My recent essay debunking a Puerto Rican tax incentive sparked a heated reaction from one of its most ardent backers. You can read it here.
Among other Puerto Rico-related products, this advisory service sells a $695 video course extolling the tax advantages of what it calls the “Island of Enchantment.” And they’ve brought out someone they claim to be an expert on US territories to address my concerns. The expert is David Nissman, who, during the administration of President George W. Bush, oversaw enforcement of federal laws in the US Virgin Islands.
David’s reason for writing the article, in the words of this service’s editor, was to “drive a stake through the heart of these misconceptions and forever put them to rest.”
When someone threatens to drive a stake through anything I have, including my misconceptions, I take the matter quite personally. But there’s a fundamental misconception in the rebuttal because it addresses two separate tax incentives enacted by Puerto Rico – Act 20 and Act 22, both enacted in 2012.
My essay didn’t address Act 20, which provides some important tax benefits for companies generating Puerto Rican source income. Act 20 may well survive the political process in San Juan and Washington, DC, and stay intact for the next few years.
Act 22 probably won’t.
But for now, anyone who becomes a bona fide resident of Puerto Rico is eligible for the following benefits, courtesy of Act 22:
- 100% tax exemption from Puerto Rico income taxes on all dividends and interest payments on Puerto Rican source income
- 100% tax exemption from Puerto Rican income taxes on all short- and long-term capital gains accrued after becoming a resident of the territory.
Thanks to provisions in the US Tax Code exempting Puerto Rican source income from US taxes, in many cases, there’s no federal tax, either, on this income. That makes Puerto Rico, in the opinion of its promoters, a viable alternative to expatriation (giving up your US citizenship and passport and permanently ending your legal obligation to pay US income taxes on non-US income).
New residents granted these benefits sign a contract with the government of Puerto Rico guaranteeing they’ll continue in effect until 2036. A few hundred people have signed these contracts so far, although not all of them have relocated to Puerto Rico.
Incidentally, I also consulted an expert in matters relating to US territories to address the specific points our stake-driver makes in his rebuttal. This expert has asked me not to use his name, but he has a long and distinguished career in this area.
I’ve quoted extensively from the rebuttal and, with our expert’s help, address each concern, point by point. And you, dear reader, have the privilege of deciding who makes the most credible case.
“Puerto Rico’s tax incentives may allow you to totally eliminate all forms of taxation on capital gains, interest, and dividends and reduce your corporate income tax rate to just 4%. Americans can find similar benefits nowhere else in the world short of renouncing their citizenship… They are 100% real and legal. And for those who obtain them, they are here to stay.”
Response: This is a fair summary of the combined effects of Act 20 and Act 22. (Again, I did not address Act 20 in my original essay.)
It’s true that under Act 22, US citizens can find similar benefits nowhere else in the world, short of renouncing their citizenship. But the incentives are vulnerable to political, legal, and even constitutional challenges.
As far as being here to stay, as I pointed out in my original essay, Congress has zeroed in on Act 22 because it directly threatens the US tax base. Senator Charles Schumer (D-NY) is a vocal critic. On the other side of the aisle, Senator Charles Grassley (R-Iowa) advocates ending the Act 22 tax incentives, either in Puerto Rico or in the federal Tax Code.
Congress has the authority to make whatever amendments it wants to the Tax Code. That includes Section 933, which currently exempts Puerto Rican source income from US income tax.
“Puerto Rico’s tax incentives are not some fly-by-night thing. They fit into the economic development policy that has been supported by the US federal government and both political parties for many decades… Puerto Rico’s tax incentives are very sustainable.”
Response: Corporate tax incentives for US territories have a very long history. But no federal official has ever supported a policy of tax exemption for individuals relocating to Puerto Rico.
And corporate tax incentives for Puerto Rico are mostly a thing of the past. Originally enacted to help US companies compete in the Philippines in 1921, Congress revised the tax exemptions for Puerto Rico in 1976, as Section 936 of the Tax Code. Section 936 was intended to prevent tax evasion and to establish an incentive for US companies to set up job-creating manufacturing subsidiaries in Puerto Rico. The tax credits effectively exempted all territorial income from US taxation. Dividends from a territorial subsidiary to a US parent could be repatriated tax-free as well. Section 936 even exempted passive income from some territorial sources.
By 1979, the US Treasury had become concerned that companies were shifting income from the US to their Puerto Rican subsidiaries. It took 17 years, but in 1996, Congress ended the credits with overwhelming bipartisan margins in both houses.
A report from the Joint Committee on Taxation explained that the purpose of the repeal was to avoid a tax incentive to locate in Puerto Rico versus a US state.
Which, of course, is exactly what Act 22 does.
Indeed, a research report released earlier this month on Puerto Rico from Standard & Poor’s says that “if Puerto Rico becomes too successful at marketing itself as a tax haven, the US Congress in our view would likely enact restrictions, just as it did when it ruled to phase out Section 936 tax breaks.”
