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Budget Could End Dream of Puerto Rico Tax Advantage Over Foreign Countries

From 1921 until 2006, Puerto Rico had specific Federal tax advantages over the States and foreign countries as a location for manufacturing by companies in the States.  The advantages, first an exemption from Federal income taxes and, then, tax credits that substantially lowered taxes due, were phased out beginning in 1996.

There were several reasons for the repeal but a chief one was so that companies that manufactured in the territory would not have an advantage over companies that kept their manufacturing in the States.

Since the repeal, companies and many Puerto Rico officials have proposed various ways of recreating the original tax exemption despite the strong bipartisan consensus in the Federal government that ended it.  Territorial officials have explained that they at least wanted a tax advantage as a location for manufacturing over foreign countries.  They argue that a U.S. standard of living for workers and Federal environmental regulations among other factors make it difficult for Puerto Rico to compete with low-cost foreign countries as a location for manufacturing (arguments that also apply to the States).

The Federal government has provided a relatively small advantage for Puerto Rico over foreign countries since 2006 — a nine percent reduction in taxes due from income from manufacturing in the islands by companies organized in the States.  Companies organized and manufacturing in the States have benefited from the same deduction since 2004.

While the tax advantages for manufacturing in Puerto Rico by companies in the States has changed, the tax advantage for manufacturing in Puerto Rico by their subsidiaries organized in Puerto Rico or foreign countries has not changed.

The advantage is that companies do not have to pay Federal income tax on earnings by a Puerto Rican or foreign subsidiary until they take the income from the subsidiary.  Many companies hold the profits in their foreign or territorial subsidiaries or use the monies through the subsidiaries instead of claiming the funds directly.  This enables them to delay taxation for as long as they wish.

But Puerto Rico could lose its tax advantage over foreign countries as a location for manufacturing under the Fiscal Year 2014 budget proposed by U.S. House of Representatives Budget Committee Chairman Paul Ryan (R-WI).

The proposed budget calls for the House to pass legislation to reform the Federal tax system this year.  In doing so, it opposes the  current U.S. ‘worldwide’ system’ of corporate taxation and hints at adoption of a ‘territorial’ system, calling for a system that is more internationally competitive.

Under its worldwide system, the Federal government taxes the income of companies organized in the States wherever earned — which is why some companies avoid taxation by setting up subsidiaries in territories to which Federal taxes have not been extended or in foreign countries in which U.S. taxes cannot apply.

Under a territorial system of taxation, the Federal government would only tax income earned in the U.S.

If a territorial system of taxation is adopted and Puerto Rico remains a separate jurisdiction from the States for corporate taxation similar to a foreign country, there would be no tax advantage for manufacturing in the territory over foreign countries. There would be no U.S. taxation of income from either Puerto Rico or foreign countries under a territorial system.

Many, developed economies throughout the world tax on a territorial basis, but a U.S. shift to a territorial system is by no means certain … or even likely.  Some Democrats — including Obama Administration officials — are concerned that a territorial system would further encourage companies organized in the U.S. to manufacture abroad.

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