Media Center

Publications Presentations Media Blog
Taxation of Individuals in United States Possessions
March 12, 2004
BNA Tax Management International Journal, Vol 33, No. 3, p. 153



by Lawrence R. Barusch & Marjorie Rawls Roberts

This article considers current taxation under federal law of individuals who reside in or are citizens of the possessions of the United States. United States citizens residing in the "mirror image" jurisdictions (as explained below) receive special attention.

I.THE POSSESSIONS

A. What is a possession?

The United States Supreme Court, following the acquisition of Guam, Puerto Rico and the Philippines under the Treaty of Paris ending the Spanish-American War drew a distinction between those territories that were, by action of Congress, incorporated into the United States and became a part thereof and those that merely belonged to it. Incorporated territories were included within the United States for income tax purposes. The reasoning was that incorporated territories were fully protected by the Constitution including Article I Section 8, Clause 1, which requires that "all Duties, Imposts and Excises shall be uniform throughout the United States." Conversely, unincorporated territories are not subject to the Constitution, except to the extent provided by Congress, They are not part of the United States for income tax purposes. Unincorporated territories are sometimes (and in this article) referred to as "Possessions" to distinguish them from incorporated territories ("Territories"). Since the admission of Alaska and Hawaii, there have been no "Territories" (with one intriguing exception ) so that any geographic area belonging to the United States, other than the fifty states and the District of Columbia is a "Possession."

Puerto Rico was offered statehood by President Ford but by a narrow margin rejected it in November 1993. However all federal departments, agencies and officials, to the extent consistent with the Constitution and the laws of the United States must treat Puerto Rico as a state and Puerto Rico seems to have a continuing option on statehood.

The Commonwealth of the Northern Mariana Islands has been under effective U.S. control for more than half a century. The United States Virgin Islands have been owned by the United States for more than three-quarters of a century. Puerto Rico, Guam and American Samoa have been governed by the United States for more than a century. The historic context of the decisions in the Insular Tax Cases has changed, and indeed the rule has been criticized. It is therefore possible special rules for the Possessions are unconstitutional, in whole or in part . However, as these rules generally favor the taxpayer, it is unlikely they will be challenged.

At the other end of the spectrum, the distinction between possession and foreign country or something else may not be clear. The extended occupations of Germany and Japan following World War II and of islands and countries in the Caribbean Basin from time to time would seem to be possessions within the contemplation of the Insular Tax Cases, although not so treated for tax purposes. Tests could be developed for military presence based on whether authority was exercised over civilians, all armed forces or only U.S. forces, whether that authority extended to all functions or a limited set of functions, whether it was exercised as martial law or civil law and how long it lasted, to distinguish between possession and something else.

A similar issue arises with respect to U.S. citizens wintering at McMurdo Sound or other U.S. bases in Antarctica. The Antarctic Treaty signed December 1, 1959 does not recognize foreign claims of sovereignty , but is a U.S. base a possession. What will happen if the United States places a permanent station in orbit around the earth or a U.S. spacecraft carries individuals on a multi-year trip to Mars?

For present purposes these questions need not be answered, for with the repeal of former Section 931 by the Tax Reform Act of 1986, and the phase-out of the Section 936 Possessions Tax Credit by the Small Business Job Protection Act of 1996 the status of "possession" only has significance to the particular jurisdictions discussed in this article.

B. Uninhabited Islands, Former Possessions and the Continental Shelf
The United States governs, claims or formerly claimed a number of uninhabited islands. These islands have no citizens and seldom have residents so there is little to consider within the scope of this article. A resident would be treated as discussed in "C" below. These islands, like all current possessions of the United States are part of the "North American area" which permits more generous deduction of expenses of attending a convention under Code Section 274(h).

Former possessions are similarly not of concern.
The U.S. continental shelf cannot have residents until technology improves. However it is part of the United States for purposes of allowing the use of the accelerated cost recovery system for purposes of depreciating property (other than vessels or aircraft) for exploring and exploiting resources, treating such property as United States investment property for Subpart F purposes and sourcing and withholding on service income of those using such property. The Continental Shelf is likewise part of the United States for purposes of computing the taxes levied on the import or export of petroleum to finance the Hazardous Substance Superfund and the Oil Spill Liability Trust Fund. It is part of the United States for purposes of the foreign earned income exclusion. In short, for present purposes the U.S. continental shelf is treated as part of the United States.

C. Inhabited Islands Without Permanent Residents
The Defense Nuclear Agency maintains a runway and base on Johnston Island.

