On March 11, 2013, Bloomberg published an article informing the financial community about New York billionaire John Paulson’s rumored move to Puerto Rico lured by income tax savings. The article triggered a flurry of applications for grants of tax benefits under the theretofore dormant Act to Promote the Transfer of Investors to Puerto Rico and Act to Promote the Exportation of Services, Act 22 and Act 20, respectively, of January 12, 2012 (“Act 22” and “Act 20”, respectively)1 Reportedly, close to 200 individuals have already become bona-fide residents of Puerto Rico; about 100 applications for Act 22 tax grants are pending approval and 155 Act 20 applications were filed during 2013.
The new residents of Puerto Rico are mostly securities traders, hedge fund managers, money managers and a wide array of other service providers. Hedge fund managers have been enticed by tax savings of more than 23.8% (20% United States federal long-term capital gains tax plus 3.8% tax on investment income) on their performance fee, plus state income taxes, if applicable, whereas traders in securities have been attracted by tax savings that generally exceed 60% (39.6% United States federal income tax on short term capital gains, 3.8% tax on investment income plus state income tax). For money managers and other service providers the decision to move has been fueled by the tax savings resulting from the reduction of the 39.6% federal income tax (plus the applicable state income tax) to the 4% Puerto Rico income tax imposed by Act 20.
In this newsletter we will describe the services that qualify for Act 20 tax benefits; the structure generally used to obtain such tax benefits and, more importantly, the pitfalls that must be avoided to realize the expected tax savings and fend-off unexpected tax costs.
Advisory services on matters relating to any trade or business; investment banking and other financial services; advertising and public relations; economic, environmental, technological, scientific, management, marketing, human resources, information and audit consulting; professional services (such as legal, tax and accounting services); development of computer programs and research and development , are among the services that qualify for Act 20 tax benefits. Act 20’s reduced 4% income tax rate and 60% municipal license tax (i.e., gross receipts tax) exemption during a 20 year period2, together with the total income tax exemption on dividends, are provided by means of a grant of tax benefits issued by the Secretary of the Department of Economic Development and Commerce of Puerto Rico.
The grant is a contract between the grantee and the Government of Puerto Rico and, therefore, the tax benefits should be protected from revocation by future legislation pursuant to the prohibition against impairment of contractual obligations of the Constitution of Puerto Rico.
A minimum of three employees, each of which must be a resident of Puerto Rico, is required to qualify for the Act 20 tax grant. Generally, the new Puerto Rico resident is one of such employees.
Structure of Act 20 Operations
Generally, new Puerto Rico residents avail themselves of the Act 20 tax benefits by creating a Puerto Rico limited liability company (“Newco”) to provide services theretofore rendered by them, or an entity controlled by them, in the United States. By doing this, fee income that was subject to a federal income tax rate of up to 39.6% (plus state income taxes) will be subject only to a 4% Puerto Rico income tax rate. In addition, Newco is generally treated as a corporation for Puerto Rico and United States income tax purposes; its dividends are exempt from Puerto Rico income tax under Act 20, and such dividends qualify as Puerto Rico source income not subject to United States income tax under section 933 of the United States Internal Revenue Code of 1986, as amended (the “IRC”).
Alternatively, Newco elects treatment as a pass-through partnership for Puerto Rico income tax purposes and as a corporation or disregarded entity for United States income tax purposes. In these cases, the new Puerto Rico residents (instead of Newco) are subject to the 4% Puerto Rico income tax rate on the net fee income, instead of the United States federal income tax rate of up to 39.6% plus the state income tax. In addition, if Newco is treated as a partnership or disregarded entity for United States income tax purposes, the fee income qualifies as Puerto Rico source income not subject to United States income tax, so long as the services are rendered in Puerto Rico, and, if Newco is treated as a corporation, the dividends generally constitute Puerto Rico source income not subject to United States income tax.
The Potential Pitfalls
To achieve the expected tax savings and avoid unexpected tax costs, the new residents of Puerto Rico must steer around several potential pitfalls that are a trap for the unwary. The pitfalls are the following:
1. Transfer Pricing. If Newco renders the eligible services to a related entity, the fee paid by the related entity for the services rendered by Newco must be an arm’s length fee that meets the requirements of IRC section 482 and the regulations thereunder. Generally, to have a high degree of certainty that the fee paid by the related entity to Newco qualifies as an arm’s length fee that will pass muster in the event of an IRS audit, it is advisable to retain a reputable firm to perform a transfer pricing study to determine the fee that should be paid for such services. In the absence of a transfer pricing study, unrealistic expectations may lure the individual to become a resident of Puerto Rico.
2. Transfer of United States Operations or Assets to Newco. If the operations conducted by Newco were previously conducted in the United States by an entity controlled by the new Puerto Rico resident, the transfer of such operations to Newco (including the transfer of intangible assets, such as client lists) will generally result in the payment of United States federal income tax. United States federal income taxes may be imposed even if the transfer is effected pursuant to a reorganization or other transaction that generally results in no recognition of gain or loss under the IRC. IRC section 367 must be analyzed to determine the US federal income tax cost of such transfer of operations or assets. The inversion rules of IRC section 7874 must also be examined to determine the impact of such rules, if any, on the transfer.
3. Newco’s Operations in the United States. If Newco is treated as a corporation for United States income tax purposes, and the new resident of Puerto Rico renders services in the United States as an employee of Newco, Newco will be engaged in trade or business in the United States pursuant to IRC section 864(b). As a result, the tax savings will be reduced because the net taxable income attributable to such services will be subject to United States federal income tax at the regular corporate rate of a maximum of 35%, plus a 30% branch profits tax pursuant to IRC sections 882(a)(1) and 884(a), respectively. Similarly, if Newco is treated as a pass-through partnership or disregarded entity for United States income tax purposes, the tax savings will also be impaired by the rendering of services in the United States, because the Puerto Rico resident will be subject to United States income tax on the portion of the fee income attributable to such services at a maximum income tax rate of 39.6%.
