Foreign Taxation in Puerto Rico

A United States Senate subcommittee investigating U.S. companies that shelter overseas profits from taxation has found that Microsoft withheld up to $4.5 billion in federal taxes from 2009 to 2011 by transferring profits to a Puerto Rican subsidiary.

Puerto Rico is a territory of the United States and its citizens are U.S. citizens, but the island is not treated as the rest of the United States under the Internal Revenue Code. 

At a recent hearing of the Senate Permanent Subcommittee on Investigations, there was broad acceptance that corporate tax avoidance strategies using offshore subsidiaries are legal.  The predominant sentiment among Senators, however, was that the practice is not good policy.

A statement by Subcommittee Chairman Sen. Carl Levin (D-MI) highlighted the Microsoft/Puerto Rico example as particularly egregious.  Noting that international tax strategies normally involve offshore subsidiaries selling assets in foreign countries, Sen. Levin criticized the way that Microsoft has “devised a way to avoid U.S. taxes even on a large portion of the profit it makes from sales here in the United States.”

It is not unusual for U.S. based international companies to reduce federal tax liability through Puerto Rican subsidiaries.  The federal government has encouraged this practice based on the premise that the corporate tax breaks would help create jobs in Puerto Rico.  Former section 936 of the tax code, enacted in 1976, explicitly exempted income earned by U.S. firms operating in all U.S. possessions.  According to the U.S. Senate Finance Committee’s accompanying report, the goal of section 936 was “assisting the U.S. possessions in obtaining employment.”  The Government Accounting Office (GAO) determined in 1993 that over 99% of section 936 benefits went to companies operating in Puerto Rico.

The 1976 law, however, was short lived.  In 1982 and again in 1986, Congress modified section 936 to reduce its significant cost to the government relative to the small amount of jobs created and investments made in Puerto Rico.  In a 1993 report, the Government Accounting Office (GAO) continued to cite “[c]oncerns about the tax benefits in relation to employment generated.”  Congress ultimately enacted legislation in 1996 that repealed the credit after a ten year phase-out.

Critics claim that section 936 did help Puerto Rico grow its manufacturing base and that its repeal is a factor in current unemployment.  Yet Puerto Rico’s history of manufacturing has largely followed the general decline in U.S. based manufacturing, and the current favorable tax treatment does not appear to be helping Puerto Rican unemployment, which is the highest in the nation.

In his testimony before the Permanent Subcommittee on Investigations last week, William J. Sample, Vice President for Worldwide Tax at Microsoft, noted that “Puerto Rico has a long history of offering tax incentives to attract export business to operate development, production, and distribution facilities there.”  The long history of tax incentives is true, but it is not Puerto Rico that has offered them.  The tax incentives come from federal tax law, in which Puerto Rico has almost no formal representation.

If Puerto Ricans had a voice in the federal government, they may have chosen to allocate the $4.5 billion in federal revenues differently.  For example, refundable tax credits – such as the Earned Income Tax Credit and Child Tax Credit – which are paid directly to lower income workers living in the fifty states, have proven effective in encouraging work and reducing poverty.  Attempts have been made in Congress to fully extend these tax credits to the people of Puerto Rico, but they have not yet been successful.  Expense is frequently cited as a factor.

A legal tax structure that permits the transfer of profits to Puerto Rico has benefitted Microsoft.  As in the case of section 936, its relative benefit to the people of Puerto Rico is more questionable.  History seems to be repeating itself, and Puerto Ricans, as residents of a territory, lack a voice to change its course.

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