A View of San Juan from Nashville- Enjoying the Benefit of Puerto Rican Tax Incentives While Remaining Home
Overview
By now most of the readers know that I grew in Panama Canal Zone. As an American growing up in the Panama Canal Zone (“the Zone”), looking back, it was an odd existence. Literally outside looking in!
The Americans only had American TV from the U.S. military from 4:30 in the afternoon until midnight. College football games were seen two weeks after the fact. The military operated one radio station. At least we could listen to Casey Kasem and American Top 40 each week and Wolfman Jack. We watched Scooby Doo and The Three Stooges (Los Tres Chiflados) in Spanish.
The first time that I went to Puerto Rico (“the PR”), I had an immediate connection to La Isla Del Encanto. It had a lot of similarities to Panama. Culturally, the PR is similar to Panama. The language, sports (boxing, and baseball) and music (Salsa) are similar. I had an instant memory of the Zone. However, I am not unlike many business owners who would move to the PR in a second but for their significant others aka “La Vieja”, who would say “Over my Dead Body”. Inevitably, if you did not grow up overseas as an ex-patriate or the child of missionary parents, making the sale to move to the PR is a hard sale. But what if I told you that you could qualify from some of the benefits of Act 22 and Act 20 without ever moving to Puerto Rico? Still listening?
This article will outline the benefits of Puerto Rican tax incentives and also leave a few tracks for how to have a view of San Juan, e.g. Puerto Rican tax incentives, without leaving your front porch in Nashville (or Dubuque or Minneapolis or Sweet Home Alabama).
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, a taxpayer will be considered a bona fide resident of Puerto Rico if the taxpayer meets 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 the taxpayer 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.
Enjoying Puerto Rican Tax Incentives While Remaining on the Mainland
At the outset of this article, I cited as one of the biggest obstacles the fact that the business owner’s spouse is unwilling to move to Puerto Rico. Under the Doctrine of When Momma Ain’t Happy, Ain’t Nobody Happy, most business owners just won’t make the leap from Sweet Home Alabama to San Juan. Clearly, it is not a question of resentment against reduced taxation. Nevertheless, the interplay of the Puerto Rican tax incentive regulations coupled with the taxation of trusts from a U.S. perspective along with fact that the controlled foreign corporation rules do not apply to Puerto Rican residents, provide the taxpayer with the ability to achieve four percent taxation as an Act 20 taxpayer without ever leaving the front porch on the Mainland.
Under this scenario, the taxpayer will be able to achieve significant accumulation in a Puerto Rican Act 20 Company without the imposition of federal and state taxation. The only taxation is the special incentive tax rate of four percent. The enhancements to the Act 20 legislation outlined above currently do not have a minimum employment requirement. Planning at the Trust level can avoid taxation on the PR and U.S. level for a future liquidation.
At the end of the day, the business owner will never have to take Salsa dancing lessons unless he wants to. Mrs. Business Owner will be able to stay home and not upset her current lifestyle and miss her grown children through any perceived hard duty in Puerto Rico.
Summary
Currently, most taxpayers on the Mainland have no interest in moving to Puerto Rico following the hurricanes and state of affairs and lack of infrastructure. The strategy outlined in this article provides powerful tax benefits to all forms of businesses on the Mainland – service businesses or manufacturers or sellers of good services. Operating companies buying good or services from a Puerto Rican Trade Company will create significant tax arbitrage. The Company will be able to provide management, administrative and marketing services from Puerto Rico. The Company will be able to achieve a four percent tax rate without any federal or state taxation. The potential tax and wealth accumulation benefits of the proposed strategy are exceedingly beneficial to business owners. All of this while remaining on the Mainland. Who said, there wasn’t a clear view from Nashville to San Juan!