Midway is a National Wildlife Refuge, administered by the U.S. Fish and Wildlife Service under the Secretary of the Interior. About 250 government and contract workers are on Midway.

Wake has about 302 residents. While Wake is under the Department of the Interior , the Ballistic Missile Defense Administration funds Wake's administration.

These islands were possessions for purposes of former Code Section 931, repealed by the Tax Reform Act of 1986.

United States citizens resident in Wake, Midway or Johnson Atoll or any other possession of the United States are not eligible for the earned income exclusion or the possessions exclusion under current Code Section 931. Since these jurisdictions do not impose taxes, the foreign tax credit is irrelevant.

Aliens resident in these islands would be taxed in the United States on certain U.S. source income and income effectively connected with the conduct of a trade or business within the United States under Code Section 871. The special rule for non-resident aliens residing in Puerto Rico or American Samoa under Code Section 876 does not apply to other islands.

Many residents of these islands would be members of the United States Armed Forces. The exclusion for combat pay under Code Section 112 is not currently applicable in these areas, although for purposes of the earned income credit, the individual may be deemed to have a U.S. abode. Civilian employees of the United States government may be able to exclude certain allowances under Code Section 912.

D. Freely Associated States
[A work in progress]
The United States formerly administered the Trust Territory of the Pacific Islands. These were divided into four jurisdictions. The Commonwealth of the Northern Mariana Islands (the "Northern Marianas") is discussed in the next section. The remaining jurisdictions became states freely associated with the United States.

1. The Marshalls/Micronesia Compact
On October 1, 1982 the Government of the Marshall Islands, subsequently the Republic of the Marshall Islands (the "Marshall Islands") together with the Federated States of Micronesia ("FSM") entered into a "Compact of Free Association" (the "Marshalls/Micronesia Compact"). The Compact was approved by Congress in January, 1986, 48 USC 1901 and became effective with respect to the Marshall Islands October 21, 1986 and with respect to the FSM November 3, 1986

As executed in 1982, the Marshalls/Micronesia Compact provided citizens of the Marshall Islands or the FSM who are not engaged in trade or business (including employment) in the United States were to be exempt from all U.S. income, estate, gift and generation-skipping transfer taxes, whether or not they may also be U.S. citizens. The Marshalls or Micronesia may only tax United States citizens on income derived (determined under U.S. source rules) from such jurisdictions. If the Marshalls or Micronesia tax their residents on U.S. source income, those residents would be relieved of U.S. tax liability. The United States agreed that these jurisdictions would be treated as possessions under the Code and that Code provisions applicable to possessions January 1, 1980 would not be changed with respect to these jurisdictions without consultation.

When Congress approved the Marshalls/Micronesia Compact in 1986 (after repeal of the territorial income tax), it added major exceptions. The reservations eliminated any special tax benefits for the Marshalls or Micronesia.

2. How Could Congress Unilaterally Change the Compact?
The United States did not claim sovereignty over the Marshalls or FSM, but merely administered them under a 1947 Agreement with the United Nations in 1947. United Nations (the "Trusteeship Agreement"). Thus the authority of the United States to unilaterally abrogate the provisions of the Marshalls/Micronesia Compacts is unclear. However, some background may be helpful.

On April 1, 1977 the Congress of Micronesia ("C.O.M."), then exercising jurisdiction over all of what would later be the Marshalls, FSM and Palau enacted Public Law 7-32 imposing a progressive income tax throughout the area. These jurisdictions appeared to be on the way to becoming broken mirror jurisdictions like Puerto Rico and American Samoa. Compact negotiations proceeded in light of this development.

The progressive income tax was originally to become effective January 1, 1978. However on October 11, 1977 C.O.M. P.L. 7-67 deferred the effective date to January 1, 1979. That date matched the effective date for the Northern Marianas Territorial income tax. On March 30, 1978 C.O.M. P.L. 7-94 again postponed the effective date, this time to January 1, 1981. On October 1, 1978 the COM ended, with legislative power passing to the three component jurisdictions.

On May 10, 1979 the FSM Constitution became effective. On August 6, 1980 FSM P.L 1-123 deferred the effective date of the progressive income tax in the FSM until January 1, 1982. On January 21, 1982 FSM P.L. 2-27 deferred the effective date until January 1, 1983. On October 1, 1982 the Marshalls/Micronesia Compact was signed. On December 14, 1982 FSM P.L. 2-56 repealed the progressive income tax.

Meanwhile the Marshall Islands repealed the progressive income tax March 22, 1979 by Marshall Islands Public Law 26-18-1. This was before the Marshall Islands Constitution became effective May 1, 1979.

