Hedge Funds Flee Tax Haven in Virgin Islands, Hounded by IRS

Date: Thursday, January 25, 2007
Author: Ryan J. Donmoyer, Bloomberg.com

(Bloomberg) -- At the Deep End Bar, a poolside grill in St. Croix just steps from the Green Cay Marina, a handful of money managers and investors sip Cruzan rum from a local distillery and reach for complimentary bug repellent as dusk brings out the no-see-ums.

Warren Mosler, who opened a hedge fund firm in St. Croix five years ago, is having what's become the usual conversation with people who were lured to the U.S. Virgin Islands in 2001 by the prospect of legally cutting their tax bill by 90 percent. Almost half of the 49 funds that set up shop in the islands have fled in the past two years.

Mosler complains that hedge funds were chased away by federal tax law changes and an Internal Revenue Service that says it suspects rampant fraud by those that signed up for the tax incentive.

``It's kind of like what happens to a community when a big company or an army base pulls out but on a smaller scale,'' says Mosler, a founding member and manager of the III Funds, which manages $3.5 billion. He now advises the fund in Christiansted, one of two Danish colonial settlements on St. Croix.

He's surveying the sparse happy-hour crowd. ``Unfortunately, the fear is causing a case of running away from the police when you're not guilty,'' he says.

Mosler, 57, and two other hedge fund managers -- Kevin Brandt, president of James River Capital Corp., and Paul Saunders, the firm's chief executive officer -- bought and renovated the Tamarind Reef Hotel four years ago in anticipation of an influx of Wall Street money managers to the island, which is 1,100 miles (1,770 kilometers) southeast of Miami.

`Corral That Horse'

The St. Croix finance boom never came. Instead, the U.S. Treasury Department and U.S. Senator Charles Grassley of Iowa, the Republican chairman of the Senate Finance Committee from 2001 to 2006, knocked it out with a combination punch of regulation and legislation, Mosler says.

The U.S. government became alarmed in 2003 when someone sent the Treasury Department an anonymous letter that included marketing materials advertising the territory's economic program as a tax dodge, Grassley says.

``Before our reforms, we had people living in the United States and claiming Virgin Islands residency to dodge their federal income taxes,'' Grassley says. ``It took a long time to corral that horse and put it in the barn.''

That sales pitch was followed by the conviction of a Massachusetts life insurance executive in February 2004 on tax evasion charges in St. Croix. The events prompted Grassley to conclude the Treasury Department wasn't acting swiftly enough to combat fraud, says Dean Zerbe, an aide who drafted the legislation for Grassley.

New IRS Form

The insurance executive, Gary Payne, of Beverly, Massachusetts, had claimed tax benefits without living in the territory.

The fund managers who remain say they face a fight with tax examiners, who are using a new IRS form that requires details about their lives: where they own a home, where their children attend school, where their cars are registered, where they attend religious services and what civic associations they've joined.

The Grassley legislation imposed a six-month residency requirement and clarified that the territory's tax benefits apply only to income earned exclusively in the islands.

U.S.V.I. officials have been waiting for two years for specific guidance on its tax program from the U.S. Treasury Department, says Kent Bernier Sr., executive director of the territory's Public Finance Authority.

`Waiting to See'

``The amount of people coming is not as before,'' he says. ``They're waiting to see what the rules are.''

Since the new law was adopted, 23 of the 49 hedge funds have either halted their activities temporarily or withdrawn from the islands, Bernier says. A hedge fund is a loosely regulated investment partnership, generally open only to wealthy individuals and institutional investors.

Bernier says the slowdown has hurt other parts of the islands' economy, such as construction; employment; and the development of service companies.

Carl Dubert, who as deputy international tax counsel at the Treasury Department from 2002 to 2004 worked on Treasury regulations governing the U.S.V.I. incentive program, says the 2004 law was necessary.

