Puerto Rico: Still a Mess?

Puerto Rico: Still a Mess?

By Mark Nestmann • April 4, 2017

I might be the only writer on the offshore beat who isn’t in love with Puerto Rico’s tax incentives.

Recently, a colleague of mine whom I greatly respect published an entire issue of his newsletter about Puerto Rico. To put it mildly, he’s now a believer in these incentives.

But I remain skeptical, for reasons I’ve written about before, here and here.

Here’s a summary of the “pitch” for Puerto Rico:

Since Puerto Rico is a US territory, not a state, under the federal tax code, the island has more latitude than states over how income is taxed. Tax incentives for US territories have come and gone over the years, but at present, the main federal tax incentive for Puerto Rico provides that bona fide residents of the territory need not pay income tax on “income derived from sources within Puerto Rico.”

By itself, this exemption is a nonstarter, because Puerto Rico taxes are much higher than those of any US state. The top rate is 33% on incomes above US$61,500 annually. Sales taxes are also higher than any US state, at 11.5%.

However, the exemption opens the door for local tax incentives. And Puerto Rico responded in 2012. Anyone who becomes a bona fide resident of Puerto Rico is now eligible for the following benefits, courtesy of this law, known as Act 22:

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

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

The law seems perfect 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) and want to reduce their federal tax liability on passive income. Best of all, Puerto Rico guarantees these provisions will remain in place until the end of 2035.

To qualify for benefits under Act 22, you must actually relocate to Puerto Rico. And you must satisfy the IRS definition of a “bona fide resident” of Puerto Rico for each year you seek to obtain them. That means:

  • You must be physically present in Puerto Rico at least 183 days annually;

  • You must not have a closer connection to the US or any other country than to Puerto Rico; and

  • Puerto Rico must be the center of your social, political, cultural, and religious activities.

But is this where you really want to live?

In many ways, Puerto Rico resembles a third-world country. More than 45% of its residents live in poverty, a rate three times higher than the US mainland. Infrastructure and public services are crumbling. Crime is rampant, with a murder rate five times that of the mainland.

The island’s economy has shrunk by one-sixth since 2006. It lost nearly 300,000 jobs and 12,000 businesses in that period as well. Nearly 10% of Puerto Rico’s residents have left – primarily to the US mainland – since 2000, with most of the losses occurring since 2010.

Many of Puerto Rico’s problems stem from its ongoing debt crisis and the measures Congress has imposed in response. Puerto Rico has a public debt exceeding $70 billion, and its municipal bonds have been downgraded to junk status. In 2016, it defaulted on roughly half of a $2 billion interest payment on its general obligation bonds – those given top priority by the island’s constitution.

To prevent that from happening again, after the default, Congress created a Financial Oversight and Management Board, which has total control over the island’s economy. It’s essentially a collection agency for the hedge funds that own much of Puerto Rico’s debt – and who persuaded the island legislature to enact Act 22 in 2012. The Board can enact any law that serves its interests and veto any Puerto Rican legislation that conflicts with its wishes. It reminds me a lot of the EU austerity program imposed on Greece.

The government has already reduced its workforce by more than a quarter, increased taxes – including a hike in the sales tax to 11.5% – and required government workers to pay much more for their pensions. Now the board is demanding pension cuts, furloughs of tens of thousands of workers, and the elimination of Christmas bonuses if the government cannot find other ways to cut spending and increase revenue.

Puerto Rico’s infrastructure is also crumbling. A case in point is PREPA, the government-owned electricity monopoly. In September 2016, Puerto Rico experienced an electricity blackout that lasted more than three days. But while local residents pay nearly twice as much for electricity than the mainland, PREPA actually gives electricity away for free to local municipalities, government-owned enterprises, and even some for-profit businesses. It also turns a blind eye to widespread electricity theft.

Now, PREPA is poised on the brink of bankruptcy. It owes creditors $9 billion, a debt it is trying to restructure by delaying principal payments to free up cash.

It’s easy to blame Puerto Rico for its own problems, and as PREPA demonstrates, there’s plenty of waste and mismanagement. But the crisis on the island is also a direct consequence of its territorial status and laws Congress can impose on it as a result.

A century-old law called the Jones Act is the most egregious example. The act requires all goods imported into or exported from Puerto Rico to be carried on US-flagged ships. Cargos bound for Puerto Rico on non-US ships must be unloaded at a US port and reloaded onto US-flagged ships. Exports from Puerto Rico to other countries must follow the same route in reverse. This system increases the price of both imported and exported goods and makes it more difficult for Puerto Rico export markets other than the US mainland.

The federal government also pays lower reimbursements for Medicaid and Medicare than on the mainland, transferring the burden to the insolvent government and its citizens.

It’s a complete mess, with no end in sight.

I’ve argued that Act 22 is unlikely to survive in its current form. I’m not so sure of that now, at least for the next few years. The hedge funds that have a stranglehold on Puerto Rico also have great influence in Congress. With Donald Trump in the White House and Republicans controlling both houses of Congress, Puerto Rico’s tax incentives won’t be on the short list of problems to tackle. About the only way those incentives will end is if they’re rolled back as part of the omnibus tax reform package Trump is pushing.

But ask yourself this: If you lived in Puerto Rico, how would you feel about a law giving the same billionaires who are forcing austerity down your throat the right to live essentially tax free on your island? Although the island legislature can no longer end Act 22 without Board approval, resentment against its wealthy beneficiaries is inevitable.

Do you really want to spend most of your time in Puerto Rico and make it the center of your vital interests?

That’s up to you of course. In the meantime, enjoy the tax savings while you’re sweltering in the dark and hoping you don’t get ambushed by angry locals.

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About The Author

Since 1990, Mark Nestmann has helped thousands of clients seeking wealth preservation and international tax planning solutions. He is the author of highly acclaimed Lifeboat Strategy and other books & reports dealing with these subjects.

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