Overview

Every financial media outlet (including Bloomberg and the Wall Street Journal) in the last several weeks has run an article on the possibility of billionaire hedge fund manager becoming a Puerto Rican resident. Having grown up in the Panama Canal Zone, and being a double major in college in Spanish and Portuguese, may not qualify to offer investment advise but I know a thing or two, about heat and humidity. Additionally, I can throw in a decade of living in Miami as well as well as being a “major league” fan of Afro-Cuban music aka Salsa. The temptation to unleash a couple of one-liners in the current situation is too great.

For starters, Mr. Paulsen may have the financial credentials but lacks the Salsa dancing credentials to become a Puerto Rican resident. Additionally, he may not be able to pass the standard residency test because he probably does not know who Gilberto Santa Rosa is and is not familiar with the music of El Gran Combo or La Sonora Pocena. However, the Puerto Rican government may be willing to have Mr. Paulsen submit to a probation period – Dancing with the Stars, the Salsa version.”

All kidding aside, the potential tax benefits for hedge fund managers are too great to ignore. Hence, Mr. Paulsen was willing to travel four hours to the Isla del Encanto to kick the tires. This article will present the basic tax provisions of the new Puerto Rican tax incentives.

These tax changes may be the most compelling financial and tax events for hedge fund and private equity managers since tax reform and the adoption of IRC Sec 457A.

Hedge Fund Basics

The typical fee structure of a hedge fund provides for a two percent annual management fee and a twenty percent carried interest (incentive) for investment performance over an investment high water mark.

Many hedge funds are set up in a master feeder structure. The domestic fund is a pass-through entity such as a limited partnership or limited liability company that invests into the Master Feeder structure – a domestic LLC or partnership. The offshore fund is a foreign corporation usually formed in a jurisdiction with no taxation for corporations. The offshore fund also invests in the Master Feeder structure. The investment management firm is the investment advisor to both funds.

Domestic funds were never able to defer the carried interest as the investment manager as domestic funds typically operate as pass-through entities. Investment management firms were able to enter into deferred compensation agreements with the offshore fund (corporation).The Emergency Economic Stabilization Act ended the not so well well-kept secret of hedge fund managers, the deferred compensation arrangement with their offshore funds or as the New York Times described, “an unlimited Super IRA for the super-wealthy.”

A reporter recently told me that he estimated the amount of offshore carried interest to be in excess of $200 billion based on a review of materials from the joint Committee of Taxation. The addition of IRC Sec 457A effectively ended the ability of investment managers to defer tax recognition of the carried interest in the investment manager’s offshore fund. Under IRC Sec 457A, hedge fund managers must repatriate the offshore deferred compensation not later than December 31, 2017.

Many hedge fund managers probably feel that the current Administration has a gun pointed at their heads and they are probably correct. The creation of tax-advantaged reinsurance companies by hedge fund managers in jurisdictions such Bermuda has also attracted negative attention.

The creation of tax incentives under recent Puerto Rican jurisdiction is a horse of a different color. Puerto Rico is a U.S. commonwealth and not a tax-haven jurisdiction. This article will outline the tax benefits that are available to investment management firms and individuals that become Puerto Rican residents.

Puerto Rican Tax Basics

Puerto Rico (“the PR”) is an unincorporated territory of the U.S. and is subject to most federal laws unless “locally inapplicable”. The currency of the PR is the U.S. currency. No passport is required for travel to the PR for U.S. citizens. The banks in the PR are regulated by the U.S. Federal Deposit Insurance Corporation.

The definition of a U.S. person under IRC Sec 7701(a)(3) does not include Puerto Rican entities. As a result, Puerto Rican entities are not subject to U.S. income taxation unless the business is engaged in a trade or business within the U.S.- effectively connected income (ECI); or investment income that would be subject to a withholding tax  with an exemption for portfolio interest.

Under IRC Sec 933, bona fide residents of the PR that have PR-sourced income are exempt from U.S. taxation. IRC Sec 937 defines a bona fide resident for tax purposes. A person is a PR resident for tax purposes if present in the PR for at least 183 days during the taxable years and does not have a tax home outside of the PR and does not have a closer connection to the U.S. or a foreign country than the PR.

