The Puerto Rican government has seen India’s success in generating billions of dollars and thousands of jobs for its relatively unskilled labor force in service-related fields, and without the environmental costs that manufacturing can bring.
Puerto Rican politicians have also witnessed the influx of investment firms to low-tax jurisdictions with stable financial systems, like Hong Kong and Singapore, as well as Panama, the Cayman Islands, and Bermuda.
Their response was Act 20.
Act 20 limits the tax rate on corporate earnings from exporting services from Puerto Rico-that is to say, performing services (not manufacturing a product) in Puerto Rico for clients outside of Puerto Rico to just 4%.
Under the US Internal Revenue Code, the country source of service income is the jurisdiction where the service is performed. The location of the client or other buyer of the service doesn’t matter. Thus, income earned by performing a service entirely in Puerto Rico is Puerto Rico-sourced income, even if the customer is sitting in Chicago. So under US Internal Revenue Code Section 933 and Section 861, if the person performing the service (whether an individual or a corporation) is a Puerto Rican resident working in Puerto Rico, the income is exempt from US tax. Puerto Rican corporations are considered foreign corporations for US tax purposes.
The “entirely” is a critical point. If the Puerto Rican resident (whether an individual or a company) that performs the service maintains an office or agent in the US that is involved in performing the service, the income will be taxable by the US. So to benefit from Act 20, your business must avoid doing anything in the US that contributes to producing the service.
That’s a tax rule that tends to invite arguments. Generally speaking, a sales meeting in the US with a customer or potential customer would not drag the service income back into the US, the logic being that selling a service is not an element in performing the service. Fixing things or giving training related to the service from the US probably would make the income taxable in the US. Maintaining a sales office in the US is problematic unless it demonstrably restricts itself to selling only.
Income from services that can be rendered entirely from Puerto Rico, such as computer programming, graphic design, document processing, call center work, asset management or financial planning, or any consulting that doesn’t require a US presence-would clearly qualify as Puerto Rico-sourced income.
Additionally, income from trading stocks, other securities, or commodities while you are a resident of Puerto Rico-for your own account or others-is Puerto Rico-sourced income.
For qualifying Puerto Rican corporations, tax on services performed in Puerto Rico for non-Puerto Rican customers is only 4% (collected as withholding on dividends paid to shareholders). A shareholder is exempt from Puerto Rican personal income tax on the dividends he receives, and under IRC Section 933 is exempt from US personal income tax. So the maximum total tax rate on the service income is 4%.
Apart from the 4% withholding, there is no Puerto Rican tax on dividends paid to nonresident shareholders. So a US shareholder who stayed on the mainland and who would be paying US tax on the dividends would not be disadvantaged by the business being in Puerto Rico, even though the Puerto Rican resident shareholders could still benefit from the combination of Act 22 and Act 20. Also, a dividend from an Act 20 company paid to a US mainland shareholder may be considered a qualified dividend, which is taxed at a preferential rate.
Act 20 has been particularly popular with hedge fund and private equity managers who relocate to Puerto Rico and earn fees for services to US clients. But it is certainly not just hedge funds that can benefit.
The following is a non-comprehensive list of services that Act 20 specifically defines as an “eligible business”:
- Research and development
- Advertising and public relations
- Commercial art and graphics services
- Architectural and engineering services
- Professional services (such as legal, tax, and accounting services)
- Data processing
- Computer programming
- Call centers
- Remote medical services
- Educational and training services
- Shared service centers
- Investment banking and other financial services
Act 20 is also a powerful incentive for American entrepreneurs to set up and grow a service-related business in Puerto Rico. And the island is open for business. The World Bank ranks Puerto Rico as the most business-friendly jurisdiction (relatively few and simple regulations, good protection of property rights) in Latin America.
Other important benefits of Act 20:
- The withholding tax rate may drop from 4% to 3% if more than 90% of a company’s gross income is derived from exporting services and the Puerto Rican government deems such services “strategic;’ which generally means that rendering such services from Puerto Rico is in “the Island’s best economic and social interest.”
- Some corporations may receive a 100% property tax exemption for the initial five years of operation. After the five-year period, a 90% tax exemption will apply for the remainder of the Act 20 decree. This benefit is mostly granted only to call centers, shared service centers, or companies that move their headquarters to Puerto Rico.
APPLYING FOR ACT 20
A Puerto Rican corporation can apply for Act 20 status immediately after it has been formed. Applications are made to the Office of Industrial Tax Exemption of Puerto Rico at the Department of Economic Development and Commerce. The actual application for Act 20 can be found by clicking here (again, this is for reference only).
