Puerto Rico Rep. Luis Vega Ramos, recently spoke out against making Puerto Rico an incorporated territory. According to Caribbean Business, Vega Ramos claims that Governor Ricardo Rosselló asked for this change.
In fact, Rossello has asked that Puerto Rico be considered a domestic jurisdiction instead of a foreign jurisdiction under the tax code. As a foreign jurisdiction, which Puerto Rico has been for tax purposes since 1917, Puerto Rico will be affected by the new tax bill’s 20% tariff on certain goods produced by foreign subsidiaries of U.S. corporations.
Do incorporated territories pay federal income tax?
Vega Ramos believes that this change — which he characterizes as making Puerto Rico into an incorporated territory — would lead to changes in Puerto Rico’s tax position.
The only incorporated Territory of the United States at present is Palmyra Atoll. There are no permanent residents of Palmyra Atoll, so the question of income taxes doesn’t arise there. Most of the former U.S. incorporated territories became states before federal income taxes began in 1913. Hawaii and Alaska, both of which were incorporated territories, paid federal income taxes before they became States. So it is possible that becoming an incorporated territory would lead to federal income tax for Puerto Rico.
What is the difference between an incorporated territory and an unincorporated territory?
One of the biggest differences between the two kinds of territories is that an incorporated territory is a permanent part of the United States, on its way to become a State. Unincorporated territories can become independent nations, as the Philippines did. Incorporated territories, like Palmyra Atoll, cannot change their political status to anything but statehood.
It was suggested in 1995 that Palmyra Atoll be changed into part of the State of Hawaii. This did not take place, but it was a legal possibility. Most of the land there is owned by the United States government, and is a designated nature reserve. In the past, Palmyra Atoll was owned by individuals. As long as it was not incorporated, those individuals could have decided to declare themselves an independent nation. Once Palmyra Atoll became an incorporated Territory (along with Hawaii), that option was gone.
The other big difference is that the U.S. Constitution applies fully in all incorporated Territories, but not in unincorporated territories. This means that people on Palmyra Atoll (between 4 and 20 people live there temporarily at any given time) are fully protected by the Constitution, while the 3.4 million or so U.S. citizens living in Puerto Rico do not have this protection.
Is “domestic jurisidiction” the same as “incorporated territory”?
A recent Congressional Research Service report on tax law in the territories explains the federal income tax rules:
“As a general rule, individuals who are bona fide residents of a territory are eligible for a possession-source income exclusion, and therefore not subject to U.S. income tax on work or business income sourced from within the territories (except for compensation of federal government employees).”
The same report mentions a paragraph later that “U.S. citizens and residents who reside in the territories cannot qualify for income or housing exclusions specified in IRC Section 911 because they are not classified as living abroad.” Incorporation of territories in not discussed.
It does not appear that asking to be treated as a domestic jurisdiction would trigger a transformation of Puerto Rico into an incorporated territory.
Are incorporated territories better off?
Being incorporated puts a territory on a clear path to statehood. People living in incorporated territories have the protection of the U.S. Constitution. This could very well be an improvement for Puerto Rico, but it is a moot point. A request to be defined as a domestic jurisdiction or, the option Vega Ramos prefers, a specific exclusion of Puerto Rico from the new tariffs in the Tax Cuts and Jobs Act, would not result in a switch to being an incorporated territory.