Dear Clients, Colleagues, and Friends: It has been a bit over 2 years since my esteemed colleague, Fernando Goyco, and I wrote an article about the Puerto Rico tax law Act 20 & 22 for Steve Leimberg’s Income Tax Planning Letter —
(Steve Leimberg’s Income Tax Planning Email Newsletter – Archive Message #44
Date: 23-Apr-13 From: Steve Leimberg’s Income Tax Planning Newsletter
Subject: Jeffrey M. Verdon & Fernando Goyco-Covas: Consider Moving to Puerto Rico to Eliminate Tax on Passive Income Exposure)
— extolling the virtues of the amazing new opportunities presented in Puerto Rico for both personal and business income tax planning. To refresh readers of the Client Alert, Act 20 eliminates capital gains tax on all Puerto Rico sourced income until the year 2034 provided you meet certain residency requirements, and Act 20 effectively reduces the tax on corporate profits to 4% (or 3% in certain special instances).
Since this article was published, we have received numerous telephone calls from U.S. taxpayers interested in determining if the new Puerto Rico tax laws will work for them. Answering their questions and sending them off to speak to their CPA’s, I would often get a message from the taxpayer that their CPA would discourage them from moving forward. The primary reason given by the CPA is that “Puerto Rico’s tax benefits are a ‘hype’ or too good to be true.”
Former United States Attorney for the U.S. Virgin Islands, David Nissman, Esq. (now in private practice), who prosecuted violators of Territory Tax laws, provides a helpful historical perspective on the geneses of the tax policy for these Territories and the reasons the U.S. government sanctions these laws:
When the United States began its relationship with Puerto Rico and the other Caribbean territories in 1898 following the Spanish-American War, Puerto Rico and the territories were left poor and economically oppressed. The U.S. Government recognized these territories were not financially independent and would, thus, become an economic burden on the U.S. Government.
From the start, U.S. merchants were being asked to pay additional duties on goods emanating from Puerto Rico and, thus, challenged the constitutionality of Article 1, Section 8, of the U.S. Constitution, which requires that “all duties, imports, and excises shall be uniform throughout the United States”. The U.S. Supreme Court, in a line of cases known as the “Insular Cases”, used a line of twisted logic and racially insensitive reasoning to accord all inhabitants of the Territories less than full constitutional rights. The trade-off from the Insular Cases was that the Territories’ ability to use special tax laws to develop their economies was not restrained by Article 1, Section 8.
This policy began in 1900 with the adoption of the Foraker Act which set up the first municipal government in Puerto Rico and permitted Puerto Rico to utilize special taxing measures. During the past 115 years since the Foraker Act, Congress and the local governments in the U.S. Territories have enacted many programs to help the Territories raise revenues to lighten the burden of the United States.
Further evidence of the U.S. Government’s support of this policy is the enactment of 26 USC 933 (Puerto Rico) and Section 934 (the U.S. Virgin Islands) passed by Congress enabling the local governments to grant benefits on territorial source income to territorial residents. These laws have been firmly in place since 1960. In 2004, Congress added 26 USC 937 to codify sourcing and residency rules. This begs the question: Why would Congress go through the trouble to pass these laws if they didn’t intend to honor them or then repeal them?
The Territories have a very special status — according to the U.S. Supreme Court case law, the Territories have the status of federal agencies. If a federal agency grants a contract to a business or individual, the federal government is bound by it; otherwise, it will violate the Contract Clause of the U.S. Constitution to invalidate it. Thus, if an individual or business enters into a contract with the Puerto Rico Government granting tax benefits (Act 20 & 22), the contract is enforceable against both Puerto Rico and the U.S. Governments. Congress cannot affect existing contracts.
Act 20 and Act 22 are carefully considered programs. The Puerto Rico Government based Act 20 on the Virgin Islands Economic Development Commission programs. These programs have been fully vetted and litigated in the federal courts. The legitimacy of these programs are undisputed, and they are a part of the U.S. developmental policy towards the U.S. Territories. The Puerto Rico Government made some improvements to the Virgin Islands program, and it is expected that the U.S. Government will treat Act 20 and Act 22 in a consistent manner.
While it is clear that Congress has been considering reforming the U.S. tax code, the aforementioned dynamics and the U.S. Government’s policies toward providing incentives to help bring additional revenue and business to these Territories is undisputed. The Puerto Rico Government is not likely to end these programs because they are designed to attract wealthy people and profitable business to relocate to Puerto Rico through these programs and supported by both political parties in Puerto Rico. Given the current financial crisis in Puerto Rico, it is unlikely that the local government — which has committed large resources to marketing these programs — will suddenly revoke the programs.
In closing, the U.S. Department of Interior continues to recognize that the Territorial tax incentives are a necessary component of the U.S. policy towards its Territories. Those that lawfully fulfill the purpose and requirements of the Territorial tax incentive programs — like Puerto Rico’s Act 20 & Act 22 — and do not attempt to “game” the system should be confident that their contracts will be honored by both governments.
Since we published the aforementioned article on Act 20 & 22, Puerto Rico has expanded the kinds of business services to which Act 20 will apply:
- Advertising and public relations
- Advice on matters relating to any trade or business
- Commercial arts and graphic services
- Production of construction drawings, architectural and engineering services, and project management
- Professional services, such as legal, tax, and accounting
- Centralized management services
- Centers for electronic data processing
- Development of computer programs
- Telecommunications voice and data between persons located outside of Puerto Rico
- Call centers
- Shared service centers
- Storage and distribution centers
- Educational and training services
- Hospitals and laboratories
- Investment banking and other financial services
- Any other service that is later decided to be treated as an eligible service because it is in the best interest of Puerto Rico
Many owners of businesses operating in the continental United States are unaware their business operations can be separated into component operations, some of which could be managed in Puerto Rico. In doing so, the taxable income of the Puerto Rico operations that would qualify under Act 20 would result in a 4% Federal tax liability. Obviously, these situations must be carefully analyzed, but wouldn’t it make good sense to find out if it would?
If you would like to know if you or your business could benefit by qualifying under Act 20 & 22, contact us as noted below and we will help determine if you or your business would be a viable candidate and how best to gain these benefits.