ACT 22

Act 22, or “The Act to Promote the Relocation of Investors to Puerto Rico,” was enacted to attract high-net-worth individuals to the island and encourage investment in the local economy.

Like Act 20, Act 22 provides tax benefits to individuals who establish residency in Puerto Rico.

The Individual Investors Act (Act 22)

Puerto Rico’s objective in enacting Act 22 is to attract individual investors to live and spend on the island. The bait is a zero tax rate on investment income.

Act 22 is pretty straightforward. It completely exempts new residents from Puerto Rican taxation on dividends, interest, and capital gains that accrue after becoming a resident of Puerto Rico. Given that Puerto Rican residents are also exempt from US income tax on Puerto Rican-sourced income, Act 22 means tax freedom for individual Americans who can arrange for their investment income to arise from Puerto Rican sources. Doing so doesn’t require as much magic as you might think.

CAPITAL GAINS

Capital gains are where the main benefit of Act 22 lies.

The country source for capital gains on the sale of securities and other personal property is your place of residence, so gains on stocks, bonds, or other personal property, like precious metals, that you recognize while a resident of Puerto Rico are treated as Puerto Rican-sourced income and thus eligible for exemption under Act 22.

This means that even if you keep your E-Trade, Fidelity, or other US brokerage account, while you are a bona fide Puerto Rican resident, capital gains earned in those accounts count as Puerto Rico-sourced income and can qualify for Act 22 treatment.

Capital gains from any appreciation that accrued before you moved to Puerto Rico is treated differently. Such capital gain is taxed by Puerto Rico at the effective capital gain tax rate at the time it is realized (currently 10%) during the first 10 years of residency and at 5% thereafter, and it is also taxed by the US. The US, with a 20% top rate on capital gains (28% for precious metals), would give you a credit for the Puerto Rican tax, so the effective rate of tax would be the higher tax rate, i.e., moving to Puerto Rico does nothing to shelter previous appreciation from tax.

SPLITTING THE PROFITS

Determining how to split a capital gain between appreciation that happened before you moved to Puerto Rico and appreciation that happened while you were there depends on the type of property.

For investments that are traded in a public market, such as listed stocks and precious metals, you start by noting the investment’s price on the day of your move to the island. All profit up to that price is considered to have been earned before your move (and is taxable by Puerto Rico and the US). The rest of the profit is considered to have accrued while you were in Puerto Rico (and is taxed by no one).

For example, suppose Charlie, a mainland US investor, purchased stock for $40 on January 2, 2010. Then he moves to Puerto Rico on January 2, 2014, on which day the stock is worth $100.

Later, on January 2, 2016, Charlie sells the stock for $200, for a capital gain of $160 ($60 of which accrued prior to moving to Puerto Rico and $100 of which accrued after moving).

  • The $60 capital gain that accrued between January 2, 2010 and January 2, 2014 will be taxed by Puerto Rico at 10% and by the US (under current rules, at 20%). Because the US will allow Charlie a credit for the Puerto Rican tax, the effective total tax rate is 20%, just as though Charlie had stayed on the mainland.
  • The $100 capital gain that accrued from January 2, 2014 to January 2, 2016 will be exempt from US tax, since Charlie was a Puerto Rican resident for all of that period. It also will be exempt from Puerto Rican taxes under Act 22. Charlie keeps the entire $100.

For non-marketable stocks and other interests in private companies, there is no clear and simple way to establish the value as of the day you become a Puerto Rican resident. To deal with that difficulty, the rules pretend that appreciation in a private security you took with you to Puerto Rico happened evenly day by day from the time you bought it while living on the mainland to the time you sold it while living in Puerto Rico.

For example, if you bought stock in your brother-in-law’s car-wash corporation 100 days before you moved and sold it at a profit 200 days after you arrived in Puerto Rico, one-third of the gain would be treated as having accrued while you were still on the mainland (fully taxable), and two-thirds would be treated as having accrued while you were a Puerto Rican resident (tax free).