Businesses that relocate to the PR can significantly reduce their taxable income providing the PR entity is not engaged in a U.S. trade or business. The top federal corporate tax rate is 35 -40 percent for most corporations assuming a federal rate of 35 percent and a state rate of 5 percent. Under the Export Services Act, the tax rate is 4 percent. Additionally, shareholders that relocate to the PR will have a 100 percent exemption on corporate distributions.

Under the Export Services Act, services that are directed to foreign markets may qualify as services under the Export Act. Services for foreign markets include services performed for non-resident individuals and businesses. In order to qualify as “promoter services” under the Export Act, the net income must be earned and service performed within the 12-month period ending on the day preceding the day the business commenced operations within the PR.

A business (service provider) must request and obtain a tax exemption decree on or before December 31, 2020. The decree has a 20 year term and may be renewed for an additional 10 years providing certain conditions are met. During the period of the exemption, the business will enjoy a 4 percent tax rate on its export services income and a 100 percent exemption on the distributions of earning and profits from the services income. The business is also eligible for a 100 percent property tax exemption during the first five years of operation and 90 percent after the fifth year.

Existing businesses that become eligible for benefits under the Export Services Act only receive the special tax rate (4%) on the portion of net income that exceeds the average net income for the three years preceding the request for a tax exemption decree. This aspect of the law is designed to prevent existing businesses from becoming tax exempt without a corresponding increase in economic activity in the PR.

The Individual Investors Act

Under IRC Sec 933, interest and dividends that qualify as PR-sourced income are excluded from the income of a “resident individual investor (an individual who has not been a resident of the PR for the past years before his first year of residence in the PR). Long term capital gains derived by the “resident individual investor” that were deemed to have accrued before the individual became a PR resident and are recognized within the first ten years after the date the individual becomes a PR resident, will be taxed at a 10 percent rate. If the gains are recognized after the ten year period but before, January 1, 2036, the gains will be taxed at a 5 percent rate. Gains considered to have accrued after the investor becomes a U.S. resident will receive a 100 percent exemption. Dividend and portfolio interest income are exempt from PR taxation under the new law.

IRC Sec 457A – Dealing with Offshore Carried Interest

IRC Sec 457A provides that any deferred compensation becomes taxable when it is no longer subject to a substantial risk of forfeiture. Deferred compensation attributable to services performed after January 1 2009 is entitled to 10-year transition relief. The deferred compensation must be included in income by the later of (1) the last tax year of “the non-qualified entity beginning before 2018 or (2) the taxable year in which the deferred compensation ceases to be subject to a substantial risk of forfeiture.

A “non-qualified entity” is any foreign corporation unless all of its income is subjectively connected with a U.S. trade or business or (2) Subject to a comprehensive foreign income tax. Any partnership (foreign or domestic) is a “non-qualified” entity unless substantially all of its income is allocated to persons other than (1) foreign persons that are not subject to a comprehensive foreign income tax and (2) tax-exempt organizations.

 A foreign person will be considered subject to a comprehensive foreign income tax if the person is eligible for benefits under a comprehensive tax treaty with the U.S. An operating partnership will be a non-qualified entity under IRC Sec 457A unless its income is allocated directly to someone taxed in the U.S. or under a comprehensive income tax treaty.

Under the IRC Sec 457A rules, deferred compensation paid by a “non-qualified entity” is subject to a substantial risk of forfeiture only if the recipient’s rights to such compensation are conditioned upon the future performance of substantial services (service-based vesting). It may be possible that compensation paid by the domestic corporate subsidiary of a “non-qualified entity or foreign entity that is subject to a comprehensive foreign income  tax, avoids the tax treatment of IRC Sec 457A.