In addition, if Newco is treated as a corporation under the IRC, and the gross income attributable to services rendered in the United States is at least 25% of Newco’s gross income for the three taxable year period ending with the payment of a dividend (or, if shorter, the period that Newco had been in existence), additional income tax savings will be lost because a portion of Newco’s dividend will not qualify as Puerto Rico source income pursuant to IRC section 861(a)(2), and thus will be subject to United States income tax. Moreover, in such event IRC section 957(c)(1)3 will not be applicable, and Newco will be treated as a “controlled foreign corporation” under the IRC. Consequently, if Newco has any “subpart f income” (as defined in IRC section 952(a))4, the income would be imputed to the new Puerto Rico resident and may be subject to United States federal income tax. For example, if Newco renders services to a related entity, the portion of Newco’s fee income attributable to services rendered in the United States would be imputed to the new Puerto Rico resident and would be subject to United States income tax.
Lastly, if the new Puerto Rico resident renders services in the United States as an employee of Newco, the portion of his or her compensation attributable to such services, determined pursuant to United States income tax principles, will be subject to United States federal income tax. Since the portion of the compensation subject to United States federal income tax would be determined pursuant to United States federal income tax principles, the taxable compensation used to compute the portion subject to federal income tax could be significantly larger than the taxable compensation for Puerto Rico income tax purposes.
4. Taxable Compensation of New Puerto Rico Resident. If the new Puerto Rico resident is also an employee of Newco, he or she should receive arm’s length taxable compensation from Newco for his or her services as an employee. Otherwise, the Puerto Rico Treasury Department could characterize a portion of the purportedly tax exempt dividends paid by Newco as taxable compensation. The Puerto Rico Supreme Court decision in Krueger v. Secretary of the Treasury, 89 DPR 345 (1963 ), holding that dividends paid to the manager of a tax exempt manufacturing corporation engaged in business in Puerto Rico (that under the generally applicable rules could have been treated as taxable salary) did not constitute taxable salary, could fend-off such characterization5. However, since Krueger was decided 50 years ago, and at that time the economic development of Puerto Rico was substantially different than what it is today, there is uncertainty as to whether the Krueger doctrine will withstand a challenge by the Puerto Rico Treasury Department. In fact, in Administrative Determination AD10-06, issued by the Puerto Rico Treasury Department on April 10, 2010 (“AD-10-06”), the Puerto Rico Treasury Department established rules to determine the taxable compensation that should be paid to shareholders/employees of “service units” under certain Puerto Rico tax incentives acts that pay dividends exempt from Puerto Rico income tax, and did not even mention the Krueger decision. Thus, it seems that the Puerto Rico Treasury Department does not abide by Krueger, and could challenge new Puerto Rico residents relying on the Krueger doctrine.
To minimize the risk of recharacterization of a portion of Newco’s tax exempt dividends as taxable compensation, the new Puerto Rico residents should compute their taxable compensation pursuant to the rules of AD10-06. Pursuant to such rules, employees of Newco who hold a proprietary interest of at least 5% in Newco, should receive compensation equal to the lower of $250,000 annually or 30% of the employee’s share in the earnings and profits of Newco for the taxable year. While AD10-06 is not technically applicable to companies with tax grants under Act 20 (such as Newco), since “service units” under the relevant Puerto Rico tax incentive acts are equivalent to export service companies under Act 20, it may be reasonably concluded that the rules of AD10-06 should be applicable to the new Puerto Rico residents who are shareholders and employees of Newco.
5. Form 926. If Newco is treated as a corporation under the IRC, pursuant to IRC section 6038B the new Puerto Rico resident must file Form 926 with the Internal Revenue Service (the “IRS”), informing the IRS of the cash or other property transferred to Newco in exchange for Newco’s membership interests. On the other hand, if Newco elects treatment as a partnership under the IRC, Form 926 must also be filed if the new Puerto Rico resident owns at least 10% of Newco or the value of the property transferred to Newco exceeds $100,000. Form 926 must be filed on the due date of the Puerto Rico resident’s federal income tax return. Generally, the penalty for failure to file the return is 10% of the cash or the value of the property transferred to Newco.
6. The Act 20 Grant. As previously stated, the grant issued pursuant to Act 20 is a contract between the new Puerto Rico resident and the government of Puerto Rico. Thus, the grant should be reviewed by legal counsel to ensure that the Act 20 tax benefits are granted and identify the contractual obligations imposed upon Newco under the grant. It is also of utmost importance that the services that will be rendered by Newco be properly described in the application for the grant, inasmuch as such description will be included in a clause of the grant that provides, in essence, that the 4% income tax rate is applicable to the income derived from such services, so long as the services are rendered substantially in the manner described in the application. Consequently, if the services actually rendered differ in a material respect from the services described in the application, Newco’s income could be subject to the regular Puerto Rico corporate income tax rate of up to 39%.
The above summary is intended for information purposes only. It cannot be considered a legal opinion, and it does not intend to consider all the tax and legal considerations that could be relevant to any particular person or entity. It should also be noted that the changes discussed herein were recently enacted, and that the PR Treasury has not yet issued regulations, tax forms or interpretative announcements on such changes.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
The contents of PUERTO RICO BUSINESS LAW NOTES may not be reproduced, transmitted, or distributed without the express written consent of Adsuar Muñiz Goyco Seda & Pérez-Ochoa, P.S.C. (“AMG”). The material contained herein is intended for information purposes only and is not to be considered legal advice. Qualified counsel should be consulted based on individual circumstances.