A popular tax credit fully available to U.S. citizens living in the fifty states was expanded in the Federal tax overhaul proposal introduced in the House of Representatives last week while Puerto Rico’s more limited version of the tax credit remained unchanged.
The Child Tax Credit (CTC) allows a family to reduce its federal tax liability – the taxes owed before tax credits are applied by up to $1,000 per child. The CTC is also refundable, meaning that if the value of the credit exceeds the amount of tax a family owes, the family may receive a full or partial refund of the difference.
The tax proposal released by the House of Representatives last week expands the CTC to $1,600/child and leaves the first $1,000 refundable. The proposal also adds a new family flexibility and non-child dependents credit of $300/year for the next five years.
The CTC fully applies to families living in the fifty states although it phases out for high income families. In Puerto Rico, the CTC does not apply to a family’s first and second born, only kicking in for the third child and any additional children.
In the final report of the Congressional Task Force on Economic Growth in Puerto Rico, issued in December of 2016, the Task Force reached full consensus in its recommendation that Congress amend the tax code to authorize eligible families in Puerto Rico with one child or two children to claim the tax credit. The chairman of the eight-member bipartisan and bicameral task force was U.S. Senate Finance Committee Chairman Orin Hatch (R-UT), who is now leading Senate efforts in its most extensive effort to reform the Federal tax code since 1986.
The Senate Finance Committee is actively working to finish its version of tax reform. It’s proposal is slated for completion on November 8, with full committee consideration planned for the week of November 13 and a Senate vote by Thanksgiving.
It is unclear at this time whether the Senate Finance version of the draft bill includes the CTC expansion endorsed in the Hatch Task Force’s final report. Historically, there has been push back against helping Puerto Rican residents through the tax code – even refundable credits – because Puerto Ricans do no pay federal income tax on Puerto Rico-sourced income. Puerto Ricans do pay payroll taxes, however, and the CTC refundable credits can be structured to only capture payroll taxes already paid, creating equality among all U.S. citizens.
By definition, refundable tax credits benefit most the people whose tax liability is minimal enough to receive a check from the I.R.S. These taxpayers are typically low wage earners. An argument has also been made that refund checks for people in the states can be balanced out by other people in their own states who have high tax liability, while Puerto Ricans have no such liability within the island population. This viewpoint singles out the territory of Puerto Rico, as states don’t typically have to justify where they are on the continuum of donors to/recipients from the federal treasury for their residents to receive refunds. In addition, with the large migration of Puerto Ricans to states, it can be said that any refunds to people in Puerto Rico could unofficially be “offset” by their fellow Puerto Ricans in the stateside diaspora.
Economists such as Arthur MacEwan and J. Tomas Hexner have published research proving that that extending the Earned Income Tax Credit and the Child Tax Credit to Puerto Rico would not only assist individuals and families, but it would also stimulate Puerto Rico’s economy.
Tax Bill Would End Puerto Rico Tax Avoidance
One of the central reforms in the major tax reform bill proposed by House Ways and Means Committee Republicans and Speaker Paul Ryan (R-WI) Thursday would end a tax avoidance strategy used by most of the major companies based in the States that complete the production of goods in Puerto Rico.
Under the practice, pharmaceutical, biotech, medical device, and computer software companies legally avoid Federal income taxation on the products by transferring the patents and trademarks that account for most of the value of the goods to foreign corporation subsidiaries that complete production in the territory and ‘sell’ the products to their parent companies for resale to consumers. Federal tax does not have to be paid on the Puerto Rico subsidiaries’ earnings unless the profits are paid to the parent companies. Companies employ the tactic to avoid U.S. taxation in low-tax foreign countries as well as in Puerto Rico.
Under the bill introduced by Ways and Means Committee Chairman Kevin Brady (R-TX) and others, the company payments to non-Federal taxpaying ‘foreign’ subsidiaries would be subject to a 20% excise tax – a rate equal to the bill’s 20% corporate income tax rate – or, in some cases, at half the income tax rate. Additionally, a Federal income tax credit could not be taken for excise taxes paid to a foreign or territorial government.
Companies using the tax tactic in Puerto Rico avoid tens of billions of dollars in Federal income taxes annually. The companies only pay a four percent excise tax to the territory on the products that they buy from their ‘foreign’ subsidiaries in the islands.
In each of the years, 2009 through 2011, Microsoft avoided about $1.5 billion a year in Federal income taxes on income of $4.5 billion that it attributed to its ‘foreign’ Puerto Rico subsidiary, which only employed an average of 179 people.
The Puerto Rico excise tax generates about $1.9 billion a year for the territorial government but was criticized by Federal tax policymakers when it was enacted half a dozen years ago. The Internal Revenue Service has allowed companies to credit payment of the excise tax against their Federal income tax liability but refused to issue a formal rule that the tax is creditable.
Past Federal tax reform proposals of Democratic as well as Republican leaders have sought to ensure that income of foreign subsidiaries in foreign countries and Puerto Rico from products made the U.S. market with assets developed in the States pay at least a double-digit rate of taxation.
The proposal disappointed Puerto Rico Governor Ricardo Rossello Nevares (NPP) and the impacted Puerto Rico subsidiaries. A claim for an exemption because companies would move to foreign countries, however, was viewed as not credible because the companies would incur the same tax liability anywhere else in the world. An exemption would make the territory the only place in the world where income from products for the market in the States made outside of the States largely with assets developed in the States could avoid taxation.
If enacted, the bill may effectively require the territory to change its economic model and tax system.
The House Republican bill was developed with Senate Republican leaders and the Trump Administration. The Ways and Means Committee will begin to formally consider it Monday with the goal of approval by Thursday and full House approval during the week of the 13th.