The Internal Revenue Service is finally cracking down on money managers who are fleeing the mainland United States for the U.S. Virgin Islands to take advantage of tax breaks that President Bush’s interior secretary, Gale Norton, has described as “very generous.”

In an announcement Thursday, the IRS clarified the rules. “A claim of USVI residency for income tax purposes may be considered without merit or fraudulent when the taxpayer continues to live and work in the United States,” the IRS notice said. The notice also says that if the income is from services performed in the United States, tax has to be paid on it at the higher, mainland rates, not the Virgin Islands rates, which are 10% of the mainland rates.

Readers of The New York Sun recall dispatches on this topic in August and September of last year. The Sun reported that several high-profile money managers — including Richard Driehaus of Chicago, Jeffrey Epstein of New York, Michael Masters of Atlanta, and Flag Capital Management of Stamford, Conn. — had moved to the Virgin Islands or had applied to do so. None of those four was named by the IRS as violating any tax rules, and no one has accused them of doing so. A newsletter published by the trade association for hedge fund operators issued an article headlined, “Tropical Beaches and Substantial Tax Incentives: Welcome to the U.S. Virgin Islands.”

The Bush administration had been divided on the issue. The IRS was reviewing the matter. But the Interior Department hosted a conference at a Washington hotel on September 8, 2003, at which Virgin Islands economic development officials wooed businessmen with bottles of rum, beach bags, and brochures detailing both the tax incentives and, in color photographs, the beaches and bikini-clad women.

Last week’s statement suggests that the IRS is getting the upper hand. That prompted dismay in the Caribbean, where the Virgin Islands Daily News banner headline Friday was “IRS Warning Leaves V.I. Stunned.” The newspaper quoted the U.S. attorney in the Virgin Islands, David Nissman, as saying that the IRS notice had spread “unbelievable panic” in the Virgin Islands business community. The paper said a Virgin Islands economic development official acknowledged that hedge funds and asset management firms may find it difficult to prove to the IRS that their income is connected to the territories.

Until the IRS notice, the definition of a Virgin Islands resident was somewhat ambiguous. There was no “day-count test” of days spent on the island, a method that some other jurisdictions use to establish residency. As a result, some of the money managers are able to maintain residences on the mainland and leave a public impression that they live on the mainland, despite having their legal residences in the U.S. Virgin Islands.

The scare created by the IRS will likely stem the tide of money-management firms leaving New York for St. Croix and St. Thomas. In a sense, that is too bad, because it reduces the pressure on New York and on America as a whole to lower its tax rates to compete with the U.S. Virgin Islands. On the whole, though, we tend to agree with the chairman of the Senate Finance Committee, Charles Grassley, who praised the IRS for going after what he called a “tax avoidance scam.” Some of the dozens of participating companies and individuals may have abused this tax incentive program. Others may have adhered to both the letter and the spirit of the law. In general, we’re for lowering tax rates on the rich. But this program rewards people by cutting their federal tax bills by 90% for fleeing the American mainland. We understand why it’d be in the interest of the islands. We even understand why it’s in America’s interest to move away from federal government grants to aid these islands, and toward incentives for free enterprise there. But it’s hard to see how this particular incentive program is in the interest of the nation as a whole, which is why the IRS’s move is a welcome one.