Silicon Boricua – What if Silicon Valley Moved to Puerto Rico?

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Overview

I have been writing over the last year on the benefits of Puerto Rican (PR”) residency. The tax benefits of Puerto Rican residency gained some attention and notoriety when hedge fund billionaire John Paulsen went to Puerto Rico to “kick the tires”. He did not become a Puerto Rican resident (not yet at least!) and ended up buying a resort in the PR instead. My theory is that John Paulsen can’t move anywhere without attracting adverse media attention. The media would declare that Paulsen’s purchase of a Big Gulp at Seven-Eleven as tax-motivated.

At the same time, the issue of Puerto Rican municipal bonds has garnered a lot of business news attention on the PR government’s ability to meet its bond obligations. Some newspapers called the PR, the Greece of the Caribbean. Based upon my single class in economics, my theory is that the U.S. federal government owns the problem one way or another and it is likely that PR will fall into the sea. I would put my “two cents” on the PR any day versus any other Latin American alternative.

Puerto Rico has long been a corporate tax haven for many large American multi-national companies. Both Apple and Microsoft can attribute a great deal of their tax benefits and success to the PR. Many pharmaceutical companies have PR operations. The PR government not lacking in creativity, passed a series of tax bills in 2012 to create economic incentives for wealthy Americans to move and start businesses in Puerto Rico. Frankly, my hat is off to the PR government for its ingenuity. Our own federal government could learn a lesson or two from this legislation.

Less well known are the substantial benefits for research and development in the PR. The combination of the R&D and business and personal tax benefits make the PR in so many respects a far better option than Silicon Valley. While the reader may argue that any intent to “unseat” Silicon Valley as the King of the technology hill is foolish and far-fetched, I will make the argument in this article, that the PR is a much better location for operations or at least a subsidiary.

To all my friends in the City by the Bay, no offense but the Fillmore has been closed for a long time, Janis Joplin has been dead for more than forty years and Journey stopped touring a long time ago. Yes, the proximity of Sonoma and world class wine and beauty is compelling, but the costs of living in the Bay area are not.

A Brief History of Silicon Valley

The term Silicon Valley originated in the early 1970’s referring to the Santa Clara Valley and the high concentration of semiconductor manufacturers in the area. The phrase was first used in the newspaper Electronic News on January 11, 1971 and is credited to Don Hoefler.

A very powerful sense of regional solidarity accompanied the rise of Silicon Valley. From the 1890s, Stanford University's leaders saw its mission as service to the West and shaped the school accordingly. At the same time, the perceived exploitation of the West at the hands of eastern interests fueled booster-like attempts to build self-sufficient indigenous local industry. Thus, regionalism helped align Stanford's interests with those of the area's high-tech firms for the first fifty years of Silicon Valley's development.

During the 1940s and 1950s Fred Terman as Stanford's dean of engineering and provost, encouraged faculty and graduates to start their own companies. He is credited with nurturing Hewlett Packard and other high-tech firms, until what would become Silicon Valley grew up around the Stanford campus. Terman is often called "the father of Silicon Valley".

During 1955-85, solid state technology research and development at Stanford University followed three waves of industrial innovation made possible by support from private corporations such as Bell Telephone Laboratories, and Shockley Semiconductor, and Xerox PARC. The Bay area has also been a key area are for military technological innovation.

Silicon Valley versus Silicon Boricua – David versus Goliath!

A few key distinctions come to mind right away when you consider the possibility of the PR versus Silicon Valley as an alternative location for high tech research and development. Immediately, I think of the dramatic different in cost of living between the PR and San Francisco and Silicon Valley. Housing is a major factor in the cost of living and typically the largest expense for employees when considering whether to relocate to a high cost urban area. Outside of San Juan, the differential becomes dramatically more pronounced. Rents are four-five times higher.

The difference in the cost of housing between San Francisco and San Juan reflect is a dramatic difference. Rents are a third of what they are in Silicon Valley. A story I heard during the early days of the tech bubble has always stayed in my mind. A single mother with a child rented a room in a person’s house without kitchen privileges for $2,000 per month in 2000. The same mother would have had a three bed room house in a nice neighborhood, a live in maid, and sent her child to the best private school in San Juan or any other Puerto Rican city for the same money.

Of course, there is the difference in the tax structure. Puerto Rico in 2012 adopted tax incentives that would allow high tech workers to exercise the sale of stock in their company following a sale or an IPO without any personal taxation. The proceeds would not be subject to federal taxation or PR taxation. The taxes in California would be confiscatory. Assuming a significant sale, the Californian resident would be subject to long term capital gains taxation of 20 percent along with the 3.8 percent Medicare tax on investment income. At the state level, the capital gains would not receive preferential treatment, and would be taxed at ordinary tax rates which could reach as high at 13.1 percent. So a high tech worker that is a PR resident would pay no federal or PR taxes on the sale of company shares while the California resident pays 36-37 percent.