Tax Breaks

``Treasury essentially treated the possessions with benign neglect, perhaps too much so in hindsight,'' says Dubert, who's now a senior manager at PricewaterhouseCoopers. ``The issue is, you have to sell your house in Greenwich or the Hamptons or whatever and actually move down there. As long as you do it right and you actually have your business down there, it works.''

The territorial government designed the tax breaks to attract new industries in a bid to broaden an economy dependent on tourism, which accounts for 60 percent of the islands' companies.

The three principal U.S. Virgin Islands -- St. Croix, St. John and St. Thomas -- have a population of 108,605. Per capita income in the territory is $18,652, less than half the average in the continental U.S. and $7,000 less than in Mississippi, the poorest state.

The islands, especially St. Croix, have struggled to recover from Hurricane Hugo in 1989. The storm killed six people in the U.S.V.I. and caused more than $2 billion in damage. Hugo and Hurricane Marilyn in 1995 decimated thousands of St. Croix houses, as well as resorts, many of which have never been rebuilt.

Roofless Houses

Roofless houses still dot the landscape on St. Croix. Cruise ships, which make St. Thomas the biggest port in the Caribbean, brought 2 million passengers to St. Thomas in 2005, while St. Croix received just 107,307 cruise tourists, according to the Virgin Islands Port Authority.

Most new housing developments are gated, with armed guards. Police urge visitors in downtown Christiansted not to stray from a three-block area at night because of crime.

Vargrave Richards, who was lieutenant governor of the territory until his term ended in December, says many of the islands' brightest leave because the economy and job opportunities are better on the mainland. Islanders also feel the U.S. routinely treats them as second-class citizens, he says.

``We needed a program to attract people back to the territories,'' he says. ``We want to lift the standard of living in the territory to the equivalent of that in the United States.''

`Witch Hunts'

To qualify for the tax incentives, firms must invest at least $100,000 in the territory, buy products such as office supplies and computers in the U.S.V.I., contribute to area charities and hire at least 10 people, 80 percent of whom must be natives of the islands.

Company owners must live in the U.S.V.I. for at least half of the year, under federal requirements. They have to undergo five examinations a year by the Economic Development Authority.

Michael Masters, principal at and founder of hedge fund firm Masters Capital Management LLC, says the 2004 law and the IRS clampdown have had a chilling effect. ``Witch hunts aren't good for anybody, including the government,'' he says. ``It's a waste of resources.''

The Payne case prompted the IRS to open about 100 audits, says Marjorie Rawls Roberts, a St. Thomas-based tax lawyer who has advised about half of all U.S.V.I.-based hedge funds. Roberts says that even her clients who aren't being audited still have to wrestle with the new residency requirement.

Audit Risk

Before the 2004 law change, establishing residency was more subjective, she says.

If hedge fund managers leave the territory on a business trip or for personal reasons, they risk triggering an audit and losing their tax benefits, Roberts says.

Others face an audit just because they switched from filing tax returns with the IRS to filing them with the territorial taxing agency, the Virgin Islands Bureau of Internal Revenue, she says.

Every dollar they earn is potentially challengeable if the IRS believes it was earned on the mainland, she says.

``I do hope the audit program comes to some rational conclusion,'' she says, adding that the federal government has been shortsighted. ``You would think they would rather encourage activities in U.S. territories that would otherwise go to foreign countries.''

Withholding Investments

About 80 firms have undergone a review process by the Economic Development Authority that takes as long as six months. They're withholding their initial investment, awaiting further federal regulations clarifying what tax benefits they could get, the authority says.

The islands' government last year launched a new lobbying push, hiring former Republican House Majority Leader Dick Armey, Chicago-based law firm Winston & Strawn LLP and Washington lobbying firm Capitol Counsel Group.

Donna Christensen, the territorial delegate to the U.S. Congress, says she's hopeful the rise to the chairmanship of the House Ways and Means Committee by Charles Rangel, a longtime Virgin Islands booster, will help their cause.

``His becoming chairman will mean that we will have a powerful and sympathetic friend to turn to for support as we continue to seek to enhance and strengthen our economy,'' she says.

