Puerto Rico

Felipe Mariani
Zaragoza & Alvarado - Taxand
Puerto Rico

Felipe Mariani of Zaragoza & Alvarado – Taxand discusses the most relevant provisions of the Puerto Rico Tax Reform

The final months of 2010 and the first of 2011 have been a busy period for Puerto Rico tax legislation, with the drafting and signing into law of the Puerto Rico Tax Reform. The Puerto Rico Tax Reform is made up of three main pieces of legislation: (1) Act 154 of October 25 2010; (2) Act 171 of November 15 2010; and (3) Act 1 of January 31 2011.

Act 154 establishes a new excise tax on certain purchases made by related parties of manufacturing companies located in Puerto Rico and amends the effectively connected income provisions of the Puerto Rico Internal Revenue Code to consider, as Puerto Rico source income, certain transactions that were previously excluded.
Act 171 amends several provisions of the Puerto Rico Internal Revenue Code of 1994, as amended (1994 code), which modify, for the most part, the income tax paid for the taxable year 2010.
Act 1, also called the Internal Revenue Code for a New Puerto Rico, replaces the 1994 code. Most of the provisions in the 2011 code are similar to those in the 1994 code. However, there are still some significant changes, which may result in a considerable tax impact.

Act 154 of October 25 2011

This revenue raising measure imposes taxes on certain nonresident individuals and foreign corporations and partnerships (the foreign taxpayers) that were not taxed under Puerto Rico's previously existing tax regime. Under the new rules, these foreign taxpayers will be taxed in Puerto Rico if certain relationship tests are met with respect to a manufacturing, or service providing (as it related to manufacturing), affiliate resident in Puerto Rico (the resident entity).

Changes applicable to nonresident foreign entities

In general terms, Puerto Rico taxes nonresident foreign persons only on their gross income from sources within Puerto Rico. The existence of a Puerto Rico trade or business by a foreign taxpayer has two effects, first it expands the types of income that are taxable in Puerto Rico to include the foreign source income, which is effectively connected with a Puerto Rico trade or business, and changes the taxation regime to one where income is taxed on a net basis rather than a gross basis.

Under the Act, a foreign taxpayer not otherwise considered engaged in a trade or business in Puerto Rico, at least under the traditional minimum contact standards applicable to income taxes or even sales and use taxes (which are traditionally lower), will be considered as such (the deemed resident taxpayer), to the extent it has a manufacturing or service providing affiliate operating in Puerto Rico, and the level of certain commercial transactions between both entities exceeds pre-established thresholds (the commercial transactions tests).

The Act imposes a tax on the deemed resident taxpayers based on two different mechanisms depending on the sales level of the resident entity. If the sales level exceeds $75 million, purchased by the deemed resident taxpayer from the resident entity, the deemed resident taxpayer will be subject to an export excise tax of 4% (which may be reduced by certain credits). The excise tax will be effective for a six year period ending on or before December 31 2016 and the 4% tax rate will reduce on a yearly basis until it reaches 1% for the last year.

For cases not meeting the sales threshold, a four factor test is used to characterise, as Puerto Rico source income, a portion of the deemed resident taxpayers' income generated outside Puerto Rico. This four factor test will also apply to those meeting the sales threshold test, for those years which the excise tax is not applicable.

How the changes are accomplished

The Act amends the effectively connected income rules under the code (which up to this point had no pertinence in determining whether a foreign taxpayer was engaged in a trade or business in Puerto Rico) as follows:

It expands the scope of what is considered a fixed place of business of a Foreign Taxpayer. This will happen under these circumstances:

The resident entity has the authority to negotiate and conclude contracts on behalf of the foreign taxpayer or has stock merchandise, from which to fill orders on its behalf and regularly does so; except general commission, agent, broker or independent agent agreements; or
The resident entity is a member of a controlled group of a foreign taxpayer and it meets one of the commercial transactions' tests (sales test, purchase test, commissions test and facilitator test). The threshold needed to meet most of these tests is so low that most foreign taxpayers operating in Puerto Rico should meet at least one of them.

It expands the scope of what is considered Puerto Rico source income, to characterise, as such, a portion of the income, gains and profits of the deemed resident taxpayer, earned outside of Puerto Rico based on a formula which averages four factors: property, payroll, sales and purchases. In the absence of this rule, no part of the foreign source income of the deemed resident taxpayer would be subject to tax in Puerto Rico.