On January 1, 1981 the Palau Constitution became effective. On December 14, 1981 Palau P. L. 1-19 repealed the progressive income tax. On August 26, 1982 Palau signed a Compact. However, this Compact never came into effect. The currently effective Palau Compact contains provisions similar to the Congress's reservations to the Marshalls/Micronesia Compact.

When the Micronesia/Marshalls compact was signed in October 1982, the negotiators must have realized that the future of the progressive income tax in the area was in doubt. In view of the difficulties already encountered, it appears they decided to save tax issues for another day.

3. Current Taxation in the Marshalls and Micronesia
The reservations provided the United States would offer residents of the Marshall Islands the foreign tax credit and foreign earned income credit. These already applied. Note that income received as an employee of the United States cannot be excluded, though income received from the United States as an independent contractor may be excluded.

The protection of the possessions exclusion was eliminated (the repeal of Code Section 931 was already planned at this time) but the Possessions Tax Credit under Section 936 was protected. If the benefits of Section 936 are reduced, the United States is required to provide "benefits substantially equivalent." In case of dispute the matter is submitted to arbitration. The Small Business Job Protection Act of 1996 terminated the Possession Tax Credit under Section 936, albeit with liberal transition rules. [So what happened?}

Products may be imported from the Marshalls or the FSM under the rules of General Head note 3a as if they came from a possession. This means products enter imp the Marshalls or Micronesia without U.S. duties. If the landed price of such goods in the Marshalls or FSM is not more than 40% of the landed price of the finished goods in the United States, such goods may enter the U.S. free of duty. [CHECK} Congress also limited these benefits with respect to tuna, watches, buttons, clothing, leather goods and other items.

4. Palau
The Government of Palau (subsequently the Republic of Palau) signed a Compact of Free Association January 10, 1986. It was approved by Congress in 1986, 48 USC 1931 but a dispute over the rights of the United States to use Palau as a port for ships carrying nuclear weapons delayed implementation. It eventually became effective October 1, 1994 at which time the old Trust territory officially ended.

Under the Palau Compact any resident of Palau may be relieved of liability for income taxes to the United States. However this relief is limited to the foreign tax credit and the earned income exclusion. (See Congress on Marshalls). Further to be eligible a person must have physical presence on Palau for at least 183 days of the taxable year.

[Topics to come: Further research Palau
Exemption of gross income of ships and aircraft operated by individuals, corporations and governments. Marshall Islands Notes of December 5, 1989 1990-2 CB 321; Withholding, exemption on those with addresses in Marshalls Rev. Proc. 90-46, probably superceded by recent income tax withholding rules]

For employment and estate taxes see subsequent sections

E. Mirror Code Jurisdictions
The Congress of the United States has enacted or approved three separate territorial income tax systems, one for the United States Virgin Islands, the Virgin Islands Territorial income tax ("VITIT"), one for Guam, the Guam Territorial income tax ("GTIT") and one for the Commonwealth of the Northern Mariana Islands ("NMTIT"). These taxes contain nearly all of the substantive provisions of the United States income tax ("USIT"), but instead of setting them out, incorporate them by reference with appropriate changes. This is sometimes called "mirroring." While there is historic evolution of these systems in some cases they just grew. As a result of trial, and not a little error the systems today consist (or should consist) of the following elements:

  • Each jurisdiction is foreign to each of the others except as explicitly set forth in the statute.
  • Individuals file a single income tax return in their jurisdiction of residence, treating all mirror jurisdictions, including the United States as domestic.
  • Corporations are relieved from withholding on interest and dividends subject to limitations.
  • A provision should deal with pass-through entities including "S" corporations, partnerships (including limited liability companies) and trusts.
  • Each jurisdiction retains the revenue it collects (i.e. Congress levies the tax, but the possessions receive the funds), subject to fair apportionment among the taxing jurisdictions.
  • The income tax systems should be coordinated for Subpart F purposes.
  • Aliens resident in "mirror" jurisdictions should be released from the regular U.S. regime and allowed to participate under the mirror.
  • The mirror systems should be integrated with United States income tax treaties.
  • The power of a territory to rebate tax it collects that properly belongs to another jurisdiction may have to be limited.

These aspects will be considered as they relate to each territorial income tax later in this article.

