Puerto Rico Debt Crisis May Force Changes in Tax Incentives

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Puerto Rico is struggling under $72 billion in debt that is forcing the territory to make some tough choices.

Without a federal bailout or the ability to claim bankruptcy, Puerto Rico’s only option is negotiation, which could mean eliminating some of the pricey tax incentives it offers to entice businesses and high net worth individuals to relocate to its shores.

The tax incentives have enabled small and midsize U.S. companies in several sectors, including IT, consulting and financial services, to cut their tax burden significantly—sometimes by up to 50 percent—without needing to expatriate.

Ramon Camacho, principal and international tax technical lead of McGladrey’s Washington National Tax Practice, believes there is a risk the incentives will be eradicated, significantly increasing tax burdens of U.S. companies that have relocated to Puerto Rico.

Those tax incentives might be eliminated the way earlier federal tax breaks that attracted pharmaceutical companies to set up shop in Puerto Rico eventually went away.

“There were incentives provided for companies that essentially did development of various types of technology and other kinds of manufacturing,” said Camacho. “They were very large incentives for folks who set up shop there, produced things there and resold them somewhere else. Over the years large Fortune 100 companies set up very big installations in Puerto Rico to research things and develop drugs. Pharmaceutical companies were there in droves, and some of them still are there. Those benefits were phased out and largely eliminated with some legislation in 1996. Many people point to that as the beginning of the end for their economy. When those incentives went away, those companies didn’t necessarily pull up stakes, but they didn’t make any further investments and they sort of let things trickle away. In the course of all these years, we’re starting to see the effect of that in a major way.”

In recent years, the Puerto Rican government put in place its own local tax incentives that were designed to attract business, initially in the service sector. Those incentives later expanded to include other companies, including those that buy and sell property and financial assets.

“This whole regime allowed people to go to Puerto Rico, relocate their business and essentially pay 4 percent tax on their business income,” said Camacho. “Then when that money is remitted back to the U.S. owners, it could be subject to tax of the qualified dividend rate, which is 20 percent, plus 3.8 percent Medicare tax. Companies like asset management firms and financial services firms have taken advantage of this regime. But it’s a very broad regime and all sorts of people can take advantage of it. People in the consulting business and the accounting business, for example, can go there and qualify. A lot of people have gone, especially from high rate jurisdictions like New York and California, where the state tax is also very high, because those people are looking at essentially 50+ percentage points in effective tax if they were residents of those jurisdictions. This regime would allow you to move there and at a minimum get yourself down to 4 percent local tax, plus the qualified dividend rate and the 3.8 percent tax. That’s for people who just moved their business and didn’t move themselves.”

Financial firms and asset management businesses found the tax incentives especially enticing, especially since they didn’t need to relocate entirely.

“There may be 40 or 50 professionals sitting in Connecticut or New York City providing advice, getting asset management fees and doing a lot of things on Excel spreadsheets,” said Camacho. “Those guys can list the business, take it to Puerto Rico, and that business income will be subject to 4 percent there. If the principals of the business stay resident in New York City, they will pay another tax when money comes out of Puerto Rico of basically 23.8 percent, plus their New York state tax. That gets them down to well below 50 percent effective tax. If the owners of that business decide to move to Puerto Rico and become residents of Puerto Rico, which is what a lot of people are doing—when they move their business, they also go too—they can qualify for an exemption in the federal tax code for Puerto Rican sourced income, which includes dividends from Puerto Rico companies in certain circumstances. That would mean they would pay no federal tax on a distribution out of say an asset management firm that is Puerto Rican and is doing services in Puerto Rico.”

That tax regime emerged in 2012, and prompted many Americans to take advantage of it.

