . This article discusses the rules governing residency. First however, it is necessary to understand the single filing rules to see why residency is significant.

Single Filing
Taxation of bona fide Virgin Islands residents
The Tax Reform Act of 1986 included a provision that each person who is a bona fide resident of the Virgin Islands on the last day of the tax year (generally 31 December) must file an income tax return - Form 1040 - for the taxable year with the Virgin Islands Bureau of Internal Revenue and pay tax on his or her worldwide income to the Virgin Islands. If a Virgin Islands resident has income from non-Virgin Islands sources, he or she must also complete V.I. Form 1040 INFO (Non-Virgin Islands source income of Virgin Islands residents) and attach it to Form 1040 before filing it with the Bureau of Internal Revenue. In determining the tax due for a bona fide resident, for purposes of Title 1 of the Internal Revenue Code, "the Virgin Islands shall be treated as including the United States".

The taxpayer has no final tax liability for such year to the United States of America as long as he or she reports all income from all sources and identifies the source of each item of income on the return filed with the Virgin Islands.

In the case of a joint return where only one spouse qualifies as a resident of the Virgin Islands, resident status of both spouses will be determined by reference to the status of the spouse with the greater adjusted gross income for the taxable year.

Taxation of residents of Guam
Code Section 935 sets out the rules for co-ordination of United States and Guam income taxes. While this section predates the Virgin Islands co-ordination provision by 14 years, the two provisions are similar. It applies to residents of Guam, and to spouses who file jointly with such individuals.

For those individuals to whom Section 935 applies (essentially any one with connection to Guam), dual filing (United States of America and Guam) is eliminated . United States residents file only with the USA. Guam residents file only with Guam. Residence is determined as of the close of the taxable year. Joint filers file based on the residency of the spouse who has the greater adjusted gross income for the taxable year. While Guam does have a community property regime, it is to be disregarded in making this computation.

Guam filers currently file with the Department of Revenue and Taxation, Government of Guam. US filers treat the United States of America as including Guam. Guam filers treat Guam as including the USA.

Taxation of residents of the Northern Mariana Islands
The Northern Marianas Territorial Income Tax consists of the same federal tax laws as those that apply to Guam. The single filing rule under Code Section 935 also applies. References to Guam in the Code will generally be understood as also referring to the Northern Marianas. Thus the filing rules in the Northern Marianas are the same as in Guam except that returns must be filed with the Division of Revenue and Taxation, Commonwealth of the Northern Mariana Islands.

Similarly, the rules for determining residency are the same in the Northern Mariana Islands as for Guam.

Determination of residence
Because of the special treatment afforded to United States citizens who are resident in the possessions it is important to determine residence for the purposes of Code Sections 932 and 935. The facts and circumstances test
The one reported case concerning residency in a possession comes from the Northern Mariana Islands, Preece v Commissioner 95 TC 594 (1990).

In March 1985, David and Debra Preece moved to Saipan, the commercial centre of the Northern Mariana Islands. On 1 April 1985 they sold a block of stock. They claimed the gain was Northern Marianas source income, filed their return in the Northern Marianas (but not the United States of America), and claimed the rebate that was then in effect in the Northern Marianas. In July 1986 they returned to the USA. The IRS asserted that the Preeces were required to file a 1985 income tax return in the USA and pay tax on the gain to the United States of America. The Preeces sought summary judgement on the basis that under Code Section 7701(b)(3)(A) as "mirrored" to the Northern Marianas they satisfied the substantial presence test for Northern Marianas residency.

Without reaching the question of how such a test would be applied, the court determined that the Deficit Reduction Act of 1984, which added the substantial presence test concerning when an alien would be treated as a resident of the USA, did not alter Code Section 935 and the regulations thereunder. Thus the facts and circumstances tests under Treasury Regulation 1.871-2(b) govern residency for purposes of the single filing rule. While the Preeces' motion for summary judgement was denied, no determination on the facts and circumstances was made.

