Act 20 and Act 22 in the Aftermath of Hurricane Maria – The Contrarian’s Nirvana
Overview
By now every American is aware of the hurricane devastation in Puerto Rico. The PR’s 9/11 occurred on September 20, 2017. First, the island suffered through Hurricane Irma on September 6, 2016 followed by the “knockout” punch of Hurricane Maria on September 20, 2017. I lived in Miami during Hurricane Andrew in 1993 about two miles from the storm. I remember the “day after” looked like a war zone after a bombing. Other cities such as New Orleans, Florida and Houston have suffered devastating hurricanes and have come back “bigger and better”. Nevertheless, the story in the PR is a different story. The PR seems to be on continued life support with lingering doubt about a full recovery. Perhaps, it might be like the Stage 3 or Stage 4 cancer patient who suffered a devastating stroke.
Since the hurricanes, over 200,000 Puerto Ricans have left the PR. Over 500,000 have left the PR in the last decade. The exodus is likely to continue due to the continued slow response to extended power outages, communication lapses and infrastructure failures and colossal financial crisis. The NY Federal Reserve reported that the power outage was the largest in U.S. history. As recently as a few weeks ago, over ninety percent of the PR lost power again. The immediate job loss was higher than any of the other significant hurricanes in recent memory. In the months preceding the hurricanes, PR filed for bankruptcy protection unable to meet its commitments on more than $70 billion in bonds and nearly $50 billion in employee pensions, declared bankruptcy. As far as municipal bond defaults go, it is the largest in U.S. history.
It is hard to avoid not having a political opinion about the federal government’s slow and delayed efforts to restore normalcy and redevelopment in Puerto Rico compared to hurricane relief on the Mainland. First, Puerto Ricans have been American citizens since 1917. Nine Puerto Ricans have won the Medal of Honor. Over 200,ooo have served in the Armed Forces since World War I. More than 1,131 Puerto Ricans have died in military combat. In a word, PR deserved a more vigorous response from the federal government than it has received to this point.
However, on the other hand, we must concede that Puerto Rico has historically been plagued by corruption, disorganization and inefficiency. In that regard, I am not certain how it makes the PR different than New Orleans. The distance from the Mainland is yet another consideration making recovery efforts difficult. The catastrophic financial condition of the PR preceding the hurricanes is another limitation.
Time will tell what will happen in the PR. In the meantime, the tourist industry is open for business. The sun still shines in and on Puerto Rico! While Puerto Ricans sprint to the Mainland to take economic cover, wealthy gringos on the Mainland have been left wondering about the tax benefits under Act 22 and Act 20 that the PR government had been aggressively promoting in the last several years. This article examines the current in the PR with respect to Act 22 and Act 20 benefits. Recent revisions to the law have been very favorable to investors.
The contrarian should achieve success in the current environment betting that the federal government will not allow Puerto Rico to fall into the sea and drown under the colossal weight of its debt and bankruptcy obligations. It is hard to imagine the federal government allowing this to happen. As a result, the infrastructure will be rebuilt, and economic incentive programs will re-energize economic activity on the Island. It may take waiting for Donaldo to leave the White House, but my bet is that it will happen.
The Puerto Rican people have an indomitable spirit and pride on the Island. More importantly, they are a people of great faith knowing that Dios has not left them “high and dry.” In the world of Salsa music, it is well known by non-Puerto Rican salsa performers that Salsa artists need to achieve success on the Isla del Encanto” to achieve stardom in the Salsa genre. This thinking is like the lyrics of Frank Sinatra’s New York, New York, i.e. if you can there it there, you can make it anywhere.
This article outlines the current state of Act 22 and Act 20 and frankly, the opportunity is better than it has ever been. The nice areas in PR are still nice. Puerto Ricans have resilience and belief that the Island will re-emerge better than before. It is not the end but the beginning! The Salsa never ends!
Overview of Puerto Rican Tax Considerations and Residency
A. Puerto Rican Tax Basics
Two important pieces of legislation were passed by the Puerto Rican legislature in 2012. Both the Export Services Act (Act 20) and the Individual Investors Act (Act 22) were signed into law by the Governor of Puerto Rico on January 17, 2012.
The definition of a U.S. person under §7701(a) (30), however, does not include Puerto Rican entities. As a result, a Puerto Rican entity is not subject to U.S. income taxation unless the entity is engaged in a trade or business within the United States and its income is considered effectively connected income, or investment income that would be subject to a withholding tax under §871 (unless an exemption for portfolio interest under §881(a) applies).