DIVIDENDS AND INTEREST

The country source of interest and dividends is the tax residence of the payer. So the only way mainland Americans can benefit from Act 22 with regard to interest or dividends is if the payer’s tax residence is Puerto Rico, which would make the income’s source Puerto Rico. This has some appeal, especially for those receiving dividends from Act 20 companies.

If you hold bank CDs as part of your portfolio, you could replace them with CDs of Puerto Rican banks (whose deposits are covered by FDIC insurance) to produce income that is completely free of tax.

A NOTE ON RETIREMENT INCOME

Withdrawals from an IRA, 401(k), or other US tax-deferred retirement account would not be covered by Act 22. So moving to the island won’t lessen the tax on withdrawals. The situation is the same with Social Security and other pension income.

Puerto Rico has its own IRA system, with both traditional and Roth plans, but it is distinct from the US IRA system. Income from employment in Puerto Rico cannot be contributed to a US IRA and vice versa.

For a resident of Puerto Rico, a distribution from a US Roth IRA would be taxable by the Puerto Rican government. That is, unless the US Roth IRA is liquidated and the proceeds are used to contribute to a Puerto Rican Roth IRA (subject to contribution limits, which are similar to the US). The opposite is true as well.

A distribution from a US traditional IRA to a Puerto Rico resident would be taxable by both the US and the Puerto Rican government, unless it is liquidated and the proceeds are used to contribute (subject to contribution limits) to a Puerto Rican traditional IRA, in which case the distribution would only be taxable by the Puerto Rican government. Again, the opposite scenario is true as well. For taxable distributions, the availability of a credit from either government for tax paid to the other prevents double taxation, and you end up effectively only paying the higher rate.

Despite the many similarities to a US IRA (more details here), a critical difference makes a Puerto Rican IRA considerably less useful: Puerto Rican IRAs allow very little investment freedom-they must invest at least 34% of contributions into obligations of the Commonwealth of Puerto Rico.

Assuming that your investments are covered by Act 22 and that your business is covered by Act 20, there would be little current advantage in funding a Puerto Rican IRA.

We see no advantage to pouring your US IRA into a Puerto Rican IRA.

APPLYING FOR ACT 22

To obtain the benefits of Act 22, you must submit an application to the Office of Industrial Tax Exemption (OITE) of Puerto Rico at the Department of Economic Development and Commerce. The actual application can be found by clicking here (for reference purposes only, as it may have been superseded after the publication of this report).

The application asks about your net worth, investment activity, residence history and criminal history, and requires a background check. Expect a decision on the application to take at least a month; it may take longer if there is anything about you that is especially interesting. Note that the OITE does not routinely acknowledge receipt of Act 22 applications, but it will give you your case number if you call and ask for it. Allow time for delivery and file creation-about 30 calendar days. Some OITE personnel speak English well, but most are more fluent in Spanish.

Even though the application is simple, there may be follow-up questions, especially if your case is anything other than straightforward. The safest approach-especially if you don’t speak Spanish or if your case comes with nuances that may need careful explanation or interpretation-is to get help from a Puerto Rican attorney or tax accountant who is familiar with the process. Some members of the Casey team have applied for Act 22 status themselves and have succeeded without hiring help. Others have succeeded using local attorneys.

ACT 22 CONCLUSIONS

Act 22 is particularly attractive for individuals who expect to generate significant capital gains. The combination of Act 22 with Section 933 of the US Internal Revenue Code gives a mainland American who moves to Puerto Rico a door to escape taxation on certain investment income that otherwise could be opened only by renunciation.

Act 22 allows a migrating American investor to eliminate taxes on:

  • Capital gains on securities (stocks, bonds, and derivatives) and other personal property (e.g., precious metals) that accrue after the move to Puerto Rico
  • The portion of capital gains on securities in private companies allocated to the period during which the investor is resident in Puerto Rico
  • Interest and dividends from Puerto Rican sources, including, most notably, dividends from Puerto Rican corporations that benefit from Act 22’s companion law, Act 20.

For more information about Act 22, please contact Lisa Nadal, Esq. at 787-525-8050   lnadal@taxcreditsint.com .

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