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Hearing Notes How Companies Used Territory to Avoid Billions in Taxes

The current use of Puerto Rico to avoid billions of dollars in Federal taxes by big businesses based in the States was raised in a recent U.S. Senate hearing on technology giant Apple counting sales and profits generated in the States as income earned abroad.

An expert witness helped explain why the longtime incentive for companies in the States to manufacture in Puerto Rico was phased out from 1996-2005 and proposals to recreate the incentive have been rejected by the Federal government.

The incentive, Internal Revenue Code Section 936, provided a credit equal to the taxes that would be due on income from Puerto Rico from 1976 through 1993. It replaced a total tax exemption on such income that dated to 1921. In 1993, the 936 credit was reduced to 40% of the taxes due. And in 1996, it was phased out, ending by 2006.

Many companies then shifted ownership of their Puerto Rico operations to subsidiaries that they established outside of the States, mostly in foreign tax havens.

Companies do not have to pay income taxes on profits attributed to subsidiaries outside of the States until they receive the funds. Many keep much of the money in the subsidiaries indefinitely.

The second in a series of hearings on “Offshore Profit Shifting and the U.S. Tax Code” held by the Homeland Security and Government Operations Permanent Subcommittee on Investigations used the case of Apple to illustrate the tax avoidance.

In Apple’s case, Puerto Rico was not used. But Chairman Carl Levin (D-Michigan) used the example of another technology giant to explain the similar Puerto Rico tax avoidance technique:

“Microsoft USA … ‘sold’ some of its intellectual property rights to a foreign corporation it controlled in Puerto Rico. Microsoft USA then immediately bought back the distribution rights in the United States. Why? Because under the distribution agreement, Microsoft USA paid Microsoft Puerto Rico a certain percentage of the sales revenues it received from selling Microsoft products in the United States.”

Levin, brother of the senior Democrat on the U.S. House of Representatives committee with jurisdiction over taxes, then laid out the benefit to Microsoft of “this corporate sleight of hand.” In 2011, he noted, it “enabled Microsoft USA to shift 47 cents of every dollar in U.S. sales, totaling $6 billion, to its Puerto Rican subsidiary, dodging payment of U.S. taxes on nearly half of its U.S. sales income.”

“During the three years examined by the Subcommittee,” he went on, “by routing its sales activity through Puerto Rico, Microsoft saved over $4.5 billion in taxes on goods sold right here in the United States.”

Many companies manufacturing in Puerto Rico use the Microsoft tax avoidance strategy. They transfer the valuable exclusive rights to make a product and move brand names to a subsidiary manufacturing in the territory and then pay no tax on the profits unless they take the earnings from the subsidiary.

Sometimes the earnings are even deposited in financial institutions and instruments in the States — but no tax is due because the money is still ‘owned’ by the subsidiary.

And many of these subsidiaries are set up in foreign tax havens instead of in Puerto Rico to avoid Puerto Rico taxation and escape audits by the Internal Revenue Service.

An invited witness at the hearing, former Deputy Assistant Treasury Secretary for International Tax Affairs in the Obama Administration and International Tax Counsel in the Reagan Administration, Stephen Shay pointed out how big the problem was in the case of companies claiming the Section 936 tax credit. “By the Tax Reform Act of 1986,” he recalled, “it became clear that international transfer pricing was a substantial issue, particularly in relation to the territorial system adopted in Code Section 936 for Puerto Rico.”

The purpose of Section 936 in 1976 had been to encourage job-creating investments in Puerto Rico by manufacturers in the States. But the Internal Revenue Service soon found out from tax filings that, by transferring to Puerto Rico the patents and trademarks developed in the States that account for most of the profits on products such as pharmaceuticals, companies were reaping tax savings much greater than their payroll costs in the territory.

This made the tax loss cost per job created many times the amount of salaries. So, in the 1986 tax reform, the Reagan Administration proposed replacing the tax credit based merely on income attributed to Puerto Rico with a credit for wages.

The proposal was dropped in the 1986 reform legislation, but President Clinton revived it in his 1993 economic package. As it passed into law that year, the credit equal to all tax due on earnings attributed to Puerto Rico was reduced from 100% to 40% and a Federally-preferred alternative credit for real economic activity and benefits in Puerto Rico was created. The real economic activity consisted of wages, investments in plants and equipment, and local tax payments.

The alternative credit was based on the model of Empowerment Zones, tax benefits for investing in undeveloped communities in the States, but it was more generous to businesses in Puerto Rico.

In 1995, a new Republican majority in the House of Representatives, led by Budget Committee Chairman John Kasich – now the Governor of Ohio, however, proposed phasing out Section 936 by 2006. He complained that it was “corporate welfare.”

In many cases, tax savings were still much larger than island payrolls in the case of the credit reducing taxes by 40%. This was the part of Section 936 used most by companies in preference to the alternative credit for spending in Puerto Rico’s economy.

In 1996, the phase-out proposal became law. The Congress’ Joint Committee on Taxation reported that the main reason was so that there would not be a greater tax incentive to manufacture in the territory than in a State.

The continuing tax avoidance is costing the Federal government many billions of dollars a year while providing much lesser economic benefits to Puerto Rico. It is likely to continue as long as Puerto Rico remains a territory.

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