As a result of these two changes (which are permanent in nature), certain foreign taxpayers, which previously were not considered engaged in trade or business in Puerto Rico, are now considered as such and certain income derived by such foreign taxpayers, which was previously considered income from sources without Puerto Rico – and, thus, not subject to Puerto Rico income tax – is now treated as Puerto Rico source income (or effectively connected income) and, therefore, subject to Puerto Rico income tax.

What to do?

For those companies operating in Puerto Rico this was an unexpected tax increase not considered in the determination of whether or not to invest (mostly manufacturing) in Puerto Rico. Those companies need to measure the impact of this tax and the probability of obtaining a foreign tax credit from it in its place of residence. This issue has been addressed by the US IRS but not by the taxing authorities of other countries.

Those companies should also meet with the Puerto Rico Treasury Department to try to negotiate the tax. Companies meeting the sales threshold, and thus subject to the excise tax, have had a better access to the Treasury than those that do not meet the sales threshold. Some of these companies have managed to reduce the excise tax with certain credits negotiated in those meetings and later included in regulations and incorporated into the Act.

Companies looking to invest in Puerto Rico have the opportunity to try to structure their business to avoid or reduce the taxes imposed by the Act. However, the determination of the possible impact should always be the first steps to determine the most efficient structure.

Act 1 of January 31 2011

As mentioned before, the Internal Revenue Code for a New Puerto Rico (new code) replaced the 1994 code. Most of the changes are a re-codification of the provisions in the 1994 code. However, it also added some significant provisions where discussion is relevant.

Reduced income tax rates

The new code retains the 20% regular income tax rate but establishes significant lower surtax rates. The 1994 code provided a maximum surtax rate of 19% while the new code provides a maximum surtax rate of 10%. This maximum surtax rate may even be further reduced in the future to 5% if certain economic tests are met.

The new code also provides a significantly higher surtax deduction. The 1994 code provided for a $25,000 surtax deduction which the new code increased to $750,000. As with the 1994 code, the new code requires that such deduction be distributed among a controlled group of corporations. However, this significant increase should also help reduce the effective income tax rate paid.

The new code also eliminated the 5% additional surtax and the 5% recapture of the benefit of the income tax tables.

Alternative minimum tax

The new code established some positive and some negative provisions regarding the computation of the alternative minimum tax. First, which is only positive, is the reduction of the alternative minimum tax from 22% to 20%. Although a positive change, the reduction in the alternative minimum tax is not proportional to the reduction in the regular income tax rate. Therefore, the probability of a company falling into an alternative minimum tax position increases.

The new code includes two additional changes. The first is to incorporate, on a permanent basis, the adjustment to the alternative minimum income of the payments to related parties for services rendered outside Puerto Rico. This adjustment was incorporated to the 1994 code as a temporary adjustment to finalise on taxable year 2010. The temporary nature of the adjustment made it possible for taxpayers to recoup any alternative minimum tax paid once the effectiveness of the adjustment ended. By making this adjustment permanent those corporations with significant management fees, technical fees or other services provided by a related company outside of Puerto Rico may end in a permanent alternative minimum tax position with a high effective tax rate.

The second additional change is the establishment of an alternate computation of alternative minimum tax, comprising of 1% of the purchases made to a related party. Under the new code, the taxpayer will prepare the two possible alternative minimum tax computations and compare the higher of those to the regular income tax rate to determine if there is an alternative minimum tax. This alternate computation provides some exceptions (in that, purchases for manufacture) that are important to consider.

These two additional changes provide a different approach to the typical transfer pricing with its complicated provisions and expensive computations (both by taxpayers and the taxing authorities). Instead of determining whether the related entities were charging reasonable fees for their services and products through a transfer pricing study made by economists or accountants, the legislation set a threshold of what they consider to be reasonable. As is always the case with this type of approach, some companies doing things right will still suffer an increase in tax.

Pass-through

The new code changed the tax treatment for partnerships in Puerto Rico. Previously, partnerships were treated as corporation (double taxation). The new code allows partnerships to be considered a pass-through (payment of tax at the partner level) with rules similar to those of the US.

Even better, the new code provides for an election for limited liability companies to be treated either as corporations or partnerships. This allows the foreign taxpayer, especially US entities, to structure their Puerto Rico operations similar to those in the US to maximise their tax efficiency and simplify the tax planning by matching foreign income and foreign taxes to those recognised in their jurisdiction.

Both Act 154 and the new code change Puerto Rico tax laws significantly for foreign entities doing, or planning to do, business in the jurisdiction. The reduced rates (together with those provided by tax incentive laws) may entice some, but due care is needed to avoid some of the pitfalls.

Felipe Mariani (fmariani@zatax.com), Zaragoza & Alvarado – Taxand, San Juan