“People have been moving to Puerto Rico because you can go there and effectively, if you fall into this little scenario I’ve just described, it’s like you’ve left the country,” said Camacho. “You’ve expatriated essentially. You’re out of the federal tax system, but you’re not out of the U.S. It’s a huge benefit. You don’t have all these crazy expatriation rules that apply when you leave. You don’t have to notify the Department of State or whatever. You don’t have to give up your passport. You still have access to the federal court system and all the protections of the federal government, but now you’ve largely taken yourself out of the federal tax system. That’s been a big draw for people who are looking at it.”

Camacho noted that the tax incentives proved irresistible to many people, but now there is no guarantee they will remain in place, given the current debt crisis.

“I’m sure there’s already quite a bit of pressure from the creditors to reform that as part of their negotiation,” said Camacho. “That’s going to be a big deal, and in a way that wasn’t a factor in Detroit or in any of the other municipal crises that we’ve seen because Puerto Rico doesn’t have access to the bankruptcy courts. It’s not a state, so it only gets out of this if it negotiates its way out of it.”

Even businesses that have industrial tax exemption agreements with the government may find themselves losing out if Puerto Rico defaults on its debt or passes legislation changing the rules.

“The folks who have these exemption rulings are pretty confident they’re not going to go away because they tend to be drafted as contracts with the government,” said Camacho. “People think of those things as pretty binding, but the problem is these contracts can essentially be rewritten. I can see legislation being passed that says, ‘OK, we’re going to change these rulings. We’re not going to honor them.’ At a minimum, I can see them being revoked on a go-forward basis.”

He advises those who are thinking of relocating their businesses to Puerto Rico to consider the impact if the tax incentives disappear.

“If anybody is thinking about going there who hasn’t gone there, it may not be the best time to put down stakes and start looking into trying to take advantage of one of these regimes,” said Camacho.

Besides tax incentives for manufacturing, banking and export services, Puerto Rico has also offered incentives for high net worth individuals to move to the territory.

“They’re looking to attract people with money,” said Camacho. “What they’ve done is say if you’re a Puerto Rican resident, after a certain date, you can exclude from income, for Puerto Rican purposes, all manner of passive income. So if you’re a retired founder of a company and you’ve sold off your shares and you’re sitting on bonds or whatever, you can move there and not pay any Puerto Rican tax on your bond income. If you go further, you can take those moneys and translate them into Puerto Rican companies, so you can buy preferred shares of Puerto Rican companies and it won’t be taxable on your dividend income because of that exemption from federal tax. Then there won’t be any tax at the local level either.”

Some people think that can be a dicey proposition, Camacho noted. “There are private placements of dividend-paying preferreds that have gone off at some of the large public companies that are actually based in Puerto Rico,” he added. “There are a number of banks and insurance companies that are pretty sizable there, and they have benefited from some of these regimes because basically they have marketed themselves out under this second regime. People who have a high net worth, and are maybe in a sort of retirement mode, or just have a lot of assets that they’re looking to invest, will buy a large quantity of preferred shares paying a decent dividend because they have a preference on the company, and if they do become residents, it becomes tax-free income. Even the folks who are money managers making 20 to 100 million dollars a year in net income in their business managing a multibillion-dollar portfolio, what do they do with that money? They’ve got to put it somewhere. So they will invest it in those types of instruments, and it’s a win-win.”

Camacho wonders how long such a tax regime can survive when Puerto Rico is in danger of defaulting on a sizable amount of debt.

“You look at the people who are benefiting from some of these things and it’s not Ma and Pa Kettle,” he said. “It is money managers, and people who are making a lot of money. Maybe some people think these are not the kinds of people who should be getting tax benefits, especially at the cost of public services and if the government has to increase regressive sales taxes, which they are doing. They just jacked up the VAT in Puerto Rico recently. That’s something that’s basically going to hit the working stiff in Puerto Rico. When you see a lot of that going on, eventually there’s going to be a ton of pressure on regimes that are providing fairly sizable benefits to people who make gobs of money. I just see it as a logical set of dominos that are going to fall. People who are looking at Puerto Rico in a serious way just need to tread very carefully or at least be prepared to be nimble.”

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