F. Broken Mirror Code Jurisdictions
Puerto Rico briefly had a mirror code under the Revenue Act of 1918. Puerto Rico promptly used the authority granted to it in the 1918 Revenue Act to enact its own system. Puerto Rico has enacted a version of the Internal Revenue Code of 1939. It is primarily foreign for U.S. purposes. There are two principal exceptions. The Puerto Rico Tax Credit under Section 936 will continues to be significant at least through 2005, despite its "termination" as of December 31, 1995. However as it only relates to domestic (U.S.) corporations it is beyond the scope of this article.

Residents of Puerto Rico are allowed to exclude all of their Puerto Rico source income (as determined under U.S. sourcing rules ) from U.S. income taxation. Compensation paid to employees of the United States or its agencies remains taxable. Deductions, other than personal exemptions, related to excluded income are not allowed. If a Puerto Rican resident moves to the United States after at least two years residence in Puerto Rico, the individual may exclude Puerto Rican source income in the year of the move under the same rules.

By agreement signed in Berlin June 14, 1899 the United States, Germany and Great Britain partitioned Samoa. Shortly thereafter the U.S. Navy obtained the cession of Tutuila, Aunu'u, the Manu'a. In 1925 U.S. sovereignty was extended over Swains Island. The Samoans are U.S. nationals, but not U.S. citizens. Samoa adopted a constitution in 1982, which was approved by the Secretary of the Interior under Executive Order 10264, effective January 1, 1984.

In 1963 Samoa adopted the United States Internal Revenue Code with limited modifications. In general the income tax provisions resemble the provisions for Guam found in 48 USC 421i. American Samoa has in effect an Implementing Agreement with the United States so that changes made by the Tax Reform Act of 1986 are effective.

[ Discuss citations to Samoa in literature. Discuss Section 931]

II. THE UNITED STATES VIRGIN ISLANDS

Section 932 of the Internal Revenue Code of 1986, as amended, sets out the rules for coordination of United States and Virgin Islands income taxes in two circumstances. First, Subsections 932(a) and (b) deal with the treatment of United States residents with income derived from sources within the Virgin Islands or income that is effectively connected with a Virgin Islands trade or business . Subsections 932(c), 932(d), and 932(e) describe the taxation of an individual if the individual is a bona fide resident of the Virgin Islands at the close of the taxable year, or such individual files a joint return for the taxable year with a bona fide Virgin Islands resident. In addition, Code section 871, as mirrored to the Virgin Islands, sets out the tax filing and payment requirements for non-resident aliens with Virgin Islands income. This article sets out the tax filing and payment requirements for individuals with Virgin Islands income who do not reside in the Virgin Islands -- both United States citizens and residents and non-resident aliens -- and for bona fide residents of the Virgin Islands.

A. Taxation of U.S. Citizens or Resident with Virgin Islands Income
The Virgin Islands tax liability for U.S. Citizens or residents with Virgin Islands income (other than bona fide residents of the Virgin Islands as discussed below) is computed as a fraction of the taxpayer's total liability, based on the ratio of adjusted gross income. Such individuals must file signed identical returns with the United States and the Virgin Islands by April 15 of the following year (assuming a calendar year taxpayer), using IRS Form 8689, to determine what portion of his or her income tax must be paid to the Virgin Islands. This form must be attached to both returns. The U.S. return must be filed with the Internal Revenue Service Center, Philadelphia, Pennsylvania, and the Virgin Islands return must be filed with the Bureau of Internal Revenue in St. Thomas . When this procedure is followed, both a taxpayer's payments to the Virgin Islands and the taxpayer's Virgin Islands employer withholdings are credited against his or her U.S. tax liability.

U.S. citizens or residents who reside in Puerto Rico and who have Virgin Islands income must file Form 1040 and Form 8689 with the Bureau of Internal Revenue and the IRS, regardless of whether they have any U.S. source income. If the individual also has Puerto Rico income, deductions must be prorated by the percentage of the Virgin Islands and the U.S. adjusted gross income to the total adjusted gross income. The individuals are allowed the full personal exemption deduction, but residents of Puerto Rico who work in the Virgin Islands are not entitled to the Earned Income Tax Credit [note].

B. 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 December 31) 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".

Specifically, Code section 932(c)(3) provides that "[I]n the case of an individual to whom this subsection [Subsection 932(c)] applies in a taxable year for purposes of so much of this title [Title X](other than this section and section 7654) as relates to the taxes imposed by this chapter [Chapter X], the Virgin Islands shall be treated as including the United States." Code section 7654, entitled Coordination of United States and Certain possession Individual Income Taxes, provides in pertinent part that "the net collection of taxes imposed by Chapter 1 for each taxable year with respect to an individual to whom section 932(c) applies shall be covered into the Treasury of the specified possession of which such individual is a bona fide resident." This section sets the basis for the IRS to cover over taxes of bona fide residents of the Virgin Islands that were initially collected by the IRS. Subsection 7654(c) provides that the transfers of funds between the United States and any specified possession required by this section -- a term that is defined to mean Guam, American Samoa, the Northern Mariana Islands, and the Virgin Islands shall be made not less frequently than annually. Subsection 7654(b)(1) provides that in determining net collections for a taxable year, an appropriate adjustment shall be made for credits allowed against the tax liability and refunds made of income taxes for the taxable year.

