Tax Planning

Tax Heavyweight Says Congress Should End Puerto Rico Tax Incentive

One of the most important services that I think I provide our consulting clients is to say “no” to some of their harebrained ideas.

Over the years, I’ve said “no” to schemes such as:

  • The idea that US citizens can use a “sovereign trust” to permanently end the requirement to pay income tax;

  • “Secret” offshore bank accounts that US citizens supposedly don’t need to report; and (my personal favorite);

  • The idea that you can squirrel away a garage full of virtually worthless foreign currency and then realize a huge profit upon “revaluation” of that currency.

Over the last year or so, the scheme that I’ve said “no” to more than anything else involves Puerto Rico. Back in 2012, Puerto Rico—a US territory—enacted tax incentives designed to entice hedge fund managers and other wealthy immigrants into relocating there from the mainland US. I first wrote about them in this essay.

The specific law I criticized is Act 22. Anyone who becomes a bona fide resident of Puerto Rico is now eligible for the following benefits, courtesy of Act 22:

  • 100% tax exemption from Puerto Rico income taxes on all Puerto Rico source dividends and interest payments.

  • 100% tax exemption from Puerto Rico income taxes on all short- and long-term capital gains accrued since becoming resident in the territory.

By itself, this exemption isn’t particularly noteworthy. But the US Tax Code provides that bona fide residents of the territory need not pay federal income tax on “income derived from sources within Puerto Rico.”

Together, Act 22 and the federal tax incentives are a big deal, because they provide a way for wealthy US citizens or green card holders who are now paying federal income taxes as high as 39.6% (plus the 3.8% Obamacare tax) to relocate to Puerto Rico and potentially cut their federal income taxes to zero. And they can do so without needing to expatriate (i.e., give up US citizenship).

Now, I don’t have anything against cutting taxes. But I was skeptical that Act 22 would remain in effect and even more skeptical that Puerto Rico would honor the contracts it signed with wealthy investors guaranteeing that they would pay no income tax for the next 20 years. I thought then, and still believe, that either:

  • Congress will repeal or substantially restrict the federal incentives for Puerto Rico; or

  • Puerto Rico will repeal Act 22; or

  • The courts of Puerto Rico will overturn the incentives on the grounds that they violate the territory’s constitution.

But until a few months ago, I hadn’t found anyone else who shared my skepticism about Act 22. Financial publishers were flocking to Puerto Rico to promote its tax incentives the way gamblers gravitate to Las Vegas. And there was absolutely no serious questioning—from anyone—about the incentives.

That changed last September, when I received a message from a true insider in these matters. He previously worked directly with the White House on tax matters related to Puerto Rico and other US territories and has more than 30 years of experience in this area. He told me:

You’re the only person I’ve read who has understood this isn’t all it’s all cracked up to be.

Our correspondence led to a second essay on Puerto Rico where I highlighted his concerns over the incentives. And that, in turn, led to a ferocious rebuttal by one of the many financial publishers promoting them. Indeed, the rebuttal claimed that it would “drive a stake through the heart of these misconceptions [i.e., my skepticism] and forever put them to rest.”

But with the help of my insider, I was able to demolish the rebuttal, point-by-point, in this essay. But interestingly, no one seemed to pay much attention, although a few influential voices in Congress were outraged by the incentives. The media hype was still as loud as ever, although every now and again, someone acknowledged my concerns, as in this article from Forbes.

That’s now started to change. Another true insider—no less than Dr. Martin Sullivan, the chief economist for the highly respected “Tax Analysts” daily and weekly publications—has now weighed in on the Act 22 incentives. (Dr. Sullivan is a former professor of economics at Rutgers University and was a staff economist at the congressional Joint Committee on Taxation.) In the March 30, 2015 Tax Notes, quoting from my most recent essay on Puerto Rico, he makes the case that Congress should wipe out the tax benefits associated with Act 22. Given Dr. Sullivan’s reputation and “clout,” my guess is that Congress will take his suggestions very seriously.

Should you move to Puerto Rico to take advantage of these incentives? That’s up to you. After all, I could be wrong—Act 22 could well stay in effect indefinitely—but before you pack your suitcase, understand why a lot more people are leaving the territory than are moving to it. This article gives a good summary.

But remember, when too many people start exploiting a loophole to save on federal taxes, the loophole usually closes. It’s happened before in Puerto Rico, as I’ve explained in past essays—and it could happen again.

Mark Nestmann
Nestmann.com

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