US IRS Looking at Taxation of Individuals and Companies Moving to Territory

The Federal Internal Revenue Service last month quietly moved to expand an investigation of individuals and corporations who move from the States and the District of Columbia to Puerto Rico and other U.S. territories.

The probe is collecting information on their residency so that individuals and corporations that move pay the Federal taxes they should.

The review was extended earlier shortly after Puerto Rico enacted laws eliminating or greatly reducing taxes on the incomes of individuals who move from the States and businesses that they establish in the territory providing services in the States.

The goal is to promulgate rules ensuring that those claiming residency in a territory where they would avoid Federal taxes are truly residents of the territory and cannot be taxed based on their State of prior residence.

The effort began after a law was enacted a decade ago to tighten residency rules for those who move to territories. U.S. Senate Finance Committee Chairman Charles Grassley (R-Iowa) led the Federal government in the enactment of the law after he became aware of how the U.S. Virgin Islands had begun to use prior law.

Residents of that territory do not have to pay Federal taxes on income, other than Social Security and Medicare taxes, but do have to pay taxes identical to Federal income taxes to the territorial treasury. To lure big traders of stocks and bonds in particular to the islands, the territory began to rebate 90% of the income taxes, effectively lowering the tax rates to 10% of the Federal rates.

Hedge fund managers flocked to take advantage of the U.S. Virgin Islands offer. The dozens who bought residences, including some who set up small offices along with others who worked from home, generally continued to operate their investment trading firms in States.

Most of the stock and bond traders left the U.S. Virgin Islands after enactment of the 2004 Federal law or after the Federal IRS began to make rules under it. The territorial government conducted a major lobbying campaign to get the Federal government to change the 2004 law and the proposed IRS regulations.

The Puerto Rico laws take advantage of provisions in the U.S. tax code that eliminate Federal taxation of insular income in the case of residents of the territory. The provisions are intended to help the local government of the underdeveloped U.S. possession by enabling it to get all of the revenue from taxation of the income.

But the Commonwealth laws enable individuals to avoid paying any tax to the Federal or territorial governments on some income — which could be the individuals’ major source of earnings. The laws also reduce the taxation of other income to very low rates.

Like the U.S. Virgin Islands laws, the Puerto Rico laws are primarily aimed at luring big traders of stocks and bonds, such as the very wealthy and hedge fund managers, from the New York tri-State area and other parts of the country to the territory. But one of the laws can be used by service providers in addition to investment managers and major investors to eliminate most of the tax on their incomes.

The U.S. IRS extended its examination a month after the Commonwealth administration announced in July that it had given “Law 22” tax exemptions to 282 individuals and “Law 20” tax cuts to 249. Many people were presumably awarded “Law 22” exemptions as individuals and “Law 20” grants for their businesses.

The typical “Law 22” beneficiary is said to be worth $7 million but officials say that the grantees include a couple of billionaires.

“Law 22” is the more controversial of the laws. It exploits the Federal tax rules for ‘capital gains’ — profits made from buying and selling stocks and bonds. For purposes of taxing the earnings, the income is generally considered to come from the residence of the seller.

Although the Federal government taxes gains on stocks and bonds bought while a resident of the States if sold within the first 10 years of living in the territory, it does not tax gains if the investments are sold later. More importantly, it does not tax gains on stocks and bonds bought after an individual moves to Puerto Rico.

“Law 22” provides for individuals who have not lived in Puerto Rico since January 1997 to be exempt from Commonwealth taxation of gains on stocks and bonds bought after moving to the territory. Thus, the individuals owe no tax to any government for earnings from buying and selling stocks after establishing residence in Puerto Rico.

The law also lowers the tax rate on gains from selling stocks and bonds bought while a resident of the States to five percent if the investment is sold 10 years or more after moving to Puerto Rico — when it also becomes exempt from Federal taxation.

The Federal government taxes capital gains of higher income earners at 23.8% of the profits.

The insular government controlled by the territory’s “commonwealth” party, which has been aggressively promoting the tax exemption laws to stock and bond traders in the States, increased the Commonwealth capital gains tax rate from 10% to 15% as of July. The tax increase is aimed at residents of Puerto Rico who are not new residents.

“Law 22,” additionally, exempts from taxation interest and dividends that come from a Puerto Rico business. The Federal government taxes interest and dividends that come from a business in the States but not from Puerto Rico concerns. So, an investor who moves to the territory can avoid any taxation of interest and dividends by buying financial investments through a company they set up in Puerto Rico.

The “Law 22” exemptions are “guaranteed” by the Commonwealth government through 2035.

Last week, Commonwealth officials said that they expect to grant 250 “Law 22” tax exemptions this year. They awarded 151 last year. From January until July this year 115 “Law 22” tax exemptions were granted.

“Law 20” lowers the territory’s corporate income tax rates, which the “commonwealth” party increased from a maximum of 33% to a maximum of 39%, to three or four percent for new Puerto Rico firms that provide services in the States. A number of services qualify but these include trading of stocks and bonds.

In addition, profits taken by the owners of the firms are totally exempted from taxation.

And the businesses are totally exempted from taxes on their property — which includes money and equipment — for five years and 90% for another 15 years.

“Law 20” tax benefits are granted businesses for 20 years.

The Federal government does not tax the operations since they are set up in the territory.

Last year, a spokesman for the U.S. Senate Finance Committee said that action was being considered response to the laws when there is a comprehensive reform of the Federal tax code.

Senator Grassley explained that the action could include taxing residents of Puerto Rico equally with residents of the States or requiring the Commonwealth to change the laws.

A former Chief of Staff of the Congress’ Joint Committee on Taxation, John Buckley, noted that the laws are “the first time … Puerto Rico” was “deliberately” eroding “the U.S. tax base for individuals.”

The Commonwealth’s Economic Development and Commerce Secretary, Alberto Baco Bague, reacted defiantly, declaring that the Commonwealth not change its law “under pressure from U.S. politicians.”

The “commonwealth” party appointee equated the laws with the territory’s political status, often misleadingly called “commonwealth” after the formal name of the insular government. This suggested that creating an argument against the statehood Puerto Ricans voted for in a 2012 plebiscite is a reason that the “commonwealth” party administration has made promoting the laws a priority.

Observers have noted that Puerto Rico gets relatively little economic benefit from the laws in comparison to the tax revenue that it gives up … and the revenue that it is taking away from the Federal and State governments.

 

 

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