The Senate Finance Committee Report [cite] for the Tax Reform Act of 1986 made it clear that:

Any taxes withheld and deposited in the United States from payments to a bona fide resident of the Virgin Islands, and any estimated tax payments properly made by such an individual to the United States, will be covered over to the Virgin Islands tax liability. A Virgin Islands resident deriving gross income from sources outside the Virgin Islands will report all items of such income on his or here Virgin Islands return. Information contained on these returns will be compiled by the Virgin Islands Bureau of Internal Revenue and transmitted to the Internal Revenue Service to facilitate enforcement assistance.

The taxpayer has no final tax liability for such year to the United States 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.

The Tax Reform Act of 1986 also gave the Virgin Islands the authority to enact nondiscriminatory local income taxes which for U.S. tax purposes would be treated as State or local income taxes in addition to those imposed under the mirror system.

C. Taxation of Non-Resident Alien Individuals
Individuals who are not U.S. residents or residents or Virgin Islands residents must file Form 1040NR with the Virgin Islands and pay tax to the Virgin Islands on Virgin Islands source income and on income effectively connected with a Virgin Islands trade or business, taking a foreign credit where applicable for the taxes paid.

D. Determination of Residence
Because of the special treatment of U.S. citizens resident in the Virgin Islands, it is important to determine residence for purposes of Code Section 932.

There are no cases specifically under Code section 932, as added by the Tax Reform Act of 1986. However, Code section 871 and Treasury Regulation section 1.871-2(b), which deal with residency for aliens, adopt a subjective test, and there are a number of cases that have been decided under Code section 871. I have summarized the cases below and enclose copies of the cases as well.

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


An alien actually present in the United States [Virgin Islands] who is not a mere transient or sojourner is a resident of the United States [Virgin Islands] 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).

  • In the case of Kowalski, 7 TCM 883, Dec. 16,720(M), the court found that a Polish seaman was a U.S. resident where he bought an automobile in the United States, married an American girl, lived in an apartment in the United States 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. Aff'd on another issue (CA-5), 79-2 USTC Paragraph 9499, the taxpayer, a U.S. citizen at birth who also became a Mexican citizen in 1943, was found to be a resident of the United States 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 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 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 paycheck was deposited in a bank in the United States and the taxpayers claimed itemized deductions for contributions to charities in the United States and also made a $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. Although he entered the United States 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. The brother's stay in the United States was limited to a definite period and, because he showed no definite intention to stay in the United States, the presumption of nonresidency was not rebutted.

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. [And what might they tell? Did IRS ask for comments earlier this year?]

The Internal Revenue Service has determined in a 1998 Field Service Advice released on February 12, 1999, that a US Virgin Islands resident who files his Form 1040 with the Virgin Islands Bureau of Internal Revenue starts the three-year statute of limitations under Code section 6501(a) with regard to the Internal Revenue Service, even if the US Virgin Islands resident fails to report all of his income from all sources on his return as filed with the Bureau of Internal Revenue. The Field Service Advice dealt with a bona fide US Virgin Islands resident who failed to report a dividend from a US corporation on his return as filed with the Virgin Islands

E. Tax Incentives Available to Individuals Resident in the Virgin Islands

III. GUAM

Code Section 935 sets out the rules for coordination of United States and Guam income taxes. While this section predates the Virgin Islands coordination provision by 14 years, the two provisions are similar. It applies to residents of Guam, citizens or residents of the United States with income derived from Guam, "Organic Act citizens" and spouses who file jointly with such individuals. It does not apply to trustees or other fiduciaries. Code section 871, as mirrored to Guam, sets out the tax filing and payment requirements for non-resident aliens with Guam income.

A. Single Filing
For those individuals to whom Section 935 applies (essentially any one with connection to Guam), dual filing (U.S. and Guam) is eliminated . United States residents file only with the United States, , Guam residents file only with Guam, and those subject to Guam or U.S. income tax who are not residents of either Guam or the United States file with the United States except for non-resident Organic Act Citizens who file with Guam. Residence is determined as of the close of the taxable year. Joint filers file based on 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. Individuals under military or naval orders are subject to Section 514 Soldiers' and Sailors' Civil Relief Act of 1940 and generally file as based on their residency determined at the time they entered the military.

