A group of companies in the States that do a lot of manufacturing in Puerto Rico is quietly lobbying Congress to make the territory the least taxed place in the world for manufacturing.
The businesses have discussed their proposal with Governor Alejandro Garcia Padilla’s Administration. It is not known whether Garcia supports the plan but PUERTO RICO REPORT revealed Friday that his administration had given a high-cost contract to a fourth lobbying firm to sway Federal officials on tax matters. (Government Law Firm: Puerto Rico Government “Foreign Government”)
The proposal responds to draft legislation for a reform of the U.S.’ system of ‘international’ taxation authored by the chairman of the U.S. House of Representatives Ways and Means Committee, Dave Camp (R-Michigan). The draft reflects a concept that has substantial support in Congress.
Camp and the chairman of the Senate Finance Committee, Max Baucus (D-Montana), want this Congress to pass the most sweeping reform of the Federal tax system in decades. Neither will chair the committees that they now head as of 2015 but they are joined in wanting a broad reform by many other top Federal officials.
One of the primary reform goals is to change the tax system as it applies to income that companies based in the States earn in foreign countries.
Currently, the Federal government does not tax income of separate subsidiaries that companies in the States set up outside of the States until — and unless — the income is paid to the parent company in the States. When the income is received, it is taxed in the same way that corporate income from the States is taxed.
This system applies to companies with subsidiaries in Puerto Rico organized in the territory or in foreign countries — usually other tax havens.
Camp’s proposal was inspired by the ‘territorial’ tax systems of many other countries. These systems only tax income earned within their borders.
Under Camp’s close-to-territorial proposal, an effective tax rate of 1.25% would apply to income from foreign operations, whether brought back to the States or kept abroad. Only five percent of foreign profits would be taxed, and the general tax rate for all corporate income would be lowered to 25% from the current 35%.
To discourage companies from shifting domestic operations abroad, however, one of Camp’s main options for his reform would also ensure that taxes of at least 15% are paid on income earned from “intangible assets,” such as patents and brand trademarks.
Intangible assets account for much of the value of products like medicines, medical devices, sophisticated electronics, and computer programs. Ownership of and rights to use these assets are easily shifted on paper from one corporate entity to another.
If a location outside of the States taxes the income at least 15% after deductions and credits, Camp would require no additional Federal tax above the 1.25%. But if a location does not tax the income at least 15%, the Federal tax rate would be increased to make up the difference.
A similar tax reform proposal by others would more simply require that at least 15% or so in taxes be paid on all corporate income from outside the States to some government.
Much of the manufacturing in Puerto Rico is by subsidiaries of companies that use transferred intangible assets.
The proposal by the companies with operations in Puerto Rico is to exempt income from U.S. territories from the 15% minimum tax.
The companies typically pay the Government of Puerto Rico nothing or not more than a two percent tax rate on their income from the territory. (They also pay a four percent tax on the value of products made in Puerto Rico but sold outside of the islands.)
Earlier Puerto Rican Proposal
Early in his administration, Garcia, who heads Puerto Rico’s “Commonwealth” party, joined the territory’s representative to the Federal government who heads the statehood party and has a seat in the U.S. House of Representatives with a vote only in committees, Pedro Pierluisi, in supporting a different proposal with a similar objective.
That Federal Internal Revenue Code Section 933A proposal would have not taxed income that a company in the States receives from an insular subsidiary if the subsidiary generated most of its earnings from the territory and chose to be treated as a “domestic” company for this purpose instead of as a “foreign” firm.
The proposal is not being discussed now for several reasons. One is that it is based on the current Federal system of taxation and not Federal tax reform proposals.
Federal officials were also cool to the proposal.
Another reason for the lack of discussion is a lack of interest on the part of companies with operations in Puerto Rico. Companies apparently decided it was more attractive to keep income outside of the States than to have it be more subject to Federal tax audits, etc.
Additionally, statehood party leaders have been split on whether the proposal is consistent with moving the territory towards statehood, which Puerto Ricans voted for in a plebiscite last November.
Past ‘Commonwealth’ Party Proposals
It would not be surprising if Gov. Garcia supports the companies’ proposal. A major economic and political strategy for Puerto Rico of his “Commonwealth” party has always been to exempt income that companies in the States earn in the territory from Federal taxation.
Party leaders long defended an exemption that Congress wound up overwhelmingly voting in 1996 to end and that totally expired at the end of 2005, Federal tax code Section 936. It initially provided a credit against all taxes due on income attributed to Puerto Rico. The credit was reduced in 1994 to 40% by President Bill Clinton’s Economic Plan.
The last two “Commonwealth” party governors, who served from 2001 through 2008, spent millions of dollars in lobbying to recreate a 100% or close to it tax exemption though amendments to other Federal tax code sections.
The proposals were rejected by Federal officials, especially the Senate Finance Committee.
Federal officials repealed section 936 and rejected the proposals to resurrect it in another tax code section for several reasons. A chief one was an objection to income companies in the States earn in Puerto Rico being taxed much less than earnings from the States. Lower (or no) taxation is unfair to companies that manufacture in the States and encourages companies to move operations from the States to Puerto Rico.
Additionally, the repealed 936 tax exemption became law in 1976 to encourage job-creating investments in Puerto Rico, and companies were saving much more in taxes than they were spending on jobs in the territory or otherwise contributing to the insular economy.
Further, the excessive tax savings were often obtained by attributing to Puerto Rico income that was really earned in the States, where it would have been taxed. This was done through paper transactions involving intangible assets between parent and subsidiary companies.
And the exemptions cost or would have cost the Federal government billions of dollars a year in lost revenue.
The “Commonwealth” party has long raised a lot of money from people who benefitted from the 936 exemption or would have benefitted from the proposals to replace it.
Perhaps more important to the party has been that the tax exemptions could not exist under statehood. The Federal government must treat all States equally in tax programs.
‘Commonwealthers’ could make a stronger argument against the benefits and opportunity that the equality of statehood would mean for Puerto Ricans if Puerto Rico’s economy were reliant upon the tax exemptions for companies from the States.
Although Garcia may agree to the new proposal by the companies and spend millions of dollars in promoting it, Federal tax policy experts think that there is little chance that the Federal government would agree to make U.S. territories — really meaning Puerto Rico — the only places in the world from which income is taxed at a rate much lower than either the States or foreign countries.
Possibilities of a Federal Tax Reform
Whether there will be a Federal tax reform has been put into serious question by differences between Democrats and Republicans on what a reform should do. Both want ‘fairer’ Federal taxation, but Republicans generally want to lower rates and not increase the Federal tax burden and Democrats mostly want tax law changes (instead of spending cuts) to reduce the Federal budget deficit.
A Federal budget deficit compromise could significantly increase the possibility of a tax system reform. The Federal government will soon have to increase the amount of money it borrows if it is to keep operating without major spending decreases.
Spending levels also have to be agreed upon to keep the government running smoothly.
Territory Status Cause of Tax Questions
Puerto Rico’s unincorporated territory status, sometimes misleadingly called “Commonwealth,” raises many Federal business and individual tax issues since the Federal government has chosen to treat the unincorporated territories — “possessions” in Federal tax law — differently than the States in most tax laws.
Any element of Puerto Rico’s current different treatment could be addressed by a reform of Federal taxation, with major economic impacts.