Puerto Rico has long been a U.S. tax avoidance haven for companies based in the States. The territory also recently became a tax haven for people who make a lot of money from sales of their of stocks and bonds.
The Commonwealth government is attracting these big financial market players to the islands with the lure of paying no Federal or territorial taxes on the profits. High-income individuals who have not lived in Puerto Rico for 15 years and move there will avoid the Federal capital gains tax of 23.8% of the profits and, under a new insular law, will not be liable for the 10% territorial capital gains tax on stocks and bonds that they buy and sell while residents.
Securities that they already own can be sold with only the 10% territorial tax unless they keep the investments for 10 years, which lowers the tax to 5%.
They receive personal guarantees of the local tax exemptions until 2036.
Taxes everywhere in the U.S. have to be the same but Puerto Rico can be a tax haven under the U.S. flag because it has not been determined yet whether the territory taken from Spain 115 years ago will become a full, permanent part of the U.S. — a State — or become a nation. Puerto Ricans decided their preference last November by voting for a transition to statehood but the Federal government would need to act.
Under current Federal law, residents of Puerto Rico are liable for Federal taxes on income from the States but not from the territory. Capital gains (profits) from stocks and bonds, however, are taxed based on residence, so no Federal tax is due.
The new territorial law became a significant attraction as the Federal tax on capital gains rose from 15% to 23.8% for high-income individuals at the beginning of this year. Before this, the capital gains tax advantage for their moving from the States was from 15% to 10%. Now it is from 23.8% to zero.
Ten wealthy individuals have already taken advantage of the law and the Federal tax loophole created by it. Commonwealth officials say that they are in talks with another 40 — one third hedge fund managers. (Hedge funds are private investment funds limited to well-to-do investors that seek to ‘hedge’ risk but often do so through aggressive, complicated investments designed to deliver outsized returns.)
The opportunity for avoiding any tax on gains from financial investments came to national attention March 11th, when it was reported that New Yorker John Paulson, manager of an $18 billion hedge fund and worth an estimated $11.2 billion personally, was considering moving to the territory. After a flurry of criticism, a spokesperson for Paulson said March 15th that Paulson would not make the move — but word on the Puerto Rico tax haven was out.
It had reached some key figures in writing Federal tax laws. A spokesman for the Senate Finance Committee said Chairman Max Baucus (D-MT) is looking into the situation as he prepares to work on what may be the most far-reaching Federal tax reform since 1954.
Committee Member Chuck Grassley (R-IA) was more specific, saying that “Harmonizing the tax rules of the territories” — making taxes in territories consistent with Federal taxes — “could be something to look at” in a reform bill. An alternative, he suggested, is conditioning the current partial non-extension of Federal taxes to Puerto Rico on the territory “accepting certain rules to prevent tax evasion.”
Grassley, a former Finance Committee Chairman, was deeply involved in 2004 in closing a similar loophole created by Puerto Rico’s neighboring territory of the U.S. Virgin Islands. Federal law provides that residents only have a tax liability to the territorial government and that the territory use the U.S. Internal Revenue Code as its tax law. It also permits the territory to encourage external investment by lowering the tax burden. For decades, the Virgin Islands used the authority for investments such as factories and hotels. It then started cutting to 10% of Federal rates the taxes of financial players from Wall Street who claimed residence in the islands. With a growing loss to the Federal treasury and only much smaller gains for the Virgin Islands, Congress stepped in to require actual presence in the islands for more than half the year, costing the territory at least half of its new hedge fund managers.
John Buckley, who retired as a top congressional staff tax-writer after 35 years in 2011, noted that the new Puerto Rico law is is “the first time that Puerto Rico would … deliberately erode the U.S. tax base for individuals.” The former Chief of Staff of Congress’ Joint Committee on Taxation and Tax Counsel for the House of Representatives Committee on Ways and Means pointed out that plugging the loophole would recover revenue for the Federal government — at a time when the budget deficit is the primary issue in Washington, DC. He thought that few members of Congress would oppose corrective legislation.
Puerto Rico’s Secretary of Economic Development and Commerce, Alberto Bacó Bagué, reacted with defiance. The territory would not change the law “under pressure from U.S. politicians,” he declared, referring to national government officials.
To the contrary, he asserted, it would enlist “armies of promoters” to bring in as many people as possible seeking to avoid Federal taxes on profits from selling stocks and bonds.
Bacó, a Puerto Rico ‘commonwealther,’ misleadingly asserted that closing the loophole “would change Puerto Rico’s status,” referring to its political status, and contended that a closing is unlikely “because statehood is unlikely.” He equated ensuring that big sellers of securities who move to Puerto Rico pay taxes equally with big sellers in the States with statehood and equated not taxing them with “commonwealth,” as Puerto Rico’s unincorporated territory status is popularly, but imprecisely, called. Some members of Puerto Rico’s “commonwealth” status party wrongly contend that Puerto Rico is not a territory and has tax autonomy from the Federal government (others want the autonomy).
New residents who move to avoid Federal taxes would probably sympathize with Bacó’s views.
The U.S. Supreme Court, however, has ruled that Puerto Rico is subject to the authority of Congress to govern territories in all matters not limiting the fundamental rights of individuals (such as freedom of speech) In any case, Federal laws are supreme, applying irrespective of local law, and Congress has amended tax laws that are part of the current governing arrangement.