Guam filers currently file with the Department of Revenue and Taxation, Government of Guam, P.O. Box 23607, GMF, GU 96921. U.S. filers, subject to Section 935 file with the Internal Revenue Service, Philadelphia, Pennsylvania, 19255-0215 . Thus in principle a U.S. citizen who maintains a savings account in Guam should file in Philadelphia, regardless of where in the United States he may reside.

U.S. filers treat the United States as including Guam. Guam filers treat Guam as including the United States. These seemingly simple rules have been the source of considerable controversy, as discussed below. U.S. filers with adjusted gross income of $50,000 or more must include Form 5074. This permits (in theory) the United States to cover over tax it collects on Guam source income to Guam.

Estimated tax payments are based on the same principles, except that a taxpayer determines where to file a particular estimated tax payment based on the facts and circumstances existing on the date the payment is due. A credit is allowed against U.S. taxes for estimated taxes paid to Guam and vice versa. However, the Virgin Islands requires filing of Form 8689 for Guam residents with Virgin Islands income. The Virgin Islands has not always given credit to its residents for estimated tax payments made to Guam. Thus there is potential for problems with estimated tax payments for individuals moving between these jurisdictions. The Guam/CNMI relationship currently appears to be working well, although this point has not been definitively resolved.

B. Residency
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).

The rules for residency in the Virgin Islands and Guam generally draw on the same body of case law. However, there is a difference. A person can have multiple residences. Therefore a "tie-breaking rule" is needed. None currently exists for the Virgin Islands under Code Section 932. The italicized language in the preceding paragraph could be read to mean that in the case of a tie, the individual is a U.S. resident. However, it could also be read as merely descriptive of the contents of the regulations, without giving any guidance on ties.

Section 1277(e) of the Tax Reform Act of 1986 provides that if a United States person becomes a resident of Guam or the CNMI or American Samoa (but not the Virgin Islands) then for ten years gain on sale or exchange of stock of a U.S. corporation, debt obligations of U.S. persons and other property located in the United States will be U.S. source income. While this may affect the ability of a possession to rebate tax, it does not affect the filing rules stated here.

IV. COMMONWEALTH 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 CNMI. Thus the filing rules in the CNMI are the same as in Guam except the address for filing returns in the CNMI is

Division of Revenue and Taxation Commonwealth of the Northern Mariana Islands P. O. Box 5234, CHRB Saipan, MP 96950

Similarly the rules for determining residency are the same. The one reported case deciding residency in a possession comes from the CNMI: Preece v Commissioner 95 TC 594 (1990).

In March 1985 David and Debra Preece moved to Saipan, the commercial center of the CNMI. On April 1, 1985 they sold a block of stock. They claimed the gain was CNMI source, filed in the CNMI (but not the United States) and claimed the rebate that was then in effect in the CNMI. In July 1986 they returned to the United States. The IRS asserted that the Preeces were required to file a 1985 income tax return in the United States. The Preeces sought summary judgment on the basis that under Code Section 7701(b)(3)(A) they satisfied the substantial presence test for CNMI 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 United States did not alter Code Section 935 and the regulations thereunder. Thus the facts and circumstances test under Regulation 1.871-2(b) govern residency for purposes of the single filing rule. While the Preeces' motion for summary judgment was denied, no determination on the facts and circumstances was made.

V. ESTATE, GIFT AND GENERATION SKIPPING TRANSFER TAXES

VI. EMPLOYMENT TAXES

VII. ISSUES IN MIRROR TAXATION

This section explores some of the issues that have arisen under the mirror codes of the Virgin Islands, Guam and the Commonwealth of the Northern Mariana Islands in an effort to lay a foundation for suggestions for improving the system.

A. Three Elements of Possessions Taxation.
Taxation in the possessions is significantly determined by application of three principles: (1) The system is derivative (a "mirror"). Nonetheless, (2) the system is statutory, rather than common law. (3) Revenue derived from a possession belongs to it.

1. Why a Mirror?
A skilled draftsman can prepare a comprehensive and coherent tax code embodying whatever policies the legislature desires. This has never been attempted for the possessions, where the income tax law is intended to at least resemble the federal statute. Indeed, even state income tax systems have tended to converge toward the federal model. Congress has implicitly recognized that it has neither the will nor the resources to legislate a completely new tax system for the possessions. Given the low population and limited economic development of the possessions, it would be difficult to find the talent and resources for either the government or taxpayers to learn, apply, comply with and plan for such a code.