There are no cases specifically under Code section 932, as added by the Tax Reform Act of 1986. However, in a Field Service Advice dated 18 December 1998, the IRS senior Technical Reviewer determined that the period of limitations was not open for a US citizen and resident of the Virgin Islands who failed to report income from US sources. Specifically, the individual filed Virgin Islands income tax returns for a particular tax year but failed to report a dividend from a US corporation. The IRS noted that the individual had filed a tax return for the year at issue, as required by Code section 932(c)(2). Although the individual had not reported his income from all sources, the IRS concluded that it could not assess additional tax because the limitations period under Code section 6501(a) had expired. In reaching that conclusion, it explicitly did not address possible exceptions to the limitations period such as fraud or a wilful attempt to avoid taxes. The Field Service Advice did not specifically deal with the determination of residency. However, the facts and circumstances test under Code section 871 and Treasury Regulation section 1.871-2(b), would seem to also apply to the Virgin Islands.

In response to the enactment of Section 932 of the Internal Revenue Code of 1986 by the Tax Reform Act of 1986, the Treasury Department in 1989 prepared draft regulations dealing with residency. These regulations have not yet been issued for comment.

Regulations and cases applying the facts and circumstances test
The rules adopt a subjective test, and there are a number of cases that have been decided under Code section 871.

Treasury Regulation section 1.871-2(b), in defining residence (and as "mirrored" to the possessions), states:

An alien actually present in the United States [possession] who is not a mere transient or sojourner is a resident of the United States [possession] 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. A mere floating intention, indefinite as to time, to return to another country is not sufficient to constitute him a transient. ... [I]f his purpose is of such a nature that an extended stay may be necessary for its accomplishment, and to that end the alien makes his home temporarily in the United States, he becomes a resident, though it may be his intention at all times to return to his domicile abroad when the purpose for which he came has been consummated or abandoned.

The courts have indicated that residency does not depend on spending a certain number of days in the jurisdiction where a person claims residency as long as the taxpayer establishes residency and subsequently maintains sufficient contacts with the jurisdiction (although under Code section 7701 there is a presumption of residency for persons meeting the substantial presence tests set out therein that is not applicable to bona fide residents of United States possessions).

In the case of Kowalski, 7 TCM 883, Dec. 16,720(M), the court found that a Polish seaman was a US resident where he bought an automobile in the United States of America, married an American girl, lived in an apartment in the USA while on shore leave, and filed his "Application for a Certificate of Arrival and Preliminary Form for a Declaration of Intention" in that year.

In the case of R. M. Brittingham, 66 TC 373, Dec. 33,856. Affirmed on another issue (CA-5), 79-2 USTC Paragraph 9499, the taxpayer, a US citizen at birth who also became a Mexican citizen in 1943, was found to be a resident of the United States of America where she maintained an apartment in California for 23 years, had a telephone listing and received telephone calls, maintained a California checking account, and filed state resident tax returns for several years.

In the case of Stallforth, CA-DC, 35-1 USTC Paragraph 9329, 77 F2d 548, the alien taxpayer was considered to be a US resident where he maintained a home in New York and performed work for American businesses for more than six months each year in Europe. (Underscoring added).

In the case of V. J. Sutton, CA-6, 81-1 USTC Paragraph 9145, the court determined that the taxpayers, who were citizens of Canada, were resident aliens of the United States of America for federal income tax purposes while they lived in England from 1971 through 1973 and were not entitled to a refund of taxes paid for those years. The taxpayers owned a residence in the United States of America that they listed as their home address on their returns for the years in questions and on the Alien Address Reports they filed with the Immigration and Naturalization Service on which they classified themselves as resident aliens. While they were abroad, all of the principal wage earner's paycheque was deposited in a bank in the United States of America and the taxpayers claimed itemized deductions for contributions to charities in the USA and also made a US$100 political contribution.

In the case of T. Park, 79 TC 252, Dec. 39,264, the court determined that during the years in issue, a South Korean citizen who was officially domiciled in South Korea was a resident alien in the United States of America. Although he entered the USA on limited visa status, his US residential and business investments, business activities, and political, social, and other ties were so deep and extensive as to show that his stay was of such an extended nature as to constitute him a resident.

In contrast, in the case of P. M. Toor, 36 TCM 1616, Dec. 34,748(M), TC Memo. 1977-399, the court denied a taxpayer a dependency exemption and a medical expense deduction for his alien brother after finding that the brother was not a resident of the United States of America. The brother's stay in the USA was limited to a definite period and, because he showed no definite intention to stay in the United States of America, the presumption of non-residency was not rebutted.