“Do we actually believe that our gridlocked Congress is currently capable of reaching a bipartisan agreement to overhaul the US tax code?… When there finally is new tax legislation, the Territories will lobby hard – with the US Department of the Interior firmly on their side – to continue making these benefits available.”
Response: Under this scenario, the territory of Puerto Rico would be lobbying the wrong agency. It’s true that the Department of the Interior has jurisdiction over relations with the US Virgin Islands (where Nissman worked), but President Kennedy moved Puerto Rico issues out of the Interior Department to the Office of the President a half-century ago.
In any event, a near-term agreement to overhaul the federal Tax Code probably isn’t likely. But there’s already bipartisan support to amend the federal incentives for territories. One of the Senate Finance Committee’s tax reform hearings has already addressed this issue.
Even if Congress doesn’t act, Puerto Rican voters may throw out Act 22 on their own. While hedge fund managers and their fat-cat friends are getting big tax breaks, the legislature in June hiked capital gains taxes and other taxes for everyone else. Needless to say, the law is very unpopular. But an assistant Treasury secretary said last week that the governor would soon propose doubling the tax from 15% to 30%.
Only 19% of Puerto Rican voters back the current government, and only 5% believe the territory is headed in the right direction. The typical Puerto Rican voter has a quite different financial profile than the populist image of an Act 22 beneficiary smoking a cigar on the veranda of his gated high rise overlooking the Caribbean.
And of course, if Puerto Rico becomes a state, it would no longer qualify for any territorial tax incentives. This could happen if a pro-statehood government is elected in 2016. In an opinion poll released last month, 54% of Puerto Rican residents say they favor the pro-statehood party. A majority of Puerto Ricans chose statehood as the best alternative to territory status in a 2012 plebiscite.
“Whether these programs change one day or whether Puerto Rican statehood requires different tax rules, the individuals and businesses that have decrees with the Puerto Rican government will have to be grandfathered in based on the Contracts Clause in the US Constitution.”
Response: Wrong again. Nothing in the contract that Act 22 immigrants sign purports to limit the authority of Congress to impose federal income tax. And the US Constitution’s Territory Clause vests in Congress “power to… make all needful Rules and Regulations respecting the Territory… belonging to the United States.”
No US court would seriously entertain an argument that Congress can’t tax income in a territory just because the territory itself agreed not to tax the income. Neither common sense nor the Supreme Court cases Nissman cites support that conclusion. And if Congress taxes the capital gains that accrue after a person has moved to Puerto Rico, the territory would have no liability to those persons, because the Act 22 agreements only promise what the local government will not do – impose a local tax – not what the federal government will or will not do. The new residents arriving courtesy of Act 22 will have to pay the federal tax themselves.
Puerto Rico also doesn’t have a great record when it comes to honoring tax incentive agreements. Dozens of US companies still manufacture in Puerto Rico and have signed legally binding agreements with the territorial government that lower their income tax liability to 0-4%. But when Puerto Rico’s fiscal crisis erupted in 2011, the territory enacted an excise tax on products the US parent companies purchase from their Puerto Rican subsidiaries. This tax now generates nearly $2 billion annually.
The lesson here is that even if Puerto Rico doesn’t rescind Act 22’s benefits, it will find a way to tax those who benefit from it. Otherwise, local politics will make it impossible to honor these contracts if Congress ends or restricts the Section 933 tax exemption on Puerto Rican source income.
How would you feel if you lived in Puerto Rico and the governor announced that you now have to pick up the tab to reimburse the federal taxes that a few hundred hedge fund managers and their friends don't have to pay?
Puerto Rico Tax Incentives: How Much Can You Really Save?
Much has been made of the Puerto Rico Tax Incentives brought in in 2012. But how much tax could you really save? And do you qualify? Find out here: Puerto Rico tax incentives.
The Silver Lining in Puerto Rico
Should you move to Puerto Rico to take advantage of these incentives? That’s up to you, but before you do, understand what it’s like to actually live there. This article gives a good summary.
The one tax-related reason you might want to relocate there is to take advantage of the Act 20 (not Act 22) incentives. To do so, you need to become legally resident in Puerto Rico and spend at least six months there each year. You also need to create a business that provides services outside the territory but uses Puerto Rico as a base. Qualifying businesses pay only 4% tax on income above $250,000 annually.
Experts like Vicente Feliciano, who heads up a business consulting group in Puerto Rico, think Act 20 is much more sustainable than Act 22. “The export of services is more in line with traditional incentives to attract businesses here, and therefore, the reaction by the US Congress to them wouldn’t be as strong,” he says.
The bottom line: If you’re a US citizen and want to legally end US tax on your worldwide income for good, there’s only one way to do it. That’s to expatriate – give up your US citizenship and passport, and live outside the US, permanently.
It’s a radical step, but unlike Puerto Rican residency, once you take it, you’ll no longer be part of the US, or subject to its taxing authority.
Mark Nestmann
Nestmann.com
