The End of Puerto Rico as a Tax Haven?

Many U.S.corporations, and wealthy individuals as well, see Puerto Rico as a tax haven. In 2019, the IRS reported to Congress on 166 individuals who had moved to Puerto Rico and once there, paid no income tax. Five years before relocation, these individuals had paid a total of $252,300,000 in income taxes.

A resident of Puerto Rico is not required to pay federal income tax on money earned in Puerto Rico. Section 933 of the tax code was developed with the goal of giving Puerto Rico more flexibility for local taxation. The idea was that Puerto Rico needed to be able to levy local income tax and the population of Puerto Rico would not be able to pay both federal and local taxes. The federal government therefore allowed residents of Puerto Rico to earn wages in Puerto Rico without paying federal income tax on those wages.

Under Act 22, now known as the Individual Investors Act, dividend and interest income and capital gains are all 100% tax exempt in Puerto Rico, in addition to the exemption from federal income tax. The IRS estimates that 23,000 individuals requested exemptions under this law.

The IRS is currently looking into whether people benefiting from this law are in fact living in Puerto Rico (183 days per year of physical presence is required) and whether the income they are sheltering is actually sourced in Puerto Rico.

Corporations

Corporations all over the world can avoid taxes by increasing their costs in high-tax jurisdictions and increasing profits in low-tax jurisdictions. Puerto Rico’s corporate tax rate is officially 37.5%, but it can be as low as 0% for some types of businesses.

A business-to-business service company which sells its services to people in the States can expect to pay a 4% corporate tax rate, compared with 21% (plus state tax in most States) in the States. The rate for “strategic” services is 3%. Dividends and profit distributions are tax exempt, too, so business owners can finesse quite a bit of their income. There is also a 75% property tax exemption.

This is the result of Act 20, now Chapter 3 of Act 60.

Companies under this law must hire one full-time employee in Puerto Rico if they have revenue of $3 million or more, and that “employee” can be the owner of the company. Entrepreneurs can move to Puerto Rico, hire themselves as their one employee, sell their services in the States, and pay almost no taxes at all.

Larger companies do not have to live or even be headquartered in Puerto Rico, and they too can have just one employee on the Island. They simply need to source their revenue in Puerto Rico. Often this is done by establishing a Puerto Rico-based subsidiary and declaring that this subsidiary owns intellectual property, such as software or a drug patent.

The main company can pay a licensing fee to the subsidiary to use the intellectual property. All the money paid to a Puerto Rico-based subsidiary counts as income in Puerto Rico –not in the stateside home of the corporation.

The goods and services sold may or may not be produced in Puerto Rico. There may be buildings and workers, but they aren’t necessary. Offices in tax havens often have just one employee, who may be responsible on paper for millions of dollars in income.

Transfer pricing, the practice of selling something from one part of a company to another part of a company, allows corporations to move profits out of a higher tax jurisdiction like New Jersey to a lower tax jurisdiction like Puerto Rico. The corporation will put costs, such as buildings and workers, in New Jersey to get the highest possible tax deductions, and put profits in Puerto Rico, in order to pay the least taxes on those profits.

This is not illegal.

Section 936

Section 936 was a special tax deal that allowed U.S. corporations to pay no federal taxes on profits earned in Puerto Rico, including transfer pricing.

Section 936 was one of the biggest tax deals intended to bring wealth to Puerto Rico. It was in force for two decades before being phased out. It was profitable for the multinational corporations that took advantage of it, and expensive for the federal government, but it did not benefit Puerto Rico economically.

A report to the Senate Finance Committee concluded that “The evidence does not support the claim that Section 936 was an important foundation for favorable economic expansion in Puerto Rico when it was in force or that the termination of 936 was an important factor bringing about the severe recession, which began in 2006…Rather than yearning for the return of 936, Puerto Rico would do well to abandon the 936 myth. This recognition of reality could be one important step in laying the foundation for a new era of economic development for Puerto Rico.”

The End of Section 936

The end of the tax haven?

Acts 20 and 22 have been subsumed under Act 60. The Department of Economic Development and Commerce describes this bundle of incentives as “An economic development tool based on fiscal responsibility, transparency and ease of doing business. In order to promote the necessary conditions to attract investment from industries, support small and medium merchants, face challenges in medical care and education, simplify processes, optimize and provide greater transparency, Act 60-2019 was signed, which establishes the new Puerto Rico Incentives Code. Its main objective is to promote economic development on our island.”

They claim that people using these incentives have brought 15,000 jobs to the Island. That would be 15,000 jobs resulting from 23,000 exemptions, if the IRS estimates are correct. They have also spent $1.3 billion on real estate, according to the same source.

The IRS is currently cracking down on those using Puerto Rico as a tax haven. Critics of Act 60 and its encouragement of wealthy transplants claim that gentrification is raising housing prices and driving current residents out of their neighborhoods. Congress is asking for explanations

Lawmakers Ask for Scrutiny of Puerto Rico Tax Loopholes

Are these indications that Puerto Rico’s days as a tax haven are numbered?

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