Under §933, bona fide residents of Puerto Rico who have Puerto Rico-sourced income are exempt from U.S. taxation. Section 937 defines a bona fide resident for tax purposes. A person is a Puerto Rican resident for tax purposes if the person is present in Puerto Rico for at least 183 days during the taxable year and he or she does not have a tax home outside Puerto Rico and does not have a closer connection to the U.S. or a foreign country than to Puerto Rico.
For federal income tax purposes you will be considered a bona fide resident of Puerto Rico if you meet the following: (i) the physical presence test (generally spending 183 days in PR, or less than 90 days in the US); (ii) the tax home test; and (iii) the closer connection test for the entire taxable year which means that you can’t have stronger personal connections to another jurisdiction that is not Puerto Rico, as prescribed in the regulations promulgated under Section 937 of the Internal Revenue Code.
(1) The Individual Investor's Act
Under the Individual Investors Act, neither capital gains (long-term or short-term), interest, nor dividends are subject to Puerto Rican taxation. Dividend income is subject to U.S. federal income taxation for U.S.-sourced dividend income, as is interest income unless the interest income is exempt under the portfolio interest exemption. Long-term capital gains derived by the resident individual investor that (1) were deemed to have accrued before the individual became a Puerto Rican resident and (2) are recognized within the first 10 years after the date the individual becomes a resident, will be taxed at a 10 percent rate.
If the gains are recognized after the 10-year period but before January 1, 2036, the gains will be taxed at a 5 percent rate. Gains considered to have accrued after the investor becomes a Puerto Rican resident will receive a 100 percent exemption. Dividend and portfolio interest income are exempt from Puerto Rican taxation under the new law.
Legislation in July 2017 added a requirement for each decree holder to make an annual donation of $5,000 to a recognized Puerto Rican not-for-profit organization.
(2) The Export Services Act
A business that relocates to Puerto Rico can significantly reduce its tax liability provided that the Puerto Rican entity is not engaged in a U.S. trade or business. The top U.S. corporate tax rate in 2018 is 21 percent at the federal level. Assume another 5-8 percent at the state level. Many pass-through businesses will qualify for the new 20 percent business deduction under IRC Sec 199A. However, most professional service companies will not qualify for this deduction. These businesses might be well served to evaluate Act 20 status.
Under Puerto Rico’s Export Services Act, the corporate tax rate is flat four percent. Additionally, shareholders who relocate to Puerto Rico will have a 100 percent exemption on corporate distributions received from the Puerto Rican company.
Under the Export Services Act, services that are directed to foreign markets may generate income that will qualify for the special tax rate. Services for foreign markets include services performed for nonresident individuals and businesses. To qualify as “promoter services” under the Export Services Act, the net income must be earned, and service performed within the 12-month period ending on the day preceding the day the business commenced operations within Puerto Rico. The term “eligible services” includes a wide range of service-oriented businesses from research and development to investment management.
Significant changes were made to Act 20 on July 11, 2017. These changes eliminated the five-employee requirement and no minimum employee requirements for most businesses. In most cases, this will be the business owner. The new legislation added two new eligible services – (1) Hospital services and laboratories including medical tourism and telemedicine services; (2) Trading companies with no less than 80% of business in PR exporting business. At least thirty percent of the of the doctors at medical tourism and telemedicine facilities should be Puerto Rican residents. International banks licensed in Puerto Rico under Act 273 also qualify for the special rate of four percent. Investment advisors, funds and family offices operating as international financial entities also qualify. Payday lenders with a hybrid licenses qualify as do fund managers with an offshore master/feeder structure.
Summary
For entrepreneurs in service-oriented businesses, Tax Reform does not offer any meaningful tax benefits. As a result, Act 20 status looks particularly attractive for service providers. The repeal of the minimum employee requirement makes the transition very smooth. The expansion of eligible companies to include trade companies provides a potential benefit that on the surface far exceeds the benefits of IC-DISCS. The economic situation in the PR on a certain level does not impact the Act 20 decree recipient since all the business owner’s business is focused outside of the PR. The reality for day-to-day living in the PR is put into proper perspective considering most of the recipients of Act 22 and Act 20 live in the neighborhoods which are in the nicest parts of the Island with no loss of in the quality of community services and quality of life.
