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VIRGIN ISLAND COURT TRIMS LIST OF CHARGES ON TAX SHELTER

August 29, 2008

We can see why St. Louis-area auto dealer James Auffenberg wanted the criminal trail arising from his Virgin Islands tax planning moved to St. Criox. A district court judge there dropped 11 of the 35 counts in his indictment this week. The dropped counts were those that depended on whether the Virgin Islands income was "effectively connected" with a Virgin Islands trade or business. The court ruled that the term "effectively connected" was too vague to enforce because regulations had not been issued under the special code section enacted to combat Virgin Islands tax avoidance, Section 934.

That seems like an odd assertion. The entire foreign tax credit scheme in the income tax is based on the concept of "effectively connected" income. If that's "void for vagueness," a lot of people are filing returns under void tax law.

The judge's decision is based on the last paragraph of Sec. 934(b), which reads:

The determination as to whether income is derived from sources within the United States or is effectively connected with the conduct of a trade or business within the United States shall be made under regulations prescribed by the Secretary.

The judge ruled that this meant the entire code section was inoperative until regulations were issued. Looking at the conference report issued when the section was enacted, it seems that's news to Congress (emphasis added):

The provision generally codifies the existing rules for determining when income is considered to be from sources within a possession by providing that, as a general rule, for all purposes of the Code, the principles for determining whether income is U.S. source are applicable for purposes of determining whether income is possession source. In addition, the provision provides that the principles for determining whether income is effectively connected with the conduct of a U.S. trade or business are applicable for purposes of determining whether income is effectively connected to the conduct of a possession trade or business.

If the section just applies existing principles, then what was the code section about "under regulations prescribed by the Secretary" about? The Conference report says this:

The provision also grants authority to the Secretary of the Treasury to create exceptions to these general rules regarding possession source income and income effectively connected with a possession trade or business as appropriate. The conferees anticipate that this authority will be used to continue the existing treatment of income from the sale of goods manufactured in a possession. The conferees also intend for this authority to be used to prevent abuse, for example, to prevent U.S. persons from avoiding U.S. tax on appreciated property by acquiring residence in a possession prior to its disposition.

So according to the Conference Report, the regulation authority of the Sectionn 934(b) is to carve exceptions and to prevent abuses, not to make the section effective in the first place. Now one might argue that committee reports mean nothing when they conflict the the plain language of the statute, but that doesn't seem to be case here. The term "effectively connected" is a fixture of the tax law; the Secretary already has extensive regulations defining "effectively connected" in other contexts. Congress here just applied it to a new problem - Virgin Islands tax schemes.

Mr. Auffenberg still faces serious tax charges, but I wouldn't be surprised if the IRS appeals this ruling just to to correct what looks like a legal error.

Cite: United States et al. v. James A. Auffenberg Jr. et al.; No. 1:07-cr-004

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