In 2012, to spur job growth and economic activity in general, the Commonwealth of Puerto Rico introduced extraordinary tax incentives for incoming residents and service businesses.
Puerto Rico is no novice at sculpting tax rules to attract foreign investors and expatriates. For decades the country has offered tax incentives to many types of businesses, especially manufacturers, which is why today you’ll find plants belonging to Praxair, Merck, Pfizer, and other big names dotting the island’s lush interior.
Those incentives worked well to bring companies seeking low-wage, low-skill labor businesses that could help the economy move forward…but only so far. Eventually the door to foreign competition opened by NAFTA and other regulatory changes eroded Puerto Rico’s advantage over Mexico in exporting to the US.
So the Commonwealth government recently went a step further and passed tax incentives to in part make up for the dwindling return from previous tax incentive programs, culminating with the bell-ringing changes enacted in 2012.
That latest round of legislation focused on three economic trends that had been passing Puerto Rico by, even though the island was well qualified to ride them:
- The flow of investors and money managers from all over the world to stable, low tax jurisdictions, such as Singapore, Hong Kong, and the Cayman Islands;
- The boom in call centers and technical support facilities in low-cost, English speaking countries, especially India and the Philippines; and
- The aforementioned migration of America’s and Europe’s wealthier retirees and investors to warm, comfortable places.
As Puerto Rico aims to ride these trends, it has an advantage few competitors can hope to match.
Puerto Rico is a territorial possession of the US. Under the US Internal Revenue Code, an American who becomes a resident of Puerto Rico begins a second tax life: all the income the person earns from Puerto Rican sources is subject to Puerto Rican income tax only, not to US income tax.
No Need to Leave
It’s an upside-down situation. Being liable for tax on their worldwide income, Americans are effectively barred from accepting any low-tax offer made by an independent foreign country … but they’re free to accept any low-tax offer made by Puerto Rico.
Although it is not a state and is excepted out of many US laws, Puerto Rico is part of the US.
- Puerto Ricans are US citizens.
- The US dollar is legal tender and the only currency in common use.
- No passport or visa is required to travel to Puerto Rico from the US. It’s as simple as any domestic flight. It is a domestic flight-just a boarding pass and driver’s license (or other accepted ID) will get you there.
- No special permit or waiver is required for an American to work in Puerto Rico. You are as eligible as anyone born there to buy real estate, register to vote, or get a driver’s license.
- Moving to Puerto Rico is little different from moving to another state, except that the primary language is Spanish.
Puerto Ricans participate in (US) Social Security and Medicare, and thus are subject to payroll taxes. However, no resident of Puerto Rico is subject to US income tax on what he earns from Puerto Rican sources. Instead, a resident of Puerto Rico is subject to Puerto Rican income tax, which generally is levied at rates similar to US federal income tax rates-but with certain critical exceptions that are the focus of this report.
Specifically, for Puerto Rican residents and businesses that qualify-mostly expatriates from the US mainland or their enterprises-the recent Act 22 and Act 20 provide for a zero tax rate on capital gains and certain interest and dividends earned by individuals, and for single-digit tax rates on qualifying service income earned by corporations operating in Puerto Rico.
When we learned of the new tax laws, we were excited but skeptical. It sounded just too good to be true … or one of those things (like US Virgin Islands partnerships) whose complexity requires paying an army of lawyers. However, our investigation found that the apparent tax advantages are real and that for many Americans, including individuals operating on a modest scale, they are a huge opportunity.
Obtaining the benefits offered by Puerto Rico and allowed by the US Internal Revenue Code is a moderately complex matter, and it’s not a solution that will work for everyone.
Also, it’s not just a tax matter, since it would require you to become a resident of the island. But if you would be comfortable living there and you or your business is able to qualify, the rewards could be life-changing.
Bottom line: if you’re an American with significant investment income or have a service business that can be relocated, the Puerto Rico option might be for you.
The starting point is to get acquainted with Puerto Rico.
Not Quite a State, Not Quite a Foreign Country - A Modern History of Puerto Rico
Puerto Rico is 100 miles long (east to west) and 35 miles wide (north to south), about midway between the size of Rhode Island and Connecticut. It’s located about 1,000 miles southeast of Miami, from which it can be reached by a 2.5-hour flight (dozens of flights per day to Miami and New York City, and dozens more to other US destinations). The island has a tropical climate and is regularly visited by Atlantic hurricanes. Between the closest points, it’s 230 miles east of the Dominican Republic.
Christopher Columbus claimed the island for Spain in 1493 after his second voyage to the Americas. In 1898, in the aftermath of the Spanish-American War, the US took control of the island and embraced it as a somewhat self-governing colony. It had its own judicial system, and the public elected a local legislature, but its governor was appointed by the US president.
Today Puerto Rico is included in the US court system, with its own US Federal District Court. This allows much higher confidence that contracts and property rights will be respected than is possible in any Latin American county.
