EDC program in the NY Times

The New York Times had an interesting article on the EDC program on Saturday...

Tax Break Bringing Businesses, and Fraud, to the Virgin Islands

September 18, 2004
By STEPHANIE STROM
and LYNNLEY BROWNING

ST. THOMAS, V.I. - Inside and outside the freshly stuccoed mansions that hug the hillsides here, the gardeners and cleaning women come and go.

No one else seems to, though. No one, that is, except the federal agents who have taken to questioning the workers and the neighbors about when the owners last took a dip in their glistening pools and when they might be expected
back.

The questions are intended to ascertain whether the owners of the candy-colored homes are bona fide residents of the Virgin Islands or instead are pretending to live in these homes to dodge an estimated $400 million in federal income taxes.

Drawn by an economic development program that is blessed by Congress and confers a special tax rate that amounts effectively to just 3.5 percent of income, well-heeled Americans have migrated in droves to this United States territory in the last few years, kindling its first real economic boom.

At least until recently. Last year, Internal Revenue Service agents raided the offices of one of the program's beneficiaries, and the Justice Department has subpoenaed others in what one government official described as three criminal investigations.

The ensuing confusion about the islands' economic development program and fears of attracting the scrutiny of tax authorities have already scared away some of the new arrivals, both individuals and companies. And local officials are beginning to fret that people violating the spirit and perhaps the letter of the tax law could derail the program, which is vital to a territory where 30 percent of the residents were living below the poverty level in 1999.

One program beneficiary, the Consolidated National Corporation, closed its office in St. Thomas in July, saying that the tax laws governing the program are ambiguous, and executives at two other beneficiary companies said they were on the verge of pulling up stakes for the same reason.

"If something were to go wrong with this program, it would have the impact of a major hurricane," Lt. Gov. Vargrave A. Richards said in an interview. "This program is the best thing that ever happened to these islands."

In June, the I.R.S. fired a warning shot at participants, saying that lawyers and estate planners promoting the program were making false claims about what income qualified for the program's tax benefits and about its residency requirements.

Its notice, which hinted at a widespread problem, came a year after its agents stormed the office of Kapok Management, a financial services company that is a
beneficiary of the program. Though Kapok and its principals and advisers have not been charged with wrongdoing, one of its partners, Gary J. Payne, pleaded guilty to tax fraud after federal investigators demonstrated that he lived in the islands less than one month a year and nonetheless claimed the program's tax benefits for income he generated selling insurance in Massachusetts.

Federal officials suspect there are dozens of other taxpayers taking advantage of the program, a group that includes a car dealer in southern Illinois, a board member of the Federal Reserve Bank of Richmond, Va., and asset managers and insurance agents.

The few people who agreed to talk about their moves said they followed the program's rules and were careful to pay proper taxes, but most of the beneficiaries declined to comment when contacted or did not respond to calls and
e-mail messages.

Many here blame the federal government for failing to carefully define what constitutes residency and what income qualifies under the program. "Congress foresaw that these two areas would be a problem and ordered Treasury to come
up with definitions in 1986," Mr. Richards said. "We have asked repeatedly for these definitions but have never gotten any."

Though the Treasury Department's work plan has called for creating more explicit definitions on four occasions since then, it has not followed through, nor did it respond to proposed definitions submitted by concerned parties after the Kapok raid.

Treasury officials insist that the rules are clear and that their goal is not to kill the program, as some here suspect. "Some people have purposefully chosen not to
follow the existing rules," said Tara Bradshaw, a Treasury spokeswoman. "Those who promote this intentional disregard of the rules are typically the source of complaints about ambiguity.''

In all, about 100 companies with an unknown number of partners and participants are eligible for tax breaks under the program, and about 70 more have approval to begin claiming the benefits.

Participating companies are saving about $1 billion a year, said David Marshall Nissman, who just retired as United States attorney for the Virgin Islands district.

But one federal official estimated that 40 percent of those savings are being claimed fraudulently.

The program's beneficiaries, known as E.D.C. beneficiaries after the Economic Development Commission that confers the tax benefit, must meet various requirements. Individuals and companies must commit $100,000 of capital, employ 10 local residents, buy goods and services from local suppliers and promise to make charitable donations. They must also establish residency, although they do not have to spend a specific number of days in the islands. Instead, they are advised to buy or lease a house and car, obtain a local driver's license and join local clubs, among other things.

In exchange, participants receive what promotional materials describe as "incredible tax benefits," paying an effective tax rate of just 3.5 percent on eligible income compared with a top rate of more than 35 percent on the
mainland.

A dispute between one of the beneficiaries and the Bureau of Internal Revenue, the islands' tax authority, reveals just how substantial the tax breaks can be.

According to papers filed in Federal District Court in St.Croix, James Auffenberg Jr., owner of the St. Clair Auto Mall in O'Fallon, Ill., had $6.4 million in income in 2000. The bureau calculated that his total federal tax liability for that income was $2.3 million.

But Mr. Auffenberg is a partner in an economic development company. He claimed that $5.4 million of that income was eligible for the accompanying tax benefits, and paid the Virgin Islands some $97,000 in taxes.

The bureau contends that he owes it $102,000 more, something he disputes. Through his lawyer, Mr. Auffenberg declined to comment or provide the name of the company in which he is a partner.

The program's benefits have been available for decades. In the 1960's, Congress gave United States territories like the Virgin Islands the ability to offer tax breaks to encourage economic development and build self-sufficiency.The islands used that tool mostly to attract manufacturers, hotel operators and tourism businesses.

About a decade ago, the local government expanded the program to attract service companies, hoping to draw highly educated, affluent workers to the islands. These businesses have kicked the program into high gear in the last few
years, pumping up government revenues and leading to a boom in restaurants, boat building, dentistry and other professional services.