The alternative is to state one or more principles to be applied to construct the tax regime. The mirror code starts with a basic principle, "the income tax laws in force in the United States shall be held likewise in force in a possession." The rule can be fleshed out. Exceptions can be made. Nevertheless the basic rule must be applied consistently and logically. Otherwise the result is confusion and potential both for abuse by and injustice to taxpayers.

2. Judicial Restraint
In a derivative system, a court will be tempted to resolve new issues justly. However a just outcome in one tax case is likely to be based on a principle that will lead to either abuse or injustice in another.

In Atkins-Kroll (Guam) Ltd. v. Government of Guam 367 F.2d 127 (1966) a California corporation received a dividend from its Guam subsidiary. The subsidiary paid corporate income tax in Guam. The parent paid corporate income tax in the United States. Guam asserted a withholding tax on the dividend. Had both companies been within the United States, a single corporate income tax would have applied. The effect of the Guam corporate income tax was mitigated by the credit the United States allowed for taxes deemed paid to a possession. Thus in the absence of a Guam withholding tax, the tax burden would have been the same in these two cases. Because the foreign tax credit is limited, the Guam withholding tax would have dramatically increased the tax burden on Guam operations. The Court reasoned Congress would not desire this result, and held that the United States was "domestic" for Guam purposes, eliminating the Guam withholding tax.

The Court turned out to be correct on its assessment of the will of Congress. This result was legislated by Congress four years later, by adding Code Section 881(b). In the meantime however, the Ninth Circuit had created a principle, "the United States is domestic for Guam." Less than two years later it was asked to apply this principle in Sayre & Company v. Riddell 395 F 2d 407(9th. Cir. 1968). In Sayre a Guam sole proprietorship paid interest and commissions to a U.S. corporation. If the U.S. corporation were "domestic", there would be a deduction by the Guam taxpayer, reducing his income tax, with the income taxed in the United States. That is, the tax on Guam source revenue would be received by the United States, not Guam. A Guam withholding tax, on the other hand, would direct the revenue to Guam. The U.S. corporation would not be worse off, as it could reduce its U.S. income tax liability by a credit for the Guam withholding tax paid. The court concluded Congress would want a Guam withholding tax in this case. The U. S. corporation was declared "foreign."

It seems unlikely, however, that Congress could have intended that Guam tax officials, with this court's occasional assistance, should have the power to vary the statutory definitions of "foreign" and "domestic" corporations in accordance with their or our notion of what would and what would not be equitable in a given situation.

Deviations from the intended dual structure by substantive revision of the basic scheme of the Code as applied to Guam must be left to Congress. Taxes, being intrinsically confiscation of private property by the government, should be clear, precise and predictable. Conversely, the flow of revenue to the government should not be unnecessarily interrupted by unpredictable judicial action. The Ninth Circuit's position appears unassailable.

Nevertheless courts are fairly regularly tempted in this direction. At the time of Chicago Bridge and Iron Company v. Wheatley 430 F.2d 973 (3rd Cir. 1970) the United States allowed domestic corporations a deduction for certain foreign income if they qualified as Western Hemisphere trade corporations. For U.S purposes income from the Virgin Islands was eligible. Chicago Bridge paid taxes both to the Virgin Islands and the United States, but avoided double taxation by taking a credit against its United States taxes for Virgin Islands taxes paid. The Western Hemisphere deduction was disallowed by the Virgin Islands, and because of the limitation on the foreign tax credit, no offsetting credit was available in the United States. Thus, had the Virgin Islands prevailed, the benefit of this provision would have been lost. So the Third Circuit declared United States corporations domestic for Virgin Islands corporations. Ironically, it purported to rely on Sayre for this result.

Four years later in Great Cruz Bay, Inc., St. John, Virgin Islands v. Wheatley 495 F. 2d 301 (3rd Cir. 1974) in the context of "S" corporations the Third Circuit held that individual United states citizens and residents were non-resident aliens for purposes of the Virgin Islands tax. This is the exact opposite of the ruling of Chicago Bridge The Third Circuit dismissed the problem because Chicago Bridge, "involved a wholly different provision of the Code. " The Third Circuit decided to vary its definition of "foreign" according to its "notion of what would and what would not be equitable in a given situation." One year later in Vitco, Inc. v. Government of Virgin Islands 560 F.2d 180 (3rd Cir. 1977) this notion was elevated to the "equality principle" A Virgin Islands corporation was not required to withhold Virgin Islands tax on interest paid to a United States bank. In holding the United States bank was domestic, the Court relied on both the equality principle and a U.S. treasury regulation relating to payments by U.S. companies to Virgin Islands companies. Subsequently the Treasury revoked the regulation , reissuing the same rule as a revenue procedure. This left the entire issue in doubt.

