Taxes Remitted to the U.S. Virgin Islands in Error were Not Compulsory Payments in an Audit
One of the common issues that comes up on audit is whether payments to foreign governments are creditable for purposes of the U.S. foreign tax credit (“FTC”). This often hinges on whether the payments were “compulsory.” There is little guidance as to what payments are compulsory. The court recently addressed this issue in Vento v. Commissioner, 147 T.C. 7 (2016).
Facts and Procedural History
The facts and procedural history of the case are as follows:
- The taxpayers are three sisters who were U.S. citizens and who lived in the U.S. in 2001.
- They made estimated payments to the IRS in 2001, but did not file individual income tax returns in the U.S. for the 2001 tax year.
- They filed individual tax returns in the U.S. Virgin Islands for the 2001 tax year. They also paid tax with their returns remitted to the U.S. Virgin Islands Bureau of Internal Revenue (“BIR”).
- The IRS transferred the taxpayers’ estimated payments to the U.S. Virgin Islands BIR in 2003.
- The IRS issued notices of deficiency in 2005 to assess tax due in the U.S., given that the taxpayers were not bona fide residents of the U.S. Virgin Islands in 2001 and they did not have income that was sourced to the U.S. Virgin Islands in 2001. The taxpayers agreed with the IRS.
- One of the taxpayers tried and was unsuccessful in obtaining a refund from the U.S. Virgin Islands BIR. The other two taxpayers apparently did not pursue refund claims.
It appears that the IRS issued the notices to the taxpayers on or near the last day for the taxpayers to file refund claims with the Virgin Islands BIR. Instead of pursuing refund claims with the U.S. Virgin Islands BIR, the taxpayers sought credit against their U.S. income taxes for 2001 for the taxes remitted to and paid to the Virgin Islands BIR.
The U.S. Foreign Tax Credit
Our tax laws tax U.S. citizens on their worldwide income. To ameliorate the impact of double taxation on the same income by more than one country, our tax laws allow for the FTC. To be creditable in the U.S., the foreign tax must be a “compulsory” payment made to a foreign government.
There is little guidance as to what payments are compulsory. It is generally thought that payments to foreign governments that are documented as taxes but that are really for bribes, to obtain other government benefits, etc. are not compulsory payments of tax. It is also generally thought that amounts paid to a foreign government in excess of what the foreign law says is due in that country is not compulsory for the amount in excess of the amount due. Similarly, the IRS’s IRM notes that paying a foreign country an amount in excess of a treaty rate is not a compulsory payment.
The Typical Fact Pattern for “Compulsory” Payments
This issue often comes up when there are disputes as to the amount of tax owed to the foreign country. If the foreign country increases the amount owed to and the taxpayer pays the increased amount, but the taxpayer has a legitimate claim that the foreign country’s increase is in error, it may not be clear whether the taxpayer is entitled to a FTC for the increased amount of taxes paid. This can be even more problematic given that the foreign tax dispute may drag on for several years–or even decades. The taxpayer may go ahead and report an increased FTC on its U.S. tax returns for the additional amount paid to the foreign country. The IRS will often audit and disallow the increased FTC, as it did in the Vento case.
The Current Fact Pattern for “Compulsory” Payments
The circumstances are easier in the Vento case, as it was clear that the taxpayers were not bona fide residents of the U.S. Virgin Islands. So there was no possibility for an increase in tax owed to the U.S. Virgin Islands.
No tax was due to the U.S. Virgin Islands. So the court concluded that the payments to the U.S. Virgin Islands were not “compulsory” and, therefore, they were not a “tax paid” for purposes of the FTC.
Instead of the FTC, the court seems to be suggesting that the taxpayers’ remedy was to pursue refund claims with the U.S. Virgin Islands.