How to establish residency in a possession
Although the rules on alien residency in the United States of America are broad, a taxpayer's residency is generally determined as of the last day of the taxpayer's tax year, generally 31 December. An individual files with the possession if, under a "totality of the circumstances test", he or she is a resident of the possession as of that date. Generally, residency requires an intent to reside in the particular possession on an indefinite basis with no intent to depart.

Criteria that can be utilised to support a determination of bona fide residency in a possession include the following.

  • A person must have permanent, year-round housing in the possession. It can be rented, leased, or owned. A taxpayer cannot rent a place periodically during the year or have a timeshare for several weeks and call it his or her residence. A person should get power bills, telephone bills, cable bills, and so forth in his or her name, to indicate that the residence is his or hers on a permanent basis.
  • The person should keep personal belongings at the residence on a year-round basis.
  • A person must file his or her personal income tax return in the possession as a resident. A person who moves to one of the possessions during the year only files his or her income tax return with the possession for that year, even if the person has income from sources outside the possession and income earned prior to the establishment of residency. A person must file any estimated tax returns and pay any estimated tax due to the particular possession's tax authorities. Any correspondence to the IRS or the possession's tax authorities should show the person's principal address in the possession. A person should notify the IRS on Form 8822 of his or her change of address to the possession.
  • A person who resides in a possession must not declare a homestead exemption on a house in a homestead state if he or she is an owner of the house, and must not utilise state residency for children attending college in a state based on the parent being a resident of the state.
  • A person must check any licences that he or she may have (such as real estate, CPA, hunting etc.) to determine whether there are any specific residency requirements, and if so should determine whether he or she must go "inactive" or resign or whether the requirements are compatible with bona fide residency in a possession. Sometimes a person can go to non-resident status for a higher annual fee.
  • A person must obtain a driver's licence in the possession where he or she resides if he or she intends to drive in the possession. A person must not renew his or her driver's licence in the United States of America.
  • A person should register to vote in the possession and take part in the possession's voting process, and must not vote in any state or national election in the USA. Bona fide residents of the possessions are not permitted to vote for the President of the United States of America.
  • A person should get a post office box in the possession if the person's abode in the possession does not offer mail delivery.
  • A person should be employed in the possession (if employed anywhere). If the person is employed by a business in the USA then that employment agreement should specify that the services can be performed in the possession.
  • A person who resides in a possession should ensure to change the address for any brokerage accounts and credit card statements to the possession address. A person should also go to non-resident status in any clubs or organisations to which he or she belongs outside the possession if such a membership category exists.
  • A professional (CPA, attorney) should consider taking the examinations to be licensed to practice in the possession.
  • A person must move to the possession for an indefinite period of time, and a short period of residency in the possession would undermine the person's position that he or she was ever a bona fide resident of the possession. For example, a person who moved to the Northern Mariana Islands for one year and then relocated back to the United States of America could be deemed to have never had the requisite intent to be a bona fide resident of the Northern Marianas.
  • A person should amend his or her will and any trusts to indicate that he or she is a resident and a domiciliary of the possession, and should generally review all estate planning documents to ensure that they are consistent with possession residency.
  • A person should get a telephone number in the possession for his or her residence and as a cellular customer as well (if the person uses a cell phone). Also, a person may consider having an e-mail address from one of the local Internet service providers.
  • It is preferable, but not required, that a taxpayer's spouse and minor children also establish residency in the possession. The statutes governing residency for Guam, the Northern Marianas, and the Virgin Islands all incorporate rules governing the filing of joint returns where one spouse is a possession resident and the other is not, thus indicating that residency of one spouse does not require residency of the other. Accordingly, visits of a personal nature by a possession resident to visit his or her spouse and children should not impact the bona fide residency of the possession resident.
  • It is important to note that the length of time to be spent in the possession by a bona fide resident is not prescribed. It depends on how many other homes a taxpayer owns or rents and how much travel, for business and pleasure, a taxpayer undertakes. There are a number of legitimate reasons to be away from home ? for business trips, vacations, medical visits, family visits, and to spend time in second homes. However, if a person only spends a few weeks in the possession and the rest of the time at only one or two other locations, then residency status would be problematic if examined by the IRS.