The equality principle reemerged in Johnson v. Quinn 821 F.2d 212 (3rd Cir. 1987). U.S. citizens resident in the Virgin Islands sought to credit California income taxes against the VTIT. . The USTIT allows a foreign tax credit for income taxes imposed by states, provinces and other secondary authorities of foreign countries. However the Third Circuit decided the case should have the same result as if an Ohio resident paid California taxes and applying the "equity principle" found that taxes paid to California were not "foreign" for this purpose.

Reading Chicago Bridge and Johnson one might conclude that the "equality principle" means taxpayers are to pay the same tax (perhaps to different collectors) as if the Virgin Islands were a state. Apart from the fact that at the time the statute did not so provide, this does not explain Great Cruz Bay, or the reliance on the now revoked regulation in Vitco.

Meanwhile the District Court of Guam was pursuing a similar course. In Bank of America, Nat. Trust and Sav. Ass'n v. Chaco 423 F. Supp. 409 (D.C. Guam 1976) Guam sought to impose tax on the effectively connected income of a U.S. bank. Judge Duenas held that the imposition of such tax on a U.S. corporation would be manifestly incompatible with the intent of Congress In effect, a U.S. corporation was not foreign to Guam for this purpose. The case was appealed to the Ninth Circuit, but settled before a decision was issued.

In an unreported decision issued January 24, 1986 in Holmes v Director of Revenue and Taxation Judge Duenas returned to his manifest incompatibility theory to find that for Guam purposes a Northern Mariana Islands corporation was foreign and therefore not an "S" corporation. However, this decision was appealed, resulting in a landmark decision on this issue, Holmes v. Director of Revenue and Taxation 827 F. 2nd 1243 (9th Cir. 1987). Judge Kozinski wrote:

We read section 601(c)'s "manifestly incompatible" provision more narrowly than the Director or the District Court.
Note in Preece the court finds U.S. citizens are not aliens for mirror image codes.

3. Revenue for the Possession.
The first income tax under the 16th amendment applied directly to Porto Rico and the Philippines but provided "all revenues collected in Porto Rico and the Philippine Islands shall accrue intact to the general governments thereof, respectively." That rule has been continued to date.

There are three ways to look at a mirror system. (1) The possession is like a state, with a special income tax. (2) The possession is a foreign country. (3) The possession and the United States are as foreign countries, but the possession has a special relationship with the States of the United States.

The footnotes show the second view is adopted by the weight of authority. However the other views have been argued and occasionally prevailed.

4. Federalism (Quinn, Abramson, Gumataotao(get treasury letter on bonds))
In the United States we recognize dual sovereignty, that of the federal government and that of the states. The USTIT, however, does not recognize the states as fully sovereign. In particular, the USTIT allows only a deduction for state income taxes, but a credit for foreign taxes. The USTIT allows a foreign tax credit for income taxes imposed by states, provinces and other secondary authorities of foreign countries.

Consider Johnson v. Quinn 821 F.2d 212 (3rd Cir. 1987). U.S. citizens resident in the Virgin Islands sought to credit California income taxes against the VTIT. As a preliminary matter, note this is an easy case under current Code Section 932. A Virgin Islands resident treats California as being within the Virgin Islands, so that California is not foreign at all and no credit should be allowed. However that section became applicable after 1986.

This case involved tax liability for 1978 and was decided under the "inhabitant rule." Former 48 USC 1642 stated that persons with permanent residence in the Virgin Islands "satisfy their income tax obligations under applicable taxing statues of the United States by paying their tax on income derived from all sources into the Treasury of the Virgin Islands." The checkered history of the inhabitant rule will be discussed elsewhere, but it is clear that this rule, unlike current Code Section 932 does not alter the basic mirror image principles.

One might have expected the taxpayer to prevail. The Third Circuit eschews "strict mirroring, " adopting rather the "equality principle," derived from Chicago Bridge and Iron Company v. Wheatley 430 F.2d 973 (1970).

5. S corporations

6. Qualified Pension Plans

7. The Possessions Exclusion (Crain v. Commissioner, etc.)

8. Withholding.

VIII. SUGGESTIONS FOR IMPROVING THE MIRROR SYSTEM

Attorneys

Practice Areas