The other day I asked the garage attendant who was of Puerto Rican (PR) ancestry and listening to Salsa music as she worked, which group was the most influential band in her estimation – La Sonora Poncena or El Gran Combo. For the uninformed, this is like asking someone to choose between The Beatles or The Rolling Stones. Both bands have over fifty years of performance history and a string of hits in Latin America that could circle the globe. She said, “Probably El Gran Combo because they don’t call it La Universidad de la Salsa for no reason.” This was indeed a very astute and thoughtful answer because the band has had so many singers and band members that have defined the Afro-Cuban aka Salsa genre around the world for decades. One of the band’s great hits was “Brujeria”(translated “Witchcraft” or “Black Magic”) speaking to the “black magic” charm that some women possess. This is my invitation to listen to the song on YouTube. It is a classic! Tax planning on a multi-jurisdictional basis effectively can also require a similar type of mysticism.
I have written a series of articles espousing the benefits of Puerto Rican Acts 22 and 20 for tax planning purposes. The combination of these benefits for an American living on the Mainland is extremely powerful. In effect, Puerto Rican residency is the antidote to expatriation fever. Unlike expatriation, an American taxpayer does not run the risk of becoming the Black Sheep of the family for expatriating. Grandpa who fought in WWII does not need to rollover in his grave. Mama does not need to cry “Where did I go wrong”! The beauty of Acts 22 and 20 is that it allows the American taxpayer to retain his U.S. citizenship while severing the shackles of worldwide taxation of U.S. taxpayers. If you want to see what patriotism looks like, take a look at all of the Puerto Ricans that have served in the Armed Forces and fought in our wars. Nine Boricuas have won the Medal of Honor!
While it is true in geometry that the shortest distance between two points is a straight line, the same may not be true in tax planning. One of the challenges for an American taxpayer who has a business and wants to move his business to the PR and become a PR resident, is the transition planning. How does a business owner with multiple shareholders take advantage of the PR opportunity when his shareholders can’t find PR on a map? How does a business owner with an existing business maintain a staff in his existing business that will remain stateside while the business owner moves to the PR? Aside from the tax planning considerations, there are a number of logistical “nuts and bolts” considerations to be weighed in this transition planning. This article is a quick summary of some of those considerations with some ideas of how to deal with them. As the cliché goes “The devil is in the details”!
Overview of Puerto Rican Tax Considerations and Residency
A. Puerto Rican Tax Basics
Two important pieces of legislation were passed by the Puerto Rican legislature in 2012. Both the Export Services Act (Act 20) and the Individual Investors Act (Act 22) were signed into law by the Governor of Puerto Rico on January 17, 2012.
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.
What does it take to become a Puerto Rican resident in order to take advantage of Act 22? How about S50 for the application fee which is less than the cost of dinner in a good restaurant, and meeting three tax tests? For federal income tax purposes the taxpayer will be considered a bona fide resident of Puerto Rico if you meet the following: (i) Substantial Presence Test -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) Closer Connection Test - 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.
(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. The law capture built in gain preceding Puerto Rican residency and taxes the pre-residency appreciation at ten percent during the first ten years following residency and five percent for the next ten years.
(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. The term range of eligible services ranges from consulting, and professional services (law, engineering, architecture) to investment management.
In many cases, a business may have multiple owners and is often the case, the business owner cannot convince the spouses of his fellow shareholders to move to Puerto Rico. Surprise! It is possible to structure a new Puerto Rican corporation with the business owner that becomes a Puerto Rican resident. The new corporation can be structured so that the new Puerto Rican corporation is not treated as a controlled foreign corporation for tax purposes allowing the Puerto Rican corporation to be taxed at four percent instead of 39.6 percent or 35 percent.
Controlled Foreign Corporation (CFC) Considerations
The CFC rules are designed to prevent U.S. owned businesses from deferring their income in low tax jurisdictions. The rules have an intricate system of attribution rules designed to eliminate the gaps designed to prevent the creation of foreign corporations in low tax jurisdictions. From a PR tax planning, a PR resident that is a shareholder is excluded from the definition of a U.S. person for U.S. CFC testing purposes under IRC Sec 957(c)(1).
A foreign corporation will be a CFC if on any day during its tax year, one or more U.S. shareholders directly, indirectly, or constructively own more than fifty percent of the total combined voting power of all classes of the foreign corporation's voting stock or more than fifty percent of the total value of the foreign corporation's stock.
For purposes of the CFC rules, a U.S. shareholder is a "United States person" who "owns or is considered as owning" ten percent or more of the total combined voting power of all classes of stock entitled to vote. In order to apply these rules, the IRS needs to determine that:
One or more U.S. taxpayers own 10% or more of the total combined voting power of all classes of stock entitled to vote,
The ten percent U.S. shareholders collectively own more than 50% of the total combined voting power of the corporation's outstanding stock or more than 50% of the total value of the stock of the corporation
In the case of a business owner with multiple shareholders who do not want to move to the PR, it may be possible to structure a new PR corporation owned by the business owner that becomes a new PR resident. A partnership or LLC could be created as a joint venture vehicle between the PR-US companies to direct profits on a pro rata basis between the two operations. Alternatively, the PR corporation might provide certain services for the U.S. corporation and have an intra-company agreement between the two companies subject to transfer pricing considerations. An important point is the fact that the new PR resident as the majority owner with voting control has the ability to legally circumvent the application of the CFC rules and consequently have business income taxed at a much lower rate – four percent instead of 45-50 percent.
Additionally, the PR Corporation has the ability to reinvest the earnings on a tax-deferred basis without the application of the passive foreign investment company (PFIC) rules or CFC rules. Dividends could be paid to the U.S. shareholders of the Puerto Rican corporation as a qualified dividend taxed at twenty percent (plus the Medicare surtax-3.8 percent). The PR shareholder is able to take a dividend from the PR corporation without PR or federal taxation.
Planning for the Year of the Move
Another tax planning consideration is minimizing U.S. taxation prior to becoming a PR Resident. Based on the existing operation, it is not practical to turn the “spigot” off on the U.S. operation. Important staff may remain behind providing the business with experience and expertise. Nevertheless, strategies that provide tax reduction and deferral become increasingly important such as qualified retirement plans (particularly defined benefit plans) and captive insurance companies. These strategies and “drain the swap” reducing current U.S. taxation while providing long-term deferral with no taxation or minimal taxation. Sophisticated tax planning strategies such as charitable remainder trust and charitable lead trusts and pooled income fund can reduce and eliminate capital gains taxation on pre-residency capital appreciation while retaining a lifetime income which may be received as a new PR resident on a tax-free basis.
We always want to know how to get from here to there and it is usually not a straight line! To the best of my knowledge, the PR offers some of the best tax incentives on the Planet for U.S. taxpayers that seek tax relief, but cannot “stomach” the thought of renouncing their U.S. citizenship. The PR solution under Acts 22 and 20 provides a nice hybrid solution. The “price” of PR residency is relatively small in terms of personal or financial considerations. The ideas in this short article should get the “wheels” turning to determine how to get from here to there!