Rangel's affinity with the islands stems from his Korean War service, when he fought alongside Puerto Ricans and Virgin Islanders. Rangel, a Democrat from New York, says he wants to ensure the territory gets fair treatment.

`Caught in a Net'

He says he's already helped persuade the Treasury Department to relax the residency requirement in November. ``Good people got caught in a net that was not intended for them, and I want to do everything I can to encourage investment,'' he says. ``I have reason to believe this can be reckoned without legislation.''

At the Deep End Bar, hedge fund founder Mosler and others wait.

The grill is just steps from his Tamarind Reef Hotel, a two-story building that houses offices for dozens of employees who work trading floors for both James River Capital and Mosler's new firm, Valance Co., which provides investors with analysis and assessment of global economies from China to the U.S.

Mosler is bespectacled and lanky, giving him a wonky demeanor that masks a passion for politics and speed. Any conversation with him eventually turns to the race cars he manufactures and sells in Riviera Beach, Florida.

High-Speed Cars

His MT900S, which is powered by a 435-horsepower Corvette Z06 V-8 engine, clocks in at top speeds higher than 200 miles per hour and sells for $189,000. ``It accelerates quicker, brakes harder and corners sharper than a Ferrari 360 Modena,'' Car and Driver magazine wrote of the MT900S.

Mosler also harbors political ambitions, having unsuccessfully run twice to replace Christensen as the territory's Congressional delegate.

The hotel does little more than break even, Mosler says, because the boom he expected has petered out. Big names once associated with the tax incentives have left.

They include hedge fund manager Richard Driehaus, CEO of Driehaus Securities Corp. He closed his U.S.V.I. subsidiary and cut or transferred to Chicago the 10 workers in his St. Thomas office last November.

Closures

The decision was made in part because of the federal tax rule changes, according to spokesman Bill Blase, who says Driehaus declined to be interviewed.

Ira Lubert, a founding partner at LLR Equity Partners in Philadelphia, closed his firm in the U.S. territory, according to the Economic Development Authority. Lubert didn't return telephone calls seeking comment.

About 80 other hedge funds approved by the authority never set up shop, says Frank Schulterbrandt, CEO of the authority. The number of companies applying for the islands' economic program, including its tax incentives, fell to 27 in 2005 from 59 a year earlier.

Grassley says he doesn't want to discourage companies from moving to the islands. ``I want to help the Virgin Islands economy but not at the expense of taxpayers,'' he says. ``If we were to look at loosening any of the reforms, we'd have to make very sure we don't reopen the door to abuse.''

Masters, a burly 40-year-old, says the law changes created uncertainty. ``One doesn't really know what they can and cannot do,'' he says. ``All of our trading is here. It's pretty straightforward to us. At the end of the day, it's needlessly confusing.''

Credit Ratings

Masters, who has 13 employees, declines to provide financial details of his company. He says he trades in domestic and international bonds and equities.

The tax benefit program began paying dividends almost immediately after hedge funds were invited in 2001. The islands' tax revenue doubled to $800 million in a five-year period ended in 2005. The increase erased a $287.6 million deficit for the territory in 1999.

Fitch Ratings sent a letter to Bernier saying the U.S.V.I.'s healthier balance sheet merited its first-ever bond rating in 2006: BBB-. Bernier estimates the investment-grade rating saves the U.S.V.I. almost 2 percentage points in its interest rate when it borrows. Standard & Poor's also issued a rating: BBB+.

`Everyone Was Calling'

``Once we got the ratings, UBS, Citigroup, Bear Stearns -- everyone was calling,'' Bernier says over lunch at Bella Blue restaurant in Charlotte Amalie, the territorial capital in St. Thomas.

Federal concern about the tax incentives took root in 2003, when the Treasury Department received the anonymous letter. It included a Jan. 15, 2002, memo recommending that an unnamed client obtain a post office box in the territory, open a local bank account with an appropriate balance, get a U.S.V.I.-issued driver's license and register to vote in the islands.

