The United States owns 14 territories, five of which are inhabited. Among these five territories, federal tax law is applied differently to its residents.
Three U.S. territories are required to use a mirror code for taxes: Guam, the U.S. Virgin Islands, and the Northern Mariana Islands. Residents of each of these territories are U.S. citizens, as are the people of Puerto Rico, which does not use a mirror code.
American Samoa, whose residents are U.S. nationals but not citizens, does not rely on a mirror code for taxes, but has chosen to use a modified version of the IRC as its local income tax law.
What’s a mirror code?
The U.S. Internal Revenue Code (IRC) imposes tax laws that apply within the fifty states. Territories that use a mirror code also rely the IRC, but they replace each instance of “the United States” in the IRC with the name of the territory.
Territories using the mirror code can levy additional taxes if they choose to do so.
Puerto Rico has its own tax code. Puerto Rico had a mirror code for a short time in 1918. The U.S. Congress granted Puerto Rico greater autonomy over its local affairs – including tax policy – in 1952.
Read here about how Congress granted Puerto Rico greater discretion in local affairs in 1952 while remaining clear that the new law “would not change Puerto Rico’s fundamental political, social, and economic relations to the United States,” as a U.S. territory.
Because it is a U.S. territory, Puerto Rico must comply with the U.S. Constitution and answer to Congress. Puerto Rico’s local government has discretion on local tax policy only within these parameters. Congress can take local autonomy away at will, as it did when it passed PROMESA legislation.
Puerto Rico’s tax structure is widely perceived as advantageous for the would-be taxpayers, but the policy also comes at a cost. For example, middle class and low-wage workers in Puerto Rico would qualify for refundable tax credits under the Child Tax Credit and Earned Income Tax Credit if they lived in a state. Their exclusion from these proven poverty fighting measures reduces their take-home pay as long as they remain in Puerto Rico.
In addition, Puerto Rico’s reduced tax burden is often cited as justification to exclude Puerto Rico or minimize the U.S. territory’s involvement in otherwise generous federal programs for individuals. On the corporate side, U.S.-based companies historically have been able to navigate their complicated tax arrangements to their advantage.
American Samoa adopted the IRC that was in effect on December 31, 2010, as its local tax code. They have made some modifications since then, but their tax code doesn’t automatically update to match the U.S. IRC, as it does in the mirror code territories. If American Samoa wants to update their tax code to reflect changes in the IRC, they must make those specific changes to their tax code directly.
How Can Congress take action to help Puerto Rico through the U.S.Tax Code?
Residents of Puerto Rico do not have to pay federal income taxes on their Puerto Rico-based income. Individuals must meet these requirements to be bona fide residents of Puerto Rico:
- They must be physically present in Puerto Rico for at least 183 days a year.
- They must not have a tax home elsewhere besides Puerto Rico.
- They must not have a “closer connection” to the U.S. or to any other country than to Puerto Rico.
Federal government employees who live in Puerto Rico are understood to have payment from the states, so their income is taxable under federal law.
A new report from the Congressional Research Service says that the U.S. Congress has some options under Puerto Rico’s tax code to enhance economic growth and well being:
- Congress could make individual credits in the IRC apply to Puerto Rico and the states equally. The Earned Income Tax Credit and the Child Tax Credit are two example of refundable credits which could help low income citizens in Puerto Rico. A bill which recently passed in the House included these tax credits for Puerto Rico.
- The payroll tax rate could be cut. Working people in Puerto Rico pay the same payroll taxes (covering Medicare and Social Security payments) as State residents, even though they do not receive the same level of benefits. Although the short term impact of this policy chose could may be appealing to Puerto Rican workers by enhancing take-home pay, the long term implications of this policy would be dangerous for workers. Cutting the payroll tax rate for Puerto Ricans would decrease their Social Security payments and leave them vulnerable to Medicare exclusion altogether.
- Congress could also use tax regulations to encourage growth in Puerto Rico’s economy by motivating certain industries to build there. The history of such policies is problematic, however, as they tend to favor industries off the island at the expense of island-based companies and many workers. Section 936, a past example of this type of tax law, was beneficial for the corporations that used it but did not create significant numbers of new jobs in Puerto Rico.