Despite the linkage to the US legal system, tax administration and the rest of the bureaucracy on the island operate at a Latin American tempo. Everything official takes longer, sometimes painfully longer, than in Western Europe or the US. Everything from opening a checking account to getting a driver’s license has the potential to turn into a time-consuming ordeal. We recommend taking a good book with you whenever you set off to fill out forms.
Separate Tax System
In many respects, Puerto Rico’s formal institutions emulate those on the US mainland, yet there is one notable exception: Puerto Rico has its own tax system, which is accommodated by provisions of US law (48 U.S.C. § 734).
Under Section 933 of the US Internal Revenue Code, income derived from sources within Puerto Rico by an individual who is resident in Puerto Rico for the year is exempt from US income tax. This is the crucial provision that allows mainland Americans who become Puerto Rican residents to benefit from the island’s new tax laws.
As a consequence of Section 933, a US citizen who is resident in Puerto Rico is taxable by the US only on his income from sources outside of Puerto Rico. If he derives all his income from Puerto Rican sources, he doesn’t even need to file a US tax return.
For many years, the Section 933 exemption meant little to a US mainlander. Tax rules and rates in Puerto Rico were close to those in the US, so relocating to Puerto Rico afforded no real benefit.
Now the benefit can be enormous, since the Puerto Rican government has adopted ultra-low tax rates for newly arriving investors and businesses that perform services locally for customers located outside of Puerto Rico.
With Section 933’s exemption, Puerto Rico realized that it had a tool no other jurisdiction could match.
Section 933 enables the government of Puerto Rico to offer Americans any benefit on locally generated income that low-tax countries offer to anyone who is not an American. The passage of Acts 22 and 20, which reduced taxes for incoming investors and businesses respectively, was an exercise of that ability.
Anyone who relocates to Puerto Rico can apply for the tax shelter of Acts 22 and 20-including mainland US citizens, who can find similar benefits nowhere else in the world.
Puerto Rico’s annual gross domestic product is roughly $100 billion, consisting primarily of manufacturing (chiefly pharmaceuticals and textiles) and services (tourism and finance). While the per-capita income is low by mainland US standards, for the Caribbean area, it’s near the top.
Although Puerto Rico has one of the most vibrant economies in the region, it still has problems. In fact, it’s Puerto Rico’s problems that gave rise to the new tax incentives.
Members of Casey Research who’ve made the move to Puerto Rico can attest that the first reaction of friends and relatives was concern about high crime rates. This is not surprising, given the cultural stereotypes, political history, and recent mainstream news coverage.
Puerto Rico’s official murder rate is 26 per 100,000 residents, which is about six times the US average. While that’s not a fetching invitation for a midnight stroll through a park in San Juan, it is 50% below Washington DC’s 20-year average and less than half Detroit’s recent rate of 55 per 100,000 residents. In fact, it puts Puerto Rico about halfway between St. Louis and Memphis on the FBI’s 2012 uniform crime statistics. By overall violent crime numbers, Puerto Rico doesn’t look at all like a dangerous place. If it were listed as a state, it would rank 19th for safety.
One Casey Research pioneer in Puerto Rico remarked, “Saying you won’t move to Puerto Rico because of crime is like saying you won’t move to Michigan because of Detroit. Or Maryland because of DC. Cities have crime, especially cities with high unemployment:’
We believe that’s a reasonable perspective, as 2.7 million of the commonwealth’s 3.7 million people live in the “San Juan-Carolina-Caguas, Puerto Rico Metropolitan Statistical Area:· It’s a dense, urban area, and it deserves the caveats that apply to most cities: there’s no better food, nightlife, shopping, etc. on the island, but those benefits come with bigcity negatives. And if those negatives are unacceptable to you, there are plenty of living options outside of San Juan that are very safe and are attractive for ex-mainlanders.
Government Finances and Debt
The financial condition of the Puerto Rican government is terrible. Public debt has outpaced economic growth for years, and Puerto Rican government bonds were downgraded to junk status early in 2014.
However, the current administration is serious about mending Puerto Rico’s public finances and has had some degree of success. The government is still running a deficit, but for the current fiscal year, it’s down to $750 million, the smallest amount of red ink since 2009. That said, they’re close to running out of borrowing power.
How exactly the situation will play out is unknown.
To escape its debt burden, Puerto Rico must either grow its economy and government revenues, cut spending, or default. A default would come without the programmed tidiness of a US bankruptcy proceeding, since, unlike Detroit, the Commonwealth is not eligible for the protections of the US Bankruptcy Code.
Puerto Rico’s predicament is similar to that of Greece: it borrowed in a currency it doesn’t control. Just as Greece can’t print euros to pay its debt, Puerto Rico can’t print dollars. However, rescue dynamics may work for Puerto Rico in much the same way as they aided Greece.