Conclusion
United States citizens prepared to take the steps outlined in this article will have a strong case that they have established residency in a possession. United States persons resident in the Virgin Islands, Guam or the Northern Mariana Islands do not have to file tax returns with the Internal Revenue Service. To the extent such persons qualify for the rebates and other tax incentives offered by the possessions, they will enjoy a permanent reduction in their income tax obligation, free of any limitation in the amount imposed under the Internal Revenue Code.

1 In this article the term "citizens" refers to individuals, not entities. 2 E.g. the foreign-earned income exclusion under Section 911 of the Internal Revenue Code of 1986 as amended, Title 26, United States Code (herein the Code). 3 US taxpayers with foreign-source income may be able to use foreign corporations and trusts to defer realisation of income. These devices are subject to many restrictions that are becoming more severe. In any event, the income is almost always taxed on repatriation (if not earlier). 4 The United States of America has a score of other possessions and freely associated states, but none of the others offers the opportunities discussed here. 5 Section 934(b)(1) of the Internal Revenue Code of 1986. 6 Section 713b, Chapter 12, Title 29, Virgin Islands Code. 7 Section 713b(e), Chapter 12, Title 29, Virgin Islands Code. 8 The Northern Marianas allows rebates of 90% of the first US$20,000 of "rebate base," 70% of the next US$80,000 and 50% of the excess without special application. Title 4 Commonwealth Code (CMC) Section 1708(b). The rebate base for most individuals will be the income tax liability calculated under the Code reduced by 9% of gross income. See 4 CMC 1708(c) and 4 CMC 1201-1204. 9 Code 865. 10 The Northern Mariana Islands Investment Incentive Act of 2000. 11 The Northern Mariana Islands Tax Free Trade Zone Act of 2000. 12 Title 12, Guam Code Annotated (GCA) 58128.6. 13 12 GCA 58128.1. 14 12 GCA 58131. 15 The availability of rebates may also depend on the source of income. Sourcing rules in the possessions generally mirror those of the United States of America, but with significant differences. Space does not permit discussion here. 16 Section 932(c)(2) of the Internal Revenue Code of 1986, as amended. 17 Section 932(c)(3) of the Internal Revenue Code of 1986, as amended. 18 Section 932(d) of the Internal Revenue Code of 1986, as amended. 19 Code Section 935 was added by USPL 92-606 effective for taxable years beginning after 31 December 1972. Section 1272(d) (2) of USPL 99-514, the Tax Reform Act of 1986, repealed it (the 86 Act). However Section 1277(b) of the 86 Act provides that the changes made by Subtitle G of Title 12 of the 86 Act apply "only if (and so long as) an implementing agreement under section 1271 is in effect?" This rule applies to the repeal of Code section 935, the amendment of Code Section 7654, the repeal of former Code Section 932 and other changes. In April 1989 the United States of America and Guam executed a Tax Implementation Agreement that by its terms would have entered into force 1 January 1991. However, that agreement was amended in December 1990. The effective date of the agreement was postponed to "such date as may be mutually agreed by the Contracting Governments." Treasury News Release dated 27 December 1990. 20 Code Section 932. 21 Code Section 935(a)(1). 22 Code Section 935(a)(4). 23 Code Section 935(c)(3). 24 Code Section 935(b)(1)(A). 25 Code Section 935(b)(2). 26 Code Section 935(b)(3). 27 Chapter 6, Title 19, Guam Code Annotated. 28 Code Section 935(c)(1). 29 Covenant Section 601(a). 30 Covenant Section 601(b). As the Commonwealth of the Northern Mariana Islands has not entered into an Implementing Agreement Code section 935 has not been repealed. See Footnote 21. 31 Covenant Section 601(c). 32 See Holmes v Director, 827 F.2d 1243 (9th Cir. 1987). 33 See also Treasury Regulation 1.935-1(a)(3). 34 UILC: 9999.9800, Release Date: 2/12/1999. 35 Residency is determined by "applying to the facts and circumstances in each case the principles of Sections 1.871-2 through 1.871-5 relating to what constitutes residence or nonresidence, as the case may be, in the United States in the case of an alien individual" (emphasis added). Treasury Regulation 1.935-1(a)(3). The language in bold could (but need not) be read to suggest that a taxpayer files in the United States of America unless he or she has no US residency, as determined under these principles.

Capabilities