Tax Minimization: Puerto Rico’s One-Two Punch
Acknowledging the importance of the service industry in fostering economic grow, Puerto Rico has enacted a tax incentives program for companies that render services to clients located abroad. The statutory basis of this program is the Services Export Development Act (SEDA), also known as Act 20-2012. Concurrently, Puerto Rico approved Act No. 22-2012 (Act 22) affording certain income tax incentives described below for individuals who move to Puerto Rico. SEDA and Act 22 are responsible for the relocation to the Island of dozens of U.S. hedge fund managers and some renounced investors.
Although the export of services had been incentivized before as part of tax a reduction regime promoting manufacturing operations and, to a lesser extent, by the International Banking Center Act, SEDA broadens the range of services eligible for tax exemptions.
Pursuant to SEDA, an entity with a bona fide office or establishment located in Puerto Rico that provides “eligible services” would benefit during 20 year from:
1. A 4% fixed income rate on “export service income” in lieu of any other tax. This fixed rate would be reduced to 3% if the entity provides strategic services and derives more than 90% of its income from export services during the taxable year. Export service income is the net income derived from performing eligible services.
Some of the factors to be taken into consideration to qualify as a strategic service are: the nature of the services, the existence or inexistence of an industry for those services Puerto Rico, the number of Puerto Rico residents to be employed, and the investment in technology.
2. A 100% exemption from Puerto Rico income tax on dividend distributions made out of export service income. Subsequent dividend distributions out of export service income are 100% exempt from further Puerto Rico income taxes.
3. A 60% exemption from gross receipts taxes imposed by municipalities. The exemption increases to 90% if the business operates in the municipality of Vieques or Culebra.
4. A 100% exemption for the first 5 years and 90% exemption thereafter from real and personal property taxes in the case of entities engaged in providing headquarters services, call centers or shared services.
Some of the eligible services are: (a) research and development; (b) advertising and public relations; (c) consulting on science, technology, environment, economy, management, marketing, human resources, computers, and audits; (d) advising on matters related to any trade or business; (e) engineering and architecture services, project management, and blueprint production; (f) professional services such as legal, tax and accounting; (g) headquarter services; (h) data processing centers; (i) software development; (j) call centers; (k) shared services centers (accounting, finance, tax, audit, human resources and marketing, among other services); (l) warehousing and distribution hub centers; (m) investment banking and other financial services: asset management, private equity management, hedge funds management, pool of capital management, and trust management; (n) educational and training services, (o) hospital and laboratory services, and (p) other services so designated by the relevant authorities through regulations. Cloud computing services have been included in this latter category.
The eligible services must also constitute “export services” to qualify for the tax incentives. Export services are those rendered for the benefit of (i) individuals that are not residents of Puerto Rico; (ii) foreign entities (i.e., not organized under the laws of Puerto Rico); (iii) trusts whose grantors, beneficiaries and trustees are not residents of Puerto Rico; (iv) non-resident estates; and (v) governmental units other than the Commonwealth of Puerto Rico. The services performed for these persons cannot have a nexus with Puerto Rico.
A nexus with Puerto Rico is deemed to exist if the services have some relation to Puerto Rico, including: (i) business or investment activities conducted in Puerto Rico, (ii) sale of any property for use, consumption or disposition within Puerto Rico, (iii) advising on the laws and regulations of Puerto Rico, (d) lobbying on Puerto Rico laws, and (iv) any other activity that the relevant authorities designate through regulations.
Promoting services also qualify for tax incentives to the extent they constitute eligible services related to the establishment of a new business and are so designated by the relevant authorities through regulations, regardless that they may have a nexus with Puerto Rico.
In order to be entitled the tax incentives, an entity must apply for and secure a tax exemptions grant. This grant is in the nature of a contract among the grantee, its shareholders, owners or partners, and the Government of Puerto Rico. Although SEDA do not impose a minimum number of employees to obtain the grant, existing Government’s policy requires that the business hires and maintains at least three full-time employees who are residents of Puerto Rico.
SEDA and the federal income taxation rules applicable to Puerto Rico corporations offer tax minimization opportunities even for those U.S. citizens (or foreign residents of the U.S.) that do not move to Puerto Rico. This is the short version of why. A corporation organized under the laws of Puerto Rico is a foreign corporation for purposes of the U.S. Internal Revenue Code (US IRC). Likewise, a Puerto Rico LLC will be taxed as a foreign corporation assuming it does not change its default classification by checking-the-box. Accordingly, if such corporation/LLC renders all its services in Puerto Rico (outside the U.S.) it would not be subject to federal income taxation on the service income. Furthermore, its shareholders/members would not be subject to federal income taxes until profits are repatriated albeit the corporation/LLC is a controlled foreign corporation. In this regard, the anti-deferral provisions of Subpart F income would not require current inclusion of the income by the U.S. shareholders inasmuch as services are not performed for or on behalf a related person, or, if rendered in such circumstances, the services are performed solely in Puerto Rico (exception for performing services in the place of incorporation of the CFC). Transfer pricing matters must be taken into consideration and addressed.
An individual who relocates to Puerto Rico can also profit from additional tax exemptions if she or he meets these requirements: (i) is domiciled in Puerto Rico, (ii) was not domiciled in Puerto Rico during 15 years before January 17, 2012, and (iii) becomes domiciled in Puerto Rico before January 31, 2035 (Eligible Resident). For these purposes, an individual who is present in Puerto Rico for more than 183 days during a calendar year is presumed to be domiciled in Puerto Rico.
An Eligible Resident is afforded 100% exemption from Puerto Rico income taxes, including the alternative minimum applicable to individuals, on:
1. Interest and dividends from all sources earned after becoming domiciled in Puerto Rico and before January 1, 2036, including but not limited to, interest and dividends received from local Registered Investment Companies (mutual funds).
2. Interest, finance charges, dividends and partnerships profits received from international banking entities licensed under the International Banking Center Act of Puerto Rico after becoming domiciled and before January 1, 2036.
3. Net capital gains related to the appreciation of securities accruing after becoming domiciled in Puerto Rico and recognized before January 1, 2036.
A 5% tax rate would apply to the net long-term capital gain realized in connection with the appreciation of securities held before becoming domiciled in Puerto Rico and recognized (i) after 10 years of establishing such domicile but (ii) before January 1, 2036.
As with SEDA an Eligible Resident must apply for and obtain a tax exemption grant. The grant is in the nature of the contract between the grantee and the Government of Puerto Rico. The grant will be effective during the exemption period set forth above.
The following table summarizes the Puerto Rico and United States federal income taxation of capital gains and dividends earned by Eligible Residents that are bona fide residents of Puerto Rico in accordance with the US IRC. Please note that bona fide residents of Puerto Rico are not subject to federal income taxes on income from Puerto Rico sources pursuant to Section 933 of US IRC. Special sourcing rules apply to income earned by said residents. See Section 937 of the US IRC and the regulations thereunder.
1 More than six-month holding period for Puerto Rico tax purpose and more than 12-month holding period for Federal tax purpose.
2 If the regular tax rate that would apply is 25% through 35%. A foreign tax credit for the tax paid to Puerto Rico would be available against the federal tax.
3 If the regular tax rate that would apply is 39.6%. A foreign tax credit for the tax paid to Puerto Rico would be available against the federal tax.
4 Qualified dividends if the regular tax rate that would apply is 25% through 35%.
5 Qualified dividends if the regular tax rate that would apply is 39.6%.
6 Qualified dividends if the regular tax rate that would apply is 25% through 35%.
7 Qualified dividends if the regular tax rate that would apply is 39.6%.