United States: Puerto Rico’s New International Tax Scenario

During the last sixty years Puerto Rico has emerged as a developed industrialized economy, similar to that of a state of the United States of America or to the most developed industrialized foreign countries. Puerto Rico is densely populated, with a population of 3.9 million people on an island of 3,500 square miles in the Caribbean. It was ceded by Spain to the United States in 1898 in the aftermath of the Spanish-American War, and became a territory of the United States at that time. The rights of the residents of Puerto Rico, who were granted American citizenship in 1917, have evolved somewhat parallel to the gradual shift of centralized power from the U.S. Government to the local Government. It has evolved from what was essentially an American military dependency to what is currently a jurisdiction similar to any one of the fifty states of the United States, with the difference that it is ruled under the territorial clause of the of the United States Constitution. Puerto Rico shares a common currency, citizenship and open borders with the United States. In general, federal statutes apply to Puerto Rico (i.e. the Merchant Marine Act applies to Puerto Rico, therefore, only United States flagships can be used for the transportation of merchandise to and from the mainland).

Puerto Rico has a stable democratic Government closely modeled on the United States system. Its Government structure and practice closely resemble those of the 50 states. Military, post office, licensing of radio and television, air traffic control, customs and immigration service are managed in Puerto Rico by their respective U.S. government agencies. Puerto Ricans are citizens of the U.S. and are protected under both the United States and Puerto Rico constitutions.

The Commonwealth of Puerto Rico, established in 1952, was invested with attributes of political sovereignty which clearly identify the status of self government attained by the Puerto Rican people as that of an autonomous political entity. Under this status Puerto Rico has a separate fiscal structure, enjoying primary jurisdiction to tax Puerto Rican source income, while the United States has secondary jurisdiction to tax Puerto Rican source income of U.S. citizens, residents and entities.

Puerto Rico authority to enact its own tax systems derives from the Foraker Act of 1900. Thus, U.S. internal revenue laws are not applicable to Puerto Rico residents or corporations regarding Puerto Rico source income. U.S. citizens and residents of Puerto Rico exclude income from Puerto Rico sources under Section 933 of the U.S. Internal Revenue Code ("IRC"). Nevertheless, there is a close relationship between the local tax rules and the federal tax rules, to the extent that in 1954 the Puerto Rico Legislature adopted the first income tax laws based on the U.S. Internal Revenue Code of 1939 which was in effect until 1994. In that year, for the first time, the local legislature enacted the Puerto Rico Internal Revenue Code which codified the different direct tax laws applicable in the Island (income tax, property tax, excise taxes).

Puerto Rico has one of the most favorable tax incentive programs available anywhere. These incentives are comparable to those in force in Singapore, Ireland and other foreign countries. Puerto Rico provides tax exemption benefits to companies who establish themselves in Puerto Rico for the purpose of developing a manufacturing industry or for the purpose of exporting products or services to markets outside of Puerto Rico. This tax incentive program ensures that Puerto Rico remains competitive worldwide as a business site. Manufacturers and export services industries enjoy a single, low, flat income tax rate of 7%, and profits may be repatriated tax-free. Also, businesses are eligible for a 90% exemption from real estate and personal property taxes. Eligible business may enjoy a 60% exemption (75% for labor-intensive industries) from municipal fees, excise taxes and other license taxes for the duration of the tax exemption grant, and a full exemption during the first year of operation (Trading companies enjoy an 80% exemption). In addition, the incentive program provides full exemption from the following: excise taxes on raw materials and certain machinery and equipment used by manufacturing plants; taxes on fuel used in the cogeneration of electric power; and taxes on chemicals utilized in the treatment of used water. Special super deductions of 200% are available for training and research and development expenses. There is also an immediate expense deduction of costs incurred in acquiring property, plant and equipment (actually, an accelerated depreciation instead of a deduction). Exemption last from 10 to 25 years, depending upon location of the operations. A decree of tax exemption is a contractual agreement between the Government of Puerto Rico and the eligible business which is protected by the Puerto Rico Constitution.

For the first time in more than fifty years Puerto Rico does not enjoy federal tax benefits for those corporations conducting business in the Island on their income from sources within Puerto Rico. In October 1976, the U.S. Congress approved IRC Section 936 to provide a tax-sparing credit to U.S. corporations engaged in trade or business in Puerto Rico. Section 936 replaced Section 931 which provided a tax benefit to companies operating on the Island. On October 13, 1995, the U.S. Congress eliminated the tax-sparing credit for new corporations. Only companies actively conducting a trade or business in Puerto Rico as of that date and that had elected as of that date to cover their operations with the tax sparing credit benefits of Section 936 now qualify for those benefits. A grandfather clause was included, providing that these benefits will be in effect through 2005. However, the U.S. Congress enacted a new Section 30A, which operates in conjunction with the general rule of Section 936. Section 30A provides wage credits to companies operating under Section 936; it is also scheduled to expire along with Section 936 in 2005. As previously mentioned, these benefits are not applicable to new corporate operations and will terminate for all businesses for tax years after 2005.

