The Commonwealth of Puerto Rico has enacted the Tax Reform Process Act, which will phase the Puerto Rican indirect tax system from a sales and use tax (SUT) to a value added tax (VAT).1 The tax reform is being implemented in a three-phase process. On July 1, 2015, the total SUT rate was increased from 7 percent to 11.5 percent.2 On October 1, 2015, the SUT base will be expanded to include a new designated professional services tax and a business-to-business (B2B) tax. Finally, on April 1, 2016, the VAT will be implemented at a rate of 10.5 percent.3 These major changes have been enacted in an effort to address Puerto Rico's budget deficit.
Earlier this year, many facets of the Puerto Rican government worked together to draft H.B. 2329. This legislation, in an early form, would have reduced certain income tax rates and phased in a VAT. Somewhat surprisingly, however, on April 30, 2015, the Puerto Rico House of Representatives voted down the measure. Acknowledging that budget issues needed to be addressed, the governor and members of the legislature soon began negotiations and bill drafting in an effort to replace the defeated bill. Their efforts succeeded, and H.B. 2482 was filed on May 18, 2015. The resulting bill passed and was signed by the governor on May 29, 2015. Under this legislation, the Tax Reform Process Act, the proposed income tax breaks were not enacted, but the transition to a VAT is retained. The legislation provides a three-phase plan to transition from the SUT to a VAT.
Current Sales and Use Tax
The SUT, commonly referenced in Puerto Rico as the "Impuesto sobre Ventas y Uso" (IVU), was originally implemented in 2006 and is governed by the 2011 Internal Revenue Code for a New Puerto Rico. The IVU rate of 7 percent in effect prior to July 1, 2015 was comprised of 6 percent allocated to the Puerto Rican government and 1 percent allocated to the associated municipality. The IVU must be collected by every merchant engaged in any business that sells taxable items as a withholding agent for the government.
The IVU applies to sales of taxable personal property, taxable services, and admission rights. A B2B exemption also applies to a number of transactions, but this exemption was limited in 2013. As a result of the 2013 limitations, certain service charges are now subject to tax, including certain bank charges, collection services, security services, cleaning services, dry cleaners, repair and maintenance services to real and personal property (noncapitalized), telecommunication services, and waste management services.
Phase I – Increased Sales and Use Tax Rates
Effective July 1, 2015, the existing IVU methodology remained in place, but the tax rates have changed dramatically. The Puerto Rican rate on taxable goods increased from 6 percent to 10.5 percent, but the local tax rate remains 1 percent and the tax treatment of such goods essentially will not be affected. Furthermore, the tax on certain enumerated services that began to be imposed in 2013 at a 7 percent tax rate is increased to 11.5 percent (based on the 10.5 percent Puerto Rican rate plus the 1 percent local rate).
Subject to restriction and proper documentation, retail sales covered by executed contracts or approved auction bids that were executed or took place prior to July 1, 2015 are subject to the 7 percent tax rate at the time of execution or bid. Furthermore, contracts for commercial, industrial, or residential construction projects that were executed prior to May 30, 2015 must be registered with the government within 90 days of execution in order to secure exclusions and rates in effect as of June 30, 2015.4
The legislation also implements a complementary service use tax. Effective July 1, 2015, to the extent a Puerto Rican resident receives the benefit of a taxable service within Puerto Rico that is provided by a non-resident person, the person receiving the service is responsible for paying the tax.5
Merchants with gross sales of less than $1 million for the preceding taxable year are allowed to remit at least 55 percent of the increased IVU liability by August 20, 2015. The balance of the additional amount due must be paid in equal installments no later than the 20th day of September, October and November 2015.
Phase II – Expanded Sales and Use Tax Base
On October 1, 2015, a state-level designated professional service tax will become effective, as well as a B2B tax. In contrast to the 11.5 percent tax rate described above, the Puerto Rican-level designated professional services and B2B tax will be imposed at a rate of 4 percent, with no local-level tax. Subject to certain exemptions, B2B services are defined as any services rendered to a person engaged in a trade or business or in the production of income. Examples of designated professional services include certified public accountants, tax return preparers, and engineers. Persons that provide designated taxable services are allowed to use the cash method of accounting for tax events that take place after September 30, 2015 for IVU purposes.
Phase III – Transition to Value Added Tax
On April 1, 2016, Puerto Rico will transition from the SUT to the VAT (referenced in Puerto Rico as the IVA, or "impuesto de valor añadido"). The IVA will have a Puerto Rican rate of 10.5 percent and will apply broadly to goods and services. As opposed to the rules in a number of other VAT jurisdictions, Puerto Rico's rules require that the VAT be shown separately at the retail level. There are some transactions that will be subject to tax, albeit at a 0 percent rate. For example, goods for export and certain sales to manufacturers are transactions that will receive the 0 percent treatment.
There are also some transaction types that are outside the purview of the IVA. For example, intangibles (excluding computer programs), electricity, and property of the Puerto Rican government are not subject to the IVA. Additional exclusions include articles introduced into foreign trade zones, alcoholic beverages deposited in a bonded warehouse, certain promotional materials, services provided between affiliated entities, services rendered to the Puerto Rican government, and the delivery of donated goods.
Exemptions from the IVA are available, including sales of prescription medicines, unprepared food and food ingredients, real property, commercial real property leases, nonprofit sales of items acquired by way of donation, printed books, certain hotel room charges, petroleum derivatives, and services that qualify for Medicare, Medicaid, or the Puerto Rico Government's Health Insurance Plan. To the extent a transaction is subject to the IVA, the person who introduces the article or service to Puerto Rico is responsible for the tax.
It should be noted that the local 1 percent surtax will remain as an IVU (sales and use tax). It is unclear at this time how B2B and designated services will be treated at a local level once the IVA is in place.
60-Day Review Period
Act 72 contains a provision that creates a tax reform commission, Comisión de Alternativas para Transformar el Impuesto al Consumo (CATIC), that has 60 days to review the tax reform proposals as passed and provide comment. The CATIC is comprised of House members, Senate members, and appointed members of the public. The CATIC may suggest alternate legislation be introduced. If, however, the CATIC suggests new legislation, the new legislation must be filed within 10 days of making a recommendation.
The July transitional period went into effect prior to the expiration of the CATIC's 60-day review period. Until further notice, businesses operating in Puerto Rico should expect that the IVA transition will be taking place as provided by Act 72.
1 Act 72-2015 (H.B. 2482).
2 These rates include the 1 percent that is allocated to local governments.
3 Note that the 1 percent local sales and use tax will be retained.
4 Also, for services rendered prior to July 1, 2015, invoices needed to be issued prior to July 20, 2015 to receive the 7 percent rate. On June 25, 2015, the Puerto Rico Department of Treasury issued guidance concerning the transition rules for pre-existing contracts.
5 Note that the date for the payment on services rendered by a non-resident person has been interpreted by the Department of Treasury to be October 1, 2015.
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