Among the newer arrivals who are beneficiaries of the program are Richard Driehaus, the Chicago money manager whose new house in St. Thomas is the talk of the town; Jeffrey Epstein, the elusive money manager who reportedly
handles only clients with $1 billion or more in assets, and Steven Gluckstern, the former head of Zurich Re who now has his own asset management business.

Economic development companies paid nearly $75 million to the local government in the 2003 fiscal year, or almost 15 percent of the territory's total tax receipts, up from 12 percent just two years earlier.

The economic impact of the program goes far beyond tax receipts. Housing sales and construction have risen sharply, as reflected in the 150 percent jump in taxes
collected when deeds are recorded from 2001 to 2003. The "sea goose," the pontoon plane that shuttles between St. Croix and St. Thomas, has hired more pilots to keep up with demand, and marinas that had stood empty since Hurricane
Hugo in 1989 now have waiting lists for berths.

Charitable contributions have also improved the quality of life. Thefts of computers from a school on St. Croix stopped after Lewis Lester, the head of Global Capital
Advisors L.L.C., an economic development company, paid to install security cameras, and the St. Croix police have bulletproof vests thanks to another beneficiary.

More than 2,000 employees have migrated off the bloated public payroll and into the private sector. But what locals prize most is the program's ability to reverse the brain drain and bring back to the islands people like Cesar A. Guerra.

Mr. Guerra, a native of St. Croix, did not even consider looking for a job here when he graduated from the University of Chicago with an economics degree. "My only
choice would have probably been to come back as an algebra teacher," he said.

He was working at Blum Capital in San Francisco when he heard that several investment management companies were moving to his hometown, drawn by the economic development program. He quickly joined one, the Valance Company. "There was kind of stigma attached to coming back, frankly, like
you couldn't make it anywhere else," Mr. Guerra said. "Now it's like you got one of the really good jobs here, there's a cachet to it."

Vetting and oversight of the program's beneficiaries seems weak, as several of them have run afoul of federal regulators in the past. For instance, Warren B. Mosler, the owner of Valance, is a principal in two mainland firms that
the I.R.S. has cited for underpaying taxes in the past. Mr.Mosler did not respond to messages left by phone and e-mail.

Frank Schulterbrandt, the chief executive of the Economic Development Authority, the umbrella agency for the Economic Development Commission and other government agencies, did not know that one beneficiary had 99 partners - he said his records showed only three - and that two other economic development companies had apparently merged or were at least sharing an office across the street from his office in St. Thomas.

He said applicants are vetted by his staff, which occasionally seeks additional help from outside services, such as the Gaming Enforcement authorities. He is
requesting $2.9 million more to beef up oversight, but he made it clear that determining participants' tax status is not his job. "Tax issues are the responsibility of the tax authorities," he said.

A reporter dropped by the offices of 17 economic development companies in St. Thomas, an exercise recently duplicated by I.R.S. agents. Most of the offices seemed empty but for support staff and receptionists, who said that their employers had just left, were off island or would otherwise be unavailable to comment.

So far, the I.R.S. and the Justice Department have focused on about a dozen companies apparently consisting of social and business acquaintances from the mainland who have banded together to share the program's tax benefits.

Kapok, for instance, appears to have had more than 60 partners whose businesses ranged from selling insurance to trading cattle futures. The partners established Virgin Islands residency and forwarded the income from their
businesses through Kapok, thus capturing the tax benefits, according to investigators and a lawsuit filed against Kapok by two of the partners.

"We're concerned about whether these are real partnerships or whether they are essentially selling tax credits to disparate groups of businesses that have no real connection to each other," said Mr. Nissman before he completed his service as United States attorney in August. (He now works at Bridge Capital, a financial services company in St. Croix that is a new E.D.C. beneficiary.)

At least two other firms have lost partners since the raid. Gary J. Hirst, a Florida money manager, declined to explain why he dropped out of Margate Management in March but said he had not taken advantage of Margate's tax benefits. "I
thought it sounded good when I joined, but then I decided it was inappropriate," he said.

Christopher Russell, a Maryland real estate developer who founded a charity that is now under the scrutiny of the Senate Finance Committee, said he had ended his partnership in International Asset Management Inc., in St. Croix. "My
tax counsel advised me after the raid on Kapok that I should get out," he said.

But federal officials say the biggest threat to mainland tax coffers may be the emigration of highly compensated hedge fund managers who have begun claiming the program's tax benefits, executives like S. Donald Sussman, the founder of Paloma Partners of Greenwich, Conn., which manages nearly $3 billion in capital.

An avid yachtsman, Mr. Sussman has a home in St. John, where he spends most of his time, and he cruises between it and houses in Greenwich and Deer Isle, Me.

In 2000, he established Trust Asset Management under the E.D.C. program, and serves as chairman and chief executive of Paloma through it. Paloma pays Trust Asset to cover his compensation and the services of 10 other Trust Asset
employees in St. Thomas.

As owner of Trust Asset, Mr. Sussman pays the Virgin Islands government the low tax rate on the share of income that Trust Asset gets from his funds and the full federal tax rate on the rest. "I live in St. John," he said in a telephone interview. "I follow the rules. I do what I'm supposed to do."

Mr. Sussman is confident that he is within the law and upset that others may be playing fast and loose. "If what has been alleged is true, those nonresidents who masquerade as residents are engaged in outrageous behavior and
potentially endangering the E.D.C. program,'' he said.

http://www.nytimes.com/2004/09/18/national/18taxes.html?ex=1096539045&ei=1&en=bd75b4b64b642cde