Let’s not understate the fact that San Francisco is a very cosmopolitan city, but when you are barely paying your bills, the quality of the local museum and Opera Company are not your biggest concerns. Many of the high tech startups tend to attract young entrepreneurs with young families. Cash compensation tends to be low in favor or “success-based” compensation after a sale or IPO.

A few recent stories have covered high tech companies providing housing for workers not only to reduce the high cost of living but also to encourage a family (more likely frat house) environment where employees can exchange ideas 24-7. Clearly, a beach house in the PR could provide a similar work and living environment at a fraction of the cost.

Weather? The Bay area is prone to earthquakes and foggy weather. The PR has Caribbean weather and sunshine and world class resorts. The Bay has wine country and the PR has world class rum. The PR is very accessible from the mainland. I once counted over fifty flights per day from the mainland U.S. originating from major East cities and Chicago. Most of the discount airlines have multiple flights per day to the PR.

What about the rule of law? Remember the PR is part of the U.S. with federal courts. Law firms in the PR are sophisticated and cost about seventy five percent less than firms in San Francisco and New York City. You need and want to keep your U.S. lawyer but your attorney in the PR also went to Harvard or Georgetown!

Ultimately, it is about the money! Shareholders and employers will be able to dramatically reduce operating costs through a combination of significant tax incentives and R&D incentives. The local universities provide a rich talent pool and U.S.-based employees that move to the PR and become PR residents will be able to personally benefit financially in a manner that is impossible in Silicon Valley and the continental U.S. If it is about the money, then it is equally about how much of the money that you get to keep.

Puerto Rican Tax Basics

Two important pieces of legislation were passed by the Puerto Rican legislature in 2012. Both the Export Services Act and the Individual Investors Act were signed into law by the Governor of Puerto Rico on January 17, 2012.

Puerto Rico is an unincorporated territory of the United States, commonly referred to as a U.S. com­monwealth. It is subject to most federal laws unless “locally inapplicable. The currency is the U.S. dol­lar, and the banks in Puerto Rico are regulated by the U.S. Federal Deposit Insurance Corporation. No U.S. passport is required for U.S. citizens to travel to Puerto Rico.

The definition of a U.S. person under §7701(a)(30), however, does not include Puerto Rican entities. As a result, a Puerto Rican entity is not sub­ject to U.S. income taxation unless the entity is en­gaged in a trade or business within the United States and its income is considered effectively connected income, or investment income that would be subject to a withholding tax under §871 (unless an exemption for portfolio interest under §881(a) applies).

Under §933, bona fide residents of Puerto Rico who have Puerto Rico-sourced income are exempt from U.S. taxation. Section 937 defines a bona fide resident for tax purposes. A person is a Puerto Rican resident for tax purposes if the person is present in Puerto Rico for at least 183 days during the taxable year and he or she does not have a tax home outside Puerto Rico and does not have a closer connection to the U.S. or a for­eign country than to Puerto Rico.

Section 2209 provides that Puerto Rican residents are not subject to U.S. estate taxation at death pro­vided that the Puerto Rican resident acquired his or her U.S. citizenship by virtue of birth in Puerto Rico or naturalization as a U.S. citizen in Puerto Rico. Puerto Rico administers its own estate and gift tax system that largely parallels the U.S. system. Note that a U.S. person who does not expatriate, but merely takes up Puerto Rican residency, will not avoid U.S. federal transfer taxes on worldwide assets, unless born in Puerto Rico. The Puerto Rico estate tax for non-Puerto Ri­can property is 10 percent.

For federal income tax purposes you  will be considered a bona fide resident of Puerto Rico if you meet the following: (i) the physical presence test (generally spending 183 days in PR, or less than 90 days in the US); (ii) the tax home test; and (iii) the closer connection test for the entire taxable year which means that you can’t have stronger personal connections to another jurisdiction that is not Puerto Rico, as prescribed in the regulations promulgated under Section 937 of the Internal Revenue Code.

(1) The Individual Investor's Act

Under the Individual Investors Act, neither capital gains (long-term or short-term), interest, nor dividends are subject to Puerto Ri­can taxation. Dividend income is subject to U.S. fed­eral income taxation for U.S.-sourced dividend income, as is interest income unless the interest income is exempt under the portfolio interest exemption. Long-term capital gains derived by the resident individual investor that (1) were deemed to have accrued before the individual became a Puerto Rican resident and (2) are recognized within the first 10 years after the date the individual becomes a resi­dent, will be taxed at a 10 percent rate.

If the gains are recognized after the 10-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 Puerto Rican resident will receive a 100 percent exemption. Dividend and portfolio interest income are exempt from Puerto Rican taxation under the new law.

