The governments of the world’s 20 largest economies have agreed to crack down on tax avoidance strategies used by most companies in the States with their manufacturing subsidiaries in Puerto Rico.
The goals of a plan for countries to eliminate the tax “loopholes” includes getting large multinational businesses to pay more tax, especially where income is really earned.
The plan was adopted by the “G-20” during meetings of the heads of their governments and finance departments earlier this month. It had been recommended by the Organization for Economic Cooperation and Development (OECD), a group of 34 governments of large and European countries.
The plan to curb “tax base erosion and profit shifting … resulting in very low tax or even double non-taxation” includes specific actions and a timetable. “Base erosion” is the loss of taxable operations by companies moving the operations elsewhere to shift profits to where the money will be taxed less … or avoid taxes altogether.
Three of the 15 actions that the heads of the 20 governments pledged to have taken within two years zero in on common tax tactics of companies in the States with Puerto Rico manufacturing operations.
One to be taken by September 2015 would strengthen rules related to ‘controlled foreign corporations.’ CFCs are separate corporations that companies set up in other tax jurisdictions. In the case of the States and Puerto Rico, companies in the States set up CFC subsidiaries for territorial operations because the Federal government does not tax CFC income until it is received by the parent companies in the States.
Most manufacturing in Puerto Rico by companies ultimately owned in the States — most manufacturing in the territory — is done by CFCs.
And most manufacturers with CFCs in Puerto Rico open the CFCs first on paper in other tax havens to avoid Commonwealth and well as Federal taxes.
Another action to be taken in two years is to “Develop rules to prevent base erosion and profit shifting by moving intangibles,” according to a statement by the governments. ‘Intangibles’ are exclusive formulas, plans, and designs for products and brand names that are responsible for much of the profits generated by medicines, medical devices, computer programs, and electronics — goods that account for much of the manufacturing in Puerto Rico.
The goal is to “ensure profits associated with the transfer and use of intangibles are appropriately allocated in accordance with … value creation.” The allocation refers to how intangibles are attributed to different locations. Values for products like most of those manufactured in Puerto Rico are largely created by the development of the formula, plan, design, or name for the product in the States vs. the actual manufacturing.
A related action to be taken within one year is to “Re-examine transfer pricing documentation.” This refers to the financial transactions between companies and their CFCs for use of the formulas, plans, and brand names through sales or leasing between patent companies and CFCs.
After the agreement to the reform by the heads of the governments of the world’s 20 largest economies, OECD Secretary-General Angel Gurria explained, “These practices, if left unchecked, undermine the fairness and integrity of our tax systems.”
“Countries will need to examine how their laws contribute to base erosion and profit shifting to ensure that international and domestic tax rules to not allow or encourage multinational enterprises to reduce overall taxes by artificially shifting profits to low tax jurisdictions.”
For manufacturers owned in the States, Puerto Rico is a very low tax jurisdiction. Although local companies are taxed at a 39% of income rate, income taxes of CFCs are no more than two percent of income.
The transfer of intangibles was largely responsible for the repeal of a Federal tax exemption that lured many of the manufacturers in Puerto Rico to the territory.
U.S. Internal Revenue Code Section 936 was enacted into law to encourage companies to make job-creating investments in Puerto Rico. The Commonwealth has long suffered from economic underdevelopment.
The law provided a tax credit equal to the income tax that would be due on profits attributed to operations in the territory, effectively eliminating Federal income taxation of the profits.
But Federal tax policymakers soon found that companies were abusing the law by attributing to Puerto Rico income that should have been allocated to operations in the States, where products were developed. This was done by paper transfers of “intangibles.”
The net result was much greater benefits dollar-wise for companies than benefits to Puerto Rico’s economy. Some companies saved hundreds of thousands of dollars each year for each job in the territory.
After several Federal efforts to prevent the abuse through reforms of the law, it was fully repealed in 1996, with all benefits for companies using the credit expiring at the end of 2005.
Companies avoided the repeal’s intended Federal taxation, however, by exploiting a loophole that enabled them to have CFCs and defer Federal taxation in Puerto Rico even though it is a U.S. territory, treated equally with the States in most Federal programs.
“Commonwealth” party administrations and companies have tried to get the Federal government to recreate the tax exemption. Most Federal officials have steadfastly refused, with the reasons for the repeal of 936 being the reasons for their rejection.
The chairman of the U.S. House of Representatives committee with responsibility for tax as well as other laws has just turned down the latest proposal, which would have exempted Puerto Rico from his draft legislation for a tax of 15% of income on profits due to intangibles.
The proposal by companies with operations in Puerto Rico was made in response to his draft plan to comprehensively reform Federal income taxation, which he hopes to have the House Committee on Ways and Means pass in the coming weeks.
The chairman of the Senate committee handling tax and other laws is drafting a tax reform proposal in coordination with the House committee chairman. And he recently noted that their reform objectives are similar to those of the Obama Administration.