Submitting the application is only the start of a process. The OITE will perform conventional due diligence on the company and its management. The government has the sole discretion to grant or withhold Act 20 status; in principle, the decision depends on whether the proposed business involves an “eligible business” (see above) or if the company appears to be “in the best interests of Puerto Rico:’
“The best interests of Puerto Rico” is a flexible concept, and the direction of the flexing will depend on the politicians in power from time to time. Needless to say, at any point the government can change the rules for new applicants.
At the time of publishing, the written and unwritten requirements for a successful Act 20 application are:
- Answering detailed questions about the nature of your business
- Providing basic revenue and profit growth projections for three years
- Generating at least three payroll jobs in Puerto Rico, with plans for growth beyond that being a major consideration
For someone running a particularly small shop, like a single-person consulting practice, the unwritten requirement for the business to generate at least three jobs may be a serious barrier. However, a relocated owner counts as one employee if he pays himself a reasonable salary ($60,000 to $75,000 generally would be enough). A spouse can be on the payroll as well, at a reasonable salary, and count as employee number two. And the third man? That would be a local who might make himself useful as a janitor, security guard, receptionist, driver, or some such work.
In any case, notice that any need to recast yourself as an employee cuts into the overall tax advantage we’ve been discussing, since your salary would be subject to Puerto Rican income tax as well as payroll taxes, Social Security, and Medicare. The same would apply to salary paid to a spouse and to your third employee. Add up the three-person payroll, and you find that Act 20 benefits don’t really start until the income of your service business passes $150,000 or so.
For significant earners or established businesses that could usefully hire locally, the tax benefits can still be substantial. If you are a small startup looking to grow, sharing your plans for hiring during the three-year period the government is thinking about should get you past having to satisfy the employment requirement on day one. Especially if those hiring plans include the local labor force, which has a supply of not just lowskilled workers, but also capable, English-speaking professionals in diverse fields. But those projections must be made in good faith, and it would be a good idea to include information on your financing to back up your projections.
What about a sole proprietorship? Given the three-employee rule, your prospects are limited but not quite nil. We’ve inquired about the possibilities for an individual whose work has no need for local assistance, such as a speaker, writer, or highly specialized consultant. The OITE will consider an application from such a person, but so far it has provided no encouragement or guidance.
Decisions by the Puerto Rican government on whether to grant Act 20 benefits generally take three or four months, depending on the size and complexity of the business proposed.
The Puerto Rican government will also conduct an annual review to determine whether your business is meeting its growth targets and whether it is still “in the best interests of Puerto Rico’.’ While the Act 20 benefits are enshrined in a legally binding private decree, the decree provides for the Puerto Rican authorities to terminate the arrangement prospectively (which most likely would be as of the start of the following year). Our reading is that the Puerto Rican government would be reluctant to revoke the Act 20 status of a legitimate business that is employing people who otherwise might be jobless. Nonetheless, a termination would be a serious blow for someone who has gone to the trouble and expense of relocating his business to Puerto Rico, so it is a risk to reflect on before moving.
RELOCATING EXISTING SERVICE BUSINESS TO PUERTO RICO
The tidiest approach to moving an existing business to Puerto Rico is to take the whole thing with you, including all the employees who like sunshine. That will leave you with no doubt that the services you generate in Puerto Rico are generated there in their entirety, so that the income is not subject to US tax.
Second best (for tax clarity) is to relocate the production of distinct services to Puerto Rico and leave behind, in a separate US company, any activities that are not practical to move. That would mean billing clients separately for services from the US company and for services from the Puerto Rican company.
The messiest strategy for a partial move is for the US company to buy or sell services from or to the Puerto Rican company. It’s messy because it takes you into the highly technical tax rules for “transfer pricing;’ and highly technical tax rules make for highly expensive legal bills. This approach is practical only for a large business.
ACT 20 CONCLUSIONS
Act 20 offers enormous tax benefits for owners of service-related business that relocate to Puerto Rico:
- A top 4% withholding tax rate on earning from exported services for 20 years
- No personal income tax on corporate distributions to Puerto Rican residents
- For certain businesses, a 100% property tax exemption for the first five years and a 90% exemption thereafter until expiration of Act 20 decree.
For more information about Act 20, please contact Lisa Nadal, Esq. at 787-525-8050 firstname.lastname@example.org .