US House Chairman Rejects Secret Puerto Rico Tax Exemption Proposal

The chairman of the U.S. House of Representatives tax committee has rejected a secret bid to exempt income that companies in the States attribute to Puerto Rico from a proposed minimum tax requirement.  The requirement would be a part of a major reform of the Federal tax system.

Ways and Means Committee Chairman Dave Camp (R-Michigan) turned down the proposal of a group of companies in the States that have manufacturing operations in Puerto Rico.

The proposal would have made the territory the least taxed place in the world for manufacturing.

Amgen, the world’s largest biopharmaceutical company, which has a major healthcare products operation in Puerto Rico, spearheaded the proposal.

The plan received some official support but has not been discussed publicly in the territory.

Camp’s rejection became clear this week as he discussed his draft tax reform bill in closed-door meetings with fellow committee Republicans.

Formal committee consideration of the legislation could come next month.  And House leaders hope that their chamber of the Congress will pass the bill this year.

Enactment into law is more of a question, however, since neither national political party has real control of the Senate.

Camp and Senate Finance Committee Chairman Max Baucus (D-Montana), however, are working closely together for the most sweeping reform of Federal taxation in three to six decades. Neither will chair the committees that they now head after next year.  And many other top Federal officials join them in wanting a broad reform.

The two chairmen said this week that official Washington is reaching a consensus on reforming the taxation of corporations.  There is less agreement so far on the taxation of individuals.

The basic, widely supported objective of the corporate reform is to lower the current 35% corporate income tax rate.  It is the highest among major countries.  Eliminating special tax credits and deductions, which deprive the government of revenue, would make a lower rate possible.

Republicans want a 25% tax rate.  President Obama is not far off, having proposed a 28% rate.

One of the key elements of the reform would replace the U.S.’ system of taxation of income from subsidiaries of companies in the States organized abroad.  Taxation of the income is ‘deferred’ until it is received by a parent company in the States.  This is the case even if the income is held in a bank account in the States as long as it is still in the name of a ‘controlled foreign corporation (CFC).’

Companies can avoid taxation through CFCs for as long as they want.  They often keep the profits in CFCs indefinitely, never paying the Federal income tax on it.

Currently, ‘foreign’ income includes CFC income from Puerto Rico and other U.S. territories.

Most manufacturing in Puerto Rico is done by CFCs (although some is done by insular operations of companies directly and taxed as it is earned).  Most of the CFCs are organized in foreign tax havens to avoid Commonwealth as well as Federal taxes.

Baucus said Monday that “there is general agreement” on taxing the income in the year it is earned even if kept outside the States.

Camp’s proposal for this 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.

To discourage companies from shifting domestic operations abroad, however, one of Camp’s main options for his reform would also require that taxes equal to at least 15% of the income be paid to some government.

If a location outside of the States taxes the income at least 15%, Camp would require no additional Federal tax above the 1.25%.  But if the income is not taxed at least 15% outside the States, the Federal tax due would be increased to make up the difference.

The Puerto Rico proposal that Camp rejected would have exempted income from U.S. territories from the 15% minimum taxation requirement.

Subsidiaries of companies from the States manufacturing in Puerto Rico typically pay the Commonwealth no income tax 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.)

Under the Camp proposal, the companies would pay the Federal government to make up the difference between what they pay Puerto Rico and 15%.

The main reason for Camp’s rejection of the Puerto Rico proposal was a deeply held congressional view that it would be unfair to tax companies manufacturing in a territory less than companies manufacturing in the States.

This was a primary reason that a Federal credit that offset the tax on income attributed to Puerto Rico, U.S. Internal Revenue Code Section 936, was repealed in 1996 and that Puerto Rico “Commonwealth” party proposals to resurrect it through similar tax mechanisms have been rejected by Federal officials.

Another reason for the repeal — which contributed to Camp’s rejection of the new Puerto Rico proposal — was that companies attributed income to the Commonwealth to avoid taxation that was really due to work in the States, where it would have been taxed.

Companies did this by transferring ownership or use of ‘intangible assets,’ such as formula patents and brand trademarks, to their Puerto Rico operations.

Indeed, Camp has considered including language in his draft bill that would specifically apply the minimum tax requirement to income from intangible assets transferred to operations outside of the States.

By transferring intangible assets to Puerto Rico operations, companies claiming the Section 936 tax credit were able to avoid much more in Federal tax than they contributed to the territory’s economy.  The practice subverted the stated congressional purpose of 936 when it became law in 1976: to encourage job-creating investments in the Commonwealth, which has perennially suffered from a lack of jobs.

While not benefitting Puerto Rico as much as they should have, the tax savings were also denying the Federal government billions of dollars in revenue yearly.

Exempting income that companies in the States earn in Puerto Rico from Federal taxation has been a major economic and political strategy of the territory’s “Commonwealth” party because the Federal government must treat all States equally in tax laws.

The “Commonwealth” party has also raised a lot of money for its campaigns from people who benefitted from the 936 exemption or would have benefitted from the proposals to replace it.