(2) The Export Services Act

A business that relocates to Puerto Rico can signifi­cantly reduce its tax liability provided that the Puerto Rican entity is not engaged in a U.S. trade or busi­ness. The top U.S. corporate tax rate is 35 percent to 40 percent for most corporations, assuming a federal rate of 35 percent and a state rate of five percent. Under Puerto Rico’s Export Services Act, the corporate tax rate is flat four percent. Addition­ally, shareholders who relocate to Puerto Rico will have a 100 percent exemption on corporate distributions re­ceived from the Puerto Rican company.

Under the Export Services Act, services that are di­rected to foreign markets may generate income that will qualify for the special tax rate. Services for for­eign markets include services performed for nonresi­dent individuals and businesses. To qualify as “pro­moter services” under the Export Services 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 Puerto Rico. The term “eligible services” includes a wide range of service-oriented businesses from research and development to investment management.

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 four 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 will also be eligible for a 100 percent property tax exemption during the first five years of operation and a 90 percent exemption after the fifth year.

Existing businesses that become eligible for ben­efits under the Export Services Act receive the special tax rate (four percent) only 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 Puerto Rico.

(3)  Puerto Rican Tax Incentives for Research and Development

The Government of Puerto Rico and the Puerto Rico Science, Technology and Research Trust (the “Trust”), in collaboration with industry and the academic community, have taken a number of measures to help create an environment conducive to stimulating competitive research.

At the individual level, the Puerto Rico Internal Revenue Code provides that eligible researchers/scientists residing in Puerto Rico will be 100 percent tax exempt on income generated for services rendered to the University of Puerto Rico or other institutions of higher education in relation to certain eligible scientific investigations.

The exemption is limited to an amount equal to the maximum salary amount established by the National Health Institute for researchers receiving grants under their programs are excluded from taxation. The amount in the initial year of the program - 2008 - was $195,000. The amount is indexed each year. Based on this legislation, many transplanted workers from Silicon Valley would be exempt from U.S. and Puerto Rican taxation on their salaried income.

The Puerto Rican Tax Code provides that up to $250,000 of the compensation may be exempt from taxation received by eligible researchers/scientists residing in Puerto Rico and conducting research within the Puerto Rico Science District created by Act No. 208 of 2011 will be exempt from Puerto Rico income taxes.

On the corporate level, companies under Act No. 73 of 2008 can receive a 50 percent tax credit for eligible investments in research and development, clinical trials, toxicology tests, etc.

Similar to the Export Services Act, technology companies are taxed at a flat rate of 4 percent fixed income tax rate available for eligible laboratories engaged in scientific or industrial research and development activities and other businesses engaged in eligible activities under Act 73.

Firms can also qualify for a one percent fixed income tax rate for innovative firms introducing "pioneer" activities or operations in Puerto Rico. This corporate tax rate can be reduced to 0.5 percent in the fixed income tax rate, when the business is located in an industrial area of low or intermediate development (as determined by the Office of Industrial Tax Exemption).

Summary

I am certain that most of the readers of this article will say “Foolish” and “Very naïve” at the idea that Silicon Valley should become Silicon Boricua.  All it takes is for someone to be first. Daddy Warbucks, the venture capitalist may finally get his fill of Governor Moonbeam and decide to move.  Daddy Warbucks might heretofore be known as the real “Big Papi” in the event he ever becomes a PR resident. No need to expatriate like Eduardo Saverin! Furthermore, under the theory that nothing is forever, the provisions of Act 20 and 22 do not stipulate a minimum time period of residency in the PR.

If the scorecard in business is money, then Daddy Warbucks and his partners should be packing a bag as quickly as they can and calling a car service to get them to the airport as quickly as possible. Young high tech entrepreneurs might consider moving their operation to the PR while retaining a small Silicon Valley office in order to pay homage to Daddy Warbucks and the venture capitalists and the investment bankers for an IPO.

I recently met two high tech entrepreneurs that were moving through another round of venture capital financing. Both were in a position to sell some of their shares following the financing. Both shareholders would reap a few million dollars each. One of the shareholders was resident of NYC while the other was a California resident. Their company had twenty employees living and working in Silicon Valley.

If instead their company had been in Silicon Boricua instead of Silicon Valley, neither of the entrepreneurs would have paid any federal or state income taxes. Neither of the two would have paid any PR taxes. The employees would have qualified for the compensation exemptions under the PR R&D provisions and most likely their entire salaries and no taxation on the sale of company shares.

The families of the employees would have enjoyed living in housing that is 300-400 percent cheaper than the Bay area. Their children would become bilingual. Their families would come to visit them every winter and the employees would return to see their families a few times per year.

In the final analysis, perhaps the proposal is a bit naïve, but if money really talks, the venture capitalists and young high entrepreneurs should be listening.

Topics:  Corporate Taxes, Export Services Act, Incentives, Income Taxes, Individual Investors Act, Silicon Valley, Tax Incentives

Published In: General Business Updates, Finance & Banking Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Osborne & Osborne, PA | Attorney Advertising

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