Since global economic models have changed significantly in recent years, the Government of Puerto Rico has deemed it necessary to adopt new economic strategies to attract new business to Puerto Rico and to be in harmony with the changing needs of industry to ensure that Puerto Rico will remain competitive worldwide as a business site.

Since the tax-sparing benefits of IRC Section 936 will be terminated, many U.S. companies have been reincorporating or reorganizing as Puerto Rico entities as a viable alternative (for example, the transfer of all assets by a 936 corporation to a newly formed Puerto Rico corporation in exchange for stock). Normally, such reorganization would qualify as a tax free reorganization under the U.S. Code, thus, any gain realized on the exchange would not be taxed. However, IRC Section 367 denies tax free treatment for the transfer of intangible property to a foreign corporation which is part of a reorganization. Since as a general rule Puerto Rico is treated as a foreign country for federal income tax purposes, a Puerto Rico corporation is considered a foreign corporation under U.S. rules, and normally any transfer of intangible property to a P.R. corporation would be considered a taxable transaction.

On the other hand, currently the profits generated by a controlled foreign corporation ("CFC") are generally not subject to federal income tax until those profits are distributed back to the stockholder in the United States. As a practical matter, such profits generated outside the United States are generally invested by the CFC in foreign countries, thus deferring the federal tax on such profits.

In order to clarify the above discussed issues and to facilitate the reincorporation or reorganization of Section 936 companies into Puerto Rico corporations, a legislative proposal named the "Economic Revitalization Tax Act of 2001" has been introduced in the U.S. House of Representatives (H.R. 2520) to amend IRC section 956, related to the investment of CFC’s earnings in United States property (the "Bill").

Basically, the Bill proposes the following principal amendments to reduce the tax rates of the CFC and to facilitate the conversion of Section 936 companies to CFC’s:

• The Bill provides a 90% tax exemption on the earnings repatriated by the qualified corporation to its stateside parent company if such earnings are invested in United States property. A qualified corporation is defined in the Bill as a controlled foreign corporation created or organized under the laws of, or engaged in the active conduct of a trade or business within the Commonwealth of Puerto Rico or a possession of the United States. The term "possession of the United States" is defined in the Bill to include the Virgin Islands, Guam, American Samoa, and the Commonwealth of the Northern Mariana Islands. This attractive exemption on dividend distributions may encourage these corporations to repatriate their earnings to the United States. This will promote domestic U.S. investment that will allow U.S. corporations to remain competitive, and will allow the U.S. Treasury to collect tax on these earnings.

• To be eligible for the 90% exemption of the qualified earnings, the CFC must derive those earnings from the active conduct of a trade or business in Puerto Rico or from a possession of the United States. Thus, passive income will be fully subject to federal taxes.

• If the CFC does not invest the earnings in United States property, such earnings could be repatriated as a qualified dividend providing for a dividend-received deduction of 85% with respect to distributions by the qualified CFC to U.S. corporate shareholders. The Bill provides that the qualified corporation must make an election to enjoy this benefit. The election is for the taxable year of the qualified corporation and for all succeeding taxable years of such corporation, unless the corporation ceases to be a qualified corporation, or the corporation revokes the election.

• The Bill provides for an exception ("safe harbor") for certain transfers or licenses of intangible property (i.e. licence, trade mark, patent) to a qualified corporation by those corporations actually conducting business in Puerto Rico under Section 936/30A in its conversion to a CFC. The purpose of this exception is to permit the tax free transfer of intangible property of a United States person into a Puerto Rico corporation that is a controlled foreign corporation. Also, an election must be made by the qualified corporation in the manner as it may be prescribed by regulations.

It is anticipated that if such benefits are approved by the U.S. Congress, the use of a Puerto Rico corporation for manufacturing products to be marketed and sold in the United States would be attractive to the U.S. companies. In such circumstances, Puerto Rico would be in an advantageous position compared to all other foreign corporations controlled by a stateside parent corporation.

In summary, Puerto Rico offers a vital economy, an ideal climate, a strong sense of community, an exceptionally productive and highly educated work force, unique tax incentives and warm hospitality, all of which attract foreign investors to do business in Puerto Rico. The island has become the transportation center in the Caribbean because of its dominant position in regional trade, its developed industrial and service economy and its heavy passenger and cargo traffic with the U.S. mainland. Most marine cargo destined for the Caribbean, Central and South America passes through the San Juan harbor, considered the fourth busiest container port in the Western Hemisphere.

The good climate for business in conjunction with the Puerto Rico and federal tax benefits would make Puerto Rico again a tax holiday country for U.S. manufacturers. U.S. manufacturing companies may wish to seriously and comprehensively evaluate the tax benefits of doing business through a Puerto Rico corporation.