Puerto Rico Governor Alejandro Garcia Padilla’s representative in the States this week claimed that the territory “will receive special treatment” in draft Federal tax reform legislation released by the chairman of the U.S. Senate Finance Committee — but the chairman’s written explanation of the draft contradicted the representative’s assertion.
Puerto Rico Federal Affairs Administration Director Juan Hernandez Mayoral contended lobbying efforts he led had persuaded Chairman Max Baucus (D-MT) that income companies from the States earn in Puerto Rico should be taxed less than profits from operations in the States or foreign countries.
Former “Commonwealth” party senator Hernandez exclaimed that his alleged “special treatment … has the potential of providing the most important economic boost the Country [referring to Puerto Rico, a U.S. territory] has seen since the surrender of Section 936 by the Rosselló Administration.”
Companies would, presumably, flock to Puerto Rico if Federal taxes on income from it and other U.S. territories were significantly lower than Federal taxes on profits from anywhere else in the world.
Baucus’ explanation, however, said that, the “draft does not separately address the taxation of foreign subsidiaries doing business in the U.S. territories.” In other words, income from the operations would be taxed at the same rates that would be applied to profits from other foreign subsidiaries. Most companies based in the States manufacturing in Puerto Rico do so through foreign subsidiaries, almost all organized on paper in foreign tax havens.
Hernandez also suggested that the U.S. House of Representatives leader in the effort to reform the Federal tax system, Ways and Means Committee Chairman Dave Camp (R-MI), was open to less taxation of corporate profits from Puerto Rico.
Camp and his Committee staff, however, rejected the idea of exempting income from the territory from their tax reform proposals in multiple meetings with companies seeking exemption and with other congressional authorities as recently as two months ago.
Both Baucus and Camp have proposed taxing income of ‘foreign’ subsidiaries of companies headquartered in the States as it is earned. Currently, the profits are not taxed until — and unless — the money is legally transferred to the parent companies in the States — even if deposited in banks in the States.
Baucus would tax income from the subsidiaries’ sales in the States at the same rate that would apply to profits from products made or services provided in the States.
He has not yet proposed what that rate would be but it is expected to be below 30% of earnings. The current corporate income tax rate is 35%.
About four-fifths of what is made in Puerto Rico is for the market in the States.
Profits from sales abroad would be taxed one of three ways, but Baucus has not determined which way.
One way would be at 80% of the rate for income from sales in the States.
Another option is a combination of 60% of the rate for income from the States in the case of profits from active business activities and 100% of the rate for income from the States for earnings from financial investments.
A third possibility Baucus is entertaining is Camp’s preferred option of taxing income earned from ‘intangible assets’ that parent companies transfer to subsidiaries outside of the States. These assets are formulae and brand names that contribute much of the value of the goods that make up most of what is manufactured in Puerto Rico, such as medicines and medical devices.
Camp would reduce corporate income taxes to 25% of earnings for income from the States and 15% for income from outside of the States.
Taxes paid outside of the States would count against Federal tax liability under the draft legislation that both chairmen have put forward.
Puerto Rico taxes currently total far less than even Camp’s proposed minimum tax for earnings in foreign countries.
Additionally, companies with subsidiaries in Puerto Rico regularly avoid paying Federal income tax on the profits by having the subsidiary continue to own the income — even if the parent companies borrow the money from the subsidiary.
If Federal taxes are reformed in the manner that either Baucus or Camp have suggested, and Puerto Rico does not increase its taxation of the profits or production from the territory, the Federal government would get the difference in revenue between what the Commonwealth taxes and Federal tax rates. Puerto Rico would give up the benefit.
The Section 936 referred to by Governor’s representative Hernandez was a provision of the Federal tax code that initially allowed companies to claim a tax credit equal to the tax that would be due on profits attributed to Puerto Rico operations.
In 1993, the credit was reduced to 40% of the tax because, to avoid taxation, companies regularly attributed income to their Puerto Rico operations that was really due to work in the States. They primarily did this by transferring intangible assets to their insular operations.
The consequence of the transfers was that Section 936, which was made law to encourage companies to make job-creating investments in the territory, had benefitted companies much more than Puerto Rico. Companies routinely took tax credits many times greater than the entire amount of wages they paid in the Commonwealth.
The 1993 reform led by President Bill Clinton also created a Federally preferred alternative credit based on real economic contributions to Puerto Rico — wages and local taxes paid and capital investments made in the territory.
But the excessive cost and the unfair advantage that the original 936 gave companies with operations in Puerto Rico over companies manufacturing in the States caused the reformed provisions to be limited to existing users in 1996, with the last credits able to be claimed in 2005.
Contrary to what Hernandez asserted, the administration of then statehood party Governor Pedro Rossello did not “surrender” 936. After defending it for years and, then, recognizing that the 40% of tax credit could not be saved in light of a 1993 GAO report documenting its flaws and an overwhelming bipartisan movement in Congress to repeal the law, Rossello proposed continuing the credit for real economic contributions to Puerto Rico as a new Section 30A of the Federal Internal Revenue Code.
The proposal, refined and strongly advocated by Clinton, won the backing of the Senate Finance Committee and majority support in the House Ways and Means Committee. The then chairman of the Ways and Means Committee blocked it from approval, however.
No longer able to avoid taxes on income attributed to Puerto Rico through the Section 936 tax credit, companies converted their Commonwealth operations into ‘foreign’ subsidiaries to avoid — or at least defer — payment of Federal tax.