20/22 Vision – Tax Consequences for Puerto Rico

In International Tax, Offshore Tax by Zach MontgomeryLeave a Comment

In 2012, Puerto Rico enacted two pieces of legislation to encourage and attract an infusion of foreign capital—Act 20 and Act 22. These two acts provide tax incentives for both individuals and businesses depending on their circumstances. Taxpayers looking for tax-saving opportunities should consider the benefits of these two acts, especially in relation to the U.S. tax system and recent tax reform.

Act 20 – The Act to Promote the Export of Services

Puerto Rico Act 20 aims to attract corporate investment in Puerto Rico through tax incentives. In fact, its purpose is “to provide the adequate environment and opportunities to develop Puerto Rico as an international service center, encourage local professionals to stay and return, and attract foreign capital, thus promoting the economic development and social betterment of Puerto Rico . . . .”[1]

Under Act 20, an entity with an office (or bona fide establishment) located in Puerto Rico, which carries out eligible services may be considered an eligible business subject to a fixed income tax rate of four percent(4%)—three percent (3%) if the business’s services are strategicservices.[2]Eligible services are those considered services for exportand include activities, such as research and development; advertising and public relations; economic, environmental, technological, scientific, managerial, marketing, human resources, computer, and auditing consulting services; professional services such as legal, tax, and accounting services; centralized management services; electronic data processing centers; call centers; and investment banking and other financial services.[3]

Further, Section 7 of Act 20 allows for zero income tax on distributions from an eligible business to its shareholders, partners, or members.[4]Moreover, once an entity is considered an eligible business, the eligible business will enjoy the benefits of Act 20 for 20 years with the possibility of obtaining a 10-year extension.[5]

Act 22 – The Act to Promote the Relocation of Individual Investors to Puerto Rico

Puerto Rico Act 22 strives “to attract new residents to Puerto Rico by providing a total exemption from Puerto Rico income taxes on all passive income realized or accrued after such individuals become bona fide residents of Puerto Rico.”[6]

Under Act 22, income derived from interest and dividends earned by a resident individual investor is completely tax-exempt.[7]Further, capital gains may be completely tax exempt if (1) the gain is recognized prior to December 31, 2035, and (2) the appreciation occurs afterthe individual becomes a resident of Puerto Rico.[8]To be considered a resident individual investor, the individual must not have been a resident of Puerto Rico for the 15 years prior to 2012 and must become a resident of Puerto Rico not later than December 31, 2035.[9]

It is important to note that timing is crucial in the analysis of whether an individual is exempt from Puerto Rico taxes. An individual’s status is largely dependent on timing and becoming a resident individual investor. Then, passive income earned afterthe individual becomes a resident individual investor will be exempt from Puerto Rico taxes. However, there is an exception for built-in capital gains. If a resident individual investor has a net long-term capital gain, which appreciated prior to the individual becoming a resident, but the gain is recognized after he or she becomes a resident, the gain will be appropriately apportioned.[10]

What about U.S. Taxation and Tax Reform?

Acts 20 and 22 are important Puerto Rican legislative measures to infuse capital and investment in Puerto Rico’s economy. The tax incentives for businesses and individuals are very attractive when evaluating them based on Puerto Rico taxation. However, do the advantages also translate to U.S. taxes?

According to Section 933 of the Internal Revenue Code, an individual who is a bona fide resident of Puerto Rico shall not include any income derived from sources within Puerto Rico as taxable gross income for U.S. tax purposes.[11]However, income derived from sources without Puerto Rico will still be subject to U.S. taxes even if an individual is a bona fide resident.

What is a bona fide resident of Puerto Rico? According to Section 937 of the Code, an individual must be present in Puerto Rico for at least 183 days during the taxable year, the individual must not have a tax home other than Puerto Rico, and the individual must not have a closer connection to the United States or any foreign country than to Puerto Rico.[12]This determination is based on various factors, such as the location of the individual’s permanent home; the location of the individual’s family; the location of the individual’s personal belongings; and the location of the social, political, cultural, or religious organizations with which the individual has a current relationship.

President Trump signed The Tax Cuts and Jobs Act, 115 P.L. 97, into law on December 22, 2017. The tax reform legislation presents many changes to U.S. taxation, especially on the international front. In particular, the tax reform pushes the U.S. tax system more towards a territorial tax system rather than a worldwide tax system. For Puerto Rico, Acts 20 and 22 are still in effect. As a result, bona fide residents of Puerto Rico and eligible businesses may still enjoy the Puerto Rico tax benefits as discussed above. It should be noted, however, that there are certain provisions of the new tax reform, such as Global Intangible Low-Taxed Income (“GILTI”), that could prove to be an issue for taxpayers in Puerto Rico (I’ll discuss this in a later post). Overall, taxpayers should explore the tax-savings opportunities offered by Puerto Rico’s Acts 20 and 22 and weigh them in the balance with their current U.S. tax situations.

[1]13 L.P.R.A. § 10831.

[2]13 L.P.R.A. § 10832 (“The determination of whether certain services constitute strategic services shall be made on the basis of the characteristics, attributes, or special or striking qualities of the service in question that benefit the socioeconomic development of Puerto Rico.”).

[3]13 L.P.R.A. § 10831.

[4]13 L.P.R.A. § 10834.

[5]13 L.P.R.A. § 10831.

[6]13 L.P.R.A. § 10851.

[7]13 L.P.R.A. § 10852.

[8]13 L.P.R.A. § 10853.

[9]13 L.P.R.A. § 10851.

[10]13 L.P.R.A. § 10853(a).

[11]I.R.C. § 933(a).

[12]I.R.C. § 933(a)(1)-(2).

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