The EU came to the aid of Greece because it feared a default would cast a long shadow of doubt on the euro. If need be, the US may come to the aid of Puerto Rico to protect US banks that hold its bonds and to avoid the cost of added unemployment insurance claims-and to placate the millions of Puerto Ricans who live and vote in the US and for whom rescuing Puerto Rico would be a high priority.
Unemployment and Economic Growth
Crime and deficits both reflect broader economic factors. Economic growth, if it’s strong enough, will hold many government and social problems at bay. An employed populace generally means a level of crime that is tolerable.
Puerto Rico has been stagnating in economic recession for several years. Even by the official statistics, the unemployment rate has exceeded 15%. Weakness in the tourism industry (an echo of weakness in the US economy) is a contributing factor. Another source of Puerto Rico’s economic troubles was the expiration of previous tax incentives for manufacturers doing business on the island, which sent many companies looking elsewhere.
Now the Puerto Rican government is aiming to encourage economic growth in neglected industries. To compete more effectively for new business, they passed two critical laws at the end of 2012.
With the new laws, Puerto Rico is seeking to emulate the success of Singapore in attracting investors with favorable tax rates. They also would like to replicate India’s success in generating billions of dollars from their relatively unskilled but English-speaking labor force in service-related fields, such as document processing and call centers. Puerto Rican officials believe that because they: (i) have a deep pool of English-speaking residents (English is taught in all Puerto Rican schools); (ii) are closely connected to US institutions; and (iii) are geographically close to the US (in a time zone just one hour ahead of Eastern Time, except during Daylight Saving Time, when the time is identical to Eastern Time), they are well-positioned to provide services to US customers. Proximity also positions Puerto Rico as a convenient home for investors who largely trade in US markets and as a home base for investment managers who do the same for US clients.
The New Laws
To drive this growth, two laws were passed that give significant breaks to new residents of Puerto Rico or for businesses creating new job growth in knowledge-worker sectors.
The two laws are The Individual Investors Act (also known as Act 22) and the Export Services Act (Act 20). In short, they eliminate Puerto Rican tax on investment income earned by new residents (you cannot qualify if you have been a resident of Puerto Rico between 1997 and 2012) and reduce the effective tax rate on corporate earnings from exporting services to 4% (or 3% in certain situations).
The tax benefits under the two Acts are not automatic; you must apply for them. If granted, Act 20 benefits are valid for 20 years and Act 22 benefits are valid until 2035, though Act 20 has an untested provision for a ten-year extension. Act 20 has a sunset provision that goes into effect on December 31, 2020. This means that a company has until the year 2020 to obtain Act 20 status, the tax benefits of which would then last 20 years, or until 2040.
The benefits of Act 22 and Act 20 come to you as a legally binding private decree from the Puerto Rican government, which should protect you from changes in the law. However, the private decree allows the Puerto Rican government broad latitude to revoke the benefits of selected individuals or companies whenever it deems it no longer “in the best interests of Puerto Rico” for the benefits to continue. But, provided that you respect the letter and spirit of your decree, we think such a revocation would be unlikely, for reasons discussed later.
Puerto Rico has crafted Acts 22 and 20 well for enforcement and stability and has good reasons for keeping them on the books. But what about the US? Couldn’t the US government put a stop to the tax benefits?
For Americans who wish to take advantage of Act 22 or Act 20, the answer is, “Yes;· of course. But we believe interference from the US is highly unlikely.
The US government always has the power to pressure the Puerto Rican government to do anything, including rolling back Acts 22 and 20. Or the US Congress could change Internal Revenue Code Section 933-the key provision that protects Puerto Rican residents from US income tax on Puerto Rican-sourced income. But why would politicians in Washington do either of those things?
By US budget standards, the revenue lost by the US Treasury won’t amount to much, since there is a high bar for garnering the benefits-becoming a bona fide resident of the island. There is little opportunity for gaining those benefits without really contributing to the Puerto Rican economy. The US government understands that Puerto Rico desperately needs an economic boost to reduce unemployment and help the government manage its enormous debt-a debt Congress doesn’t want to get stuck with in a bailout.
Statehood for Puerto Rico also would extinguish the Act 22 and Act 20 benefits. But the statehood issue has languished for decades; it’s a question on which Puerto Ricans themselves are deeply divided. While some want Puerto Rico to become the 51 st state, just as many prefer the commonwealth status quo, and a few favor complete independence. There is no consensus-and no real incentive for the US to push the issue.
Still, it would be going too far to say there is no possibility that Act 22 and Act 20 might somehow go away. But weigh the odds.
The basic reality is that the island is unlikely to draw enough attention to its tax incentives to make it worth the trouble for US legislators to interfere, and the cost of any interference might come back to Congress in the form of an unpopular bailout. So the recently enacted incentives are likely to stick for a whole lot longer.
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