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‘Commonwealth’ “Tax Autonomy” Myth Used to Argue Congress Can’t Curb PR Law’s Federal Tax Avoidance

The lead official in the Government of Puerto Rico’s effort to exploit a loophole in tax law by encouraging big traders of stock and bonds to move from the States to the territory late last week used a misleading “Commonwealth status” contention to suggest that Congress could not close the loophole.

Economic Development and Commerce Secretary Alberto Baco explained that he is not worried about congressional opposition to Commonwealth “Law 22’s” tax exemptions for high-income individuals who move to Puerto Rico because of what ‘commonwealthers’ claim is the territory’s “fiscal autonomy.”

They wrongly assert that this means the Federal Government cannot tax in Puerto Rico without the territory’s consent. They attribute this alleged limitation on congressional powers to the Federal-territorial agreement on the constitution for the local government, which named the insular government “The Commonwealth.”

The purported congressional inability to close the loophole “stems from our autonomy,” Baco declared, adding, “There is no way that Congress can act as it did with Section 936.”

The Section 936 congressional action to which Baco referred was the repeal of credits in Federal tax law that companies in the States could take to reduce their Federal taxes related to income from Puerto Rico.

Unnamed “analysts” quoted by Noticel news service agreed that the only congressional alternatives for closing the loophole are “withholding Federal funds and statehood.”

“Law 22” created the loophole by taking unintended advantage of Federal law exempting Puerto Rico income of residents of the territory from Federal taxation.

The purpose of the Federal law and similar law regarding the other territories of the U.S. is to enable the local governments of the territories, which are underdeveloped in comparison to the States, to tax the income and support themselves.

In the case of individuals who move to Puerto Rico after not living there for 15 years, “Law 22” exempts profits from buying and selling stocks and bonds in the territory from Puerto Rico taxation through 2036.

Combined with the Federal tax exemption on Puerto Rico income, the “Law 22” exemption means that there is no tax at all on the “capital gains.” For stocks and bonds bought before moving and sold at least 10 years after a move, there would only be a five percent of the profits Puerto Rico tax.

The law also exempts dividend income from the stocks and interest income from the bonds from insular taxation. Federal tax can be avoided if a company established by the individual in Puerto Rico owns the investments.

“Law 22” is aimed at individuals whose incomes come from buying and selling stocks and bonds. The Federal capital gains tax rate for high-income individuals is 23.8%. Some States levy capital gains taxes as well. The Government of Puerto Rico has just raised the tax on stock and bond sale gains if made by individuals who have not moved to the territory after not having lived there for 15 years from 10% to 15% of the profits.

The administration of Governor Alejandro Garcia Padilla (‘Commonwealth’ party) is aggressively courting very big traders of stocks and bonds to relocate to the territory. The effort is the administration’s primary economic initiative.

Key members of Congress and tax policymakers have objected to the Garcia Padilla Administration’s exploitation of the loophole, with the senior Republican on the Senate Finance Committee Charles Grassley of Iowa, threatening Federal legislation, and some Democratic tax-writers putting it on the agenda as well.

They can for two reasons. One is that Congress can tax Puerto Rico income of Puerto Rico residents. Another is that Congress, which has let the territory exercise local government authority, has the power under the Constitution’s Territory Clause to govern Puerto Rico on matters that would be considered local and beyond Federal authority in the States.

Puerto Rico’s “fiscal autonomy” is the authority that Congress has let the Commonwealth government exercise in matters that States have the right to handle. Letting the Commonwealth exercise this authority did not give up Congress’ authority to tax anyone in the territory, make whatever law it wants for the territory, or to tax U.S. citizens wherever they live.

Congress has acted to close similar loopholes in the cases of two other territories. When the owner of a major retail business tried to avoid Federal capital gains tax by moving to the Commonwealth of the Northern Mariana Islands, which taxed the income at 10% of the Federal rate, after selling his stock in the 1980s, Congress enacted a law applying the Federal tax to gains within 10 years of moving to a U.S. territory in the Pacific.

When Puerto Rico’s neighboring U.S. Virgin Islands actively lured many big traders of stocks and bonds to the territory during the last decade by cutting the tax rates for new residents to 10% of the Federal rates, Congress tightened up the residency requirements.

Puerto Rico’s “fiscal autonomy” is similar to that of each of those territories.

The Garcia Administration disclosed a few weeks ago that 288 individuals had been certified as eligible for the “Law 22” exemptions. Eighty-seven people have applied for the tax exemptions this calendar year. The individuals have an average net worth of $7 million and an average age of 51.

Members of Puerto Rico’s Senate, meanwhile, are moving to expand the benefits. A bill passed by the Rules and Calendar Committee would reduce the length of time an individual cannot have lived in Puerto Rico from 15 to six years.

The bill would also exempt beneficiaries of the law from the Commonwealth law requiring two-thirds of an individuals estate go at death to certain family members. The requirement would not be dropped for other residents of Puerto Rico — who also have to pay recently increased taxes on stock and bond capital gains, interest, and dividends.



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