These steps would allow a person to benefit from the tax breaks, the memo says. ``It is important to note that the length of time to be spent in the U.S.V.I. by a U.S.V.I. resident is not prescribed,'' the memo says.

The memo also says that those who set up in the islands would be less likely to be audited by the IRS.

These kinds of claims, which had not been tested in court, were among the reasons Congress felt the need to act, Grassley staffer Zerbe says.

IRS Raid

On May 20, 2003, the IRS raided Kapok Management LP, a Christiansted-based financial-services firm it accused of sheltering income for dozens of partners who were living on the mainland.

One man, life insurance executive Payne, pleaded guilty to criminal tax evasion charges for sheltering more than $1.2 million in income in 2000 and 2001. Payne didn't respond to requests for comment.

Payne had registered to vote in the territory, got a driver's license there and rented both an apartment and a condominium. He lived and worked full-time in Danvers, Massachusetts, according to court documents.

Facing five years in prison, he reached a plea agreement in exchange for a lenient sentence, which hasn't yet been handed down. Kapok has since been sued for fraud by some of its 63 partners.

Criminal Sanctions

In June 2004, the Treasury Department issued a notice saying, ``The IRS is aware that certain promoters are advising taxpayers to take highly questionable and, in most cases, meritless positions.''

The notice declared the federal government's intention to seek criminal sanctions against abusers of the tax advantage. The IRS activity caught the attention of Grassley's staff.

Congress's Joint Committee on Taxation estimated that Grassley's legislation, attached to a broader corporate tax measure in 2004, would increase federal revenue by $400 million over a 10-year period.

Roberts, the St. Thomas-based tax lawyer, says the IRS overreached.

It published a notice saying the statute of limitations restricting the agency from examining more than three years of tax returns doesn't apply for those newly claiming U.S.V.I. residency. That allows the IRS to inspect tax returns going back decades, she says.

The IRS also drafted a new form for island residents it says is needed to prove valid residency. The form requires those who stop filing tax returns with the IRS in order to file them in the U.S.V.I. to list where their immediate family lives, where their cars are registered and where they hold driver's licenses.

`Very Abusive'

The form also asks for a list of memberships in social, cultural, professional and country clubs as well as chambers of commerce and political organizations the resident participates in. Christensen says the IRS paperwork is too strict.

``It's a very abusive form and goes beyond what is necessary to prove you live here,'' she says. The IRS doesn't routinely ask such questions of any other U.S. tax filers, she says.

Dubert, the former Treasury Department tax counsel, says the form is needed. He says the department and Congress had to act because a cottage industry of tax avoidance had sprung up since Congress first endorsed a tax incentive plan in 1986.

David Nissman, a former U.S. attorney who prosecuted the Kapok Management case, has since relinquished his law enforcement cap to advocate for companies in the islands. He's now business director of StoneTree Group LLLP, a partnership of local U.S.V.I. investors who benefit from the tax program.

`Coming Apart'

He says the federal government succeeded in chasing away the bad elements and now must step back. ``We had this engine going, and the engine now is more pure, but it's sputtering a little bit,'' he says.

Back at the Deep End Bar in St. Croix, those who've remained are determined to tough it out. Mosler says it's ironic that his five years in the U.S.V.I. is the longest he's gone without being challenged by the IRS.

One of his U.S. firms had settled an IRS audit of income in the 1990s. Still, Mosler says, he might have been more reluctant to move to the territory from Florida in 2001 had he known then what he knows now about how Congress would act.

``There's a lot of disappointment here,'' he says. ``A lot of your friends leave. A lot of things stop happening. Neighborhoods that might develop, don't. The whole place is just dying and coming apart.''

For many Virgin Islanders, the Senate and IRS steps in the past few years are just the latest in an almost century-long struggle for acceptance.

``They think of us like we're outside the United States,'' says Richards, the former lieutenant governor. Still, islanders know Washington holds the key to their salvation.

To contact the reporter on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net