The regulations to IRC Sec 457A do not address whether an entity in a U.S. Commonwealth such as the PR qualifies as a domestic corporate subsidiary or a foreign jurisdiction subject to a comprehensive foreign income tax. Without a lot of legal analysis, my legal instinct suggests that a Puerto Rican entity would most likely qualify as an entity that is subject to a comprehensive foreign income tax. As a practical matter based upon legislative intent, it seems difficult to believe that the federal government would afford greater preferential tax treatment to a treaty partner ahead of an economically challenged U.S. Commonwealth.

As a result, it may be possible to restructure existing hedge fund deferred compensation arrangements so that they continue to qualify under IRC Sec 457A for deferral or alternatively provide for taxation at a 4 percent rate under the Export Services Act. Additionally following payment, proceeds would be able to be reinvested and distributed to a PR resident on a tax-free basis. This subject will be analyzed in greater detail in a subsequent article.

The Strategy

Facts

Acme Investment Management, LLC is a New York-based hedge fund specializing in mortgage backed securities. The firm has $1.5 billion of assets under management primarily in Acme’s offshore fund which is located in Bermuda. The firms’ assets under management have tripled in the last three years. The fund’s investment performance is strong and has averaged 15 percent per year over the last three years. The firm’s fee structure includes a 2 percent management fee and 20 percent incentive fee. The fund continues to attract new investor capital.

The fund has 20 employees. John Smith and Bob Jones are former college roommates and respectively own 50 percent of the investment management firm which is a Delaware LLC. John and Bob both reside in New York City and have a combined marginal tax bracket of 55 percent. Both principals are married and have school-aged children. The firm’s gross revenues in 2012 were $75 million. Net profits were $40 million to the two principals.

Solution

The principals decide to restructure Acme. The firm creates a new investment management company based in San Juan. The new firm will serve as the investment manager for all Acme funds. The company is designed to qualify for special tax treatment under the auspices of the Export Services Act. The firm will continue to have a New York-based office that provides services to the new investment management firm.

John and Bob retain their NY residences but become Puerto Rican residents effective in 2013. The two principals agree to reside in Puerto Rico for at least 183 days during the year. They also agree to meet the Closer Connection Test – they will register to vote in Puerto Rico, and obtain a Puerto Rican Driver’s license. The Smith and Jones families will purchase a home in Puerto Rico and enroll their children in the best English speaking school on the Island. They will consider the PR their tax home. The families will spend six months of the year in NYC while the children attend summer camp in New England. New York is a four hour flight from San Juan.

Acme enjoys repeat investment performance in 2013 and 2014. The difference is that the net profits of $40 million per year in 2013 and 2014 will be taxed at 4 percent instead of 55 percent. John and Bob will be able to reinvest their income on a tax-free basis in the offshore fund without taxation. The Puerto Rican relocation has enabled the John and Bob to save approximately $21.4 million for the two years in the example in personal income tax. Furthermore, the reinvestment of the proceeds will generate passive income that will be completely exempt from personal income taxation as a resident of the PR when distributed from the company or paid individually.

Summary

I grew up in the Panama Canal Zone and know what it is like to live outside of the continental United States. Hedge fund managers, you can do this and have a good life. I also lived in Miami for a long time. Facetiously, I might argue that there is more English spoken in the PR than in Miami.

The Puerto Rican government has done a brilliant job creating incentives for businesses and high net worth individuals to move to the PR and become PR residents. It is my prediction that the PR will become the new Florida (only much better from a tax perspective). Travel to the PR is easy and accessible. These days, every airline flight is a few hours by the time you park and wait for your flight. Many managers already spend six months per year somewhere other than their primary state of residence. 

As Congress prepares to change the tax treatment of carried interest which will impact every investment manager – hedge fund, real estate, private equity and venture capital – I promise you that the Puerto Rican hedge fund or private equity firm is the “next big thing”. The preferential taxation provides tax reduction possibilities that do not exist anywhere else. If Mr. Paulsen needs a special advisor who knows “La Sonora Pocena and “El Gran Combo,  I am qualified to help him with that.

The second installment of this series will focus on the possibility of restructuring and incorporating existing offshore carried interest arrangements into the Puerto Rican provisions outlined in the Export Services

“Clorin Colorado, este Cuento se ha acabado” (translated – this story is over).