Puerto Rico: US Territory with Compelling Tax Incentives
Puerto Rico is a beautiful tropical island 100-mile long and 35-mile wide in the Caribbean Sea and has the almost unique status of being a Commonwealth of the United States. Technically, it is an unincorporated territory where most of the US laws apply. In other words, this means that it is part of the US territory without being a State of the Union. This status -shared only with other much smaller islands: Guam, American Samoa, Northern Mariana in the Pacific Ocean and the US Virgin Islands in the Caribbean Sea- allows Puerto Rico to offer compelling fiscal incentives to foreign companies (including the ones from the US) that establish a legal presence in the island.The purpose of this article is to provide an informative and not technical overview of the tax
incentives in Puerto Rico. The article gives an introduction on the fiscal background and the business and living context of Puerto Rico. Furthermore, it summarizes the tax incentives for companies (not requiring the residency of foreign owners and managers in Puerto Rico), providing a zoom-in on Act 20 regarding the export services across different industries and an overview on other
industry-specific Acts regarding banking, insurance, manufacturing, tourism, renewable energy and film production. Finally, the article presents the tax incentives for individual investors (Act 22) that requires part-time residency in the island for the individuals.
Puerto Rico Background and Context
The Commonwealth status of Puerto Rico has three main implications. The first implication is on citizenship: individuals born or naturalized in Puerto Rico are US citizens. Therefore, travelling or moving to Puerto Rico for American nationals or residents is the same as to any other State of the Union and all the immigration rules that apply to foreign nationals for traveling or moving from abroad to the US apply also to Puerto Rico. The second implication is fiscal: Puerto Rico bona-fide residents are subject only to the local income taxes (Puerto Rico Treasury Department) and not to federal income taxes (Internal Revenue Service), as promulgated in Section 933 of the US Internal Revenue Code of 1986. The third implication is political: Puerto Rico has a local Governor as other States of the Union, but it has not voting representation in the US Congress.
Puerto Rico is suffering a long economic recession and a deep public debt crisis that affect the local population (every year 1% of the people is leaving the island because of unemployment rate around 13-15%), but represent an opportunity for foreign investors who can acquire assets at discounted prices and find a good business environment due to multiple tax incentives. The economic recession started back in 2006 prompted by the expiration of Section 936 of the IRS Code that provided US companies operating in Puerto Rico with tax-free income re-invested in the island and by a temporary closure of the government agencies that triggered a halt on the economy, mainly on the construction industry. Nonetheless, Puerto Rico ranks 32nd (comparable to Chile, Portugal and Thailand) out 144 nations in the Global Competiveness Report thanks to its modern infrastructures in transportation, telecommunication and utilities, knowledge hubs in the pharmaceutical, biotechnology, medical devices industries and competitive cost of doing business which is 10-15% lower than in the US.
The public debt crisis ($73 billion in June 2015) is the result of 15 years of fiscal deficit easily financed with tax-free bonds and of inefficient management of public companies. This crisis is aggravated by the fact that Puerto Rico has no US bankruptcy protection (since it is not a State of the Union), no option of IMF intervention (since it is not a sovereign country) and no possibility of devaluation (since it does not have its own currency). According to Krueger’s study presented on June 29, public debt restructuring and possible partial default seem to be inevitable scenarios that will affect current bondholders. At the same time, the local Governor has announced a high-level plan to renegotiate the public debt with bondholders, to fix the fiscal deficit by reducing public expenses and increasing local taxes, and to re-establish economic growth, in part through the promotion of tax advantages of doing business from Puerto Rico for foreign companies and individuals.
Living in Puerto Rico is very similar to living in South Florida, even though San Juan is a smaller city than Miami and the environment is less international. The island has approximately the same size of Connecticut in the US and Corsica in Europe and a population of 3.6 million inhabitants. The national language is Spanish, but most of the professionals are bilingual in English. Cost of living is generally lower in Puerto Rico than in the US with the main differences in the electricity cost (almost double than in the US) and the rental or home ownership (almost half the price of Miami for similar
properties), also because of the real estate crisis from which the island has not yet recovered. Puerto Rico criminality rate is higher than the US average, but still lower than other countries in Latin America and the Caribbean and in line with some cities in the US. Nonetheless, Puerto Rico offers beautiful weather and beaches all year long, a developed social infrastructure (hospitals, private education, telecom, highways, flight connection, etc.) and an active cultural and entertaining life.
Act 20 on Exporting Services for Companies
Act 20 was introduced to stimulate Puerto Rico economy by promoting the formation of companies dedicated to export eligible services from Puerto Rico to any other location in the world, including the United States. While the Act does not have any employment or investment requirement, other laws refer to other factors that could make an impact on grating the tax exemption and the most relevant is the employment of three full-time employees in Puerto Rico. The wide range of eligible services and the lack of any requirement on residency for foreign owners and managers make this Act very attractive for service companies based in the US and for companies from other countries that provide service to clients based in the US. Until June 2015, approximately 400 companies have been approved under Act 20, mainly headquarters and shared services (19%), IT services (17%), professional services (15%), financial services (14%), advertising and public relations (12%).
Benefits and terms. Act 20 allows a 4% tax rate on income instead of an up to 39.6% federal income tax rate in the US (plus the state income tax) and more than 50% aggregated tax rate in most of the European countries. Furthermore, this Act allows 60% exemption on municipal taxes that may levy a tax of up to 0.5% (1.5% for financial services) of revenue and 100% exemption of dividend taxes for Puerto Rico residents. The exemption must be submitted through an Exemption Decree (a contract not subject to subsequent legislative changes) to the Secretary of Economic Development and it may take 3-4 months to be approved. The exemption is valid until 2032 and it is extendable to 2042.
Requirements. Act 20 applies to any entity with a bona-fide office or establishment located in Puerto Rico engaged in an eligible service. The services must be performed for non-resident individuals and/or foreign entities outside of Puerto Rico with no nexus to Puerto Rico. This Act does not have any requirement for the owner and manager of the company to reside in Puerto Rico. The eligible services are research and development, advertising and public relations, consulting, advise on trade and business, engineering services and project management, professional services (legal, tax, accounting), centralized management services, electronic data processing, software development, telecom voice and data, call centers, shared service centers, storage and distribution centers, educational and training, hospitals and laboratories, investment and financial services.
Other Industry-specific Acts for Companies
The Government of Puerto Rico has promulgated different laws aimed at attracting foreign
investment through tax invectives and creating employment in the territory. These Acts are specific to some industries where the island has competitive advantages either because of its geographical location or because of the skilled workforce available. Most of the benefits/terms and requirements of the industry-specific Acts are similar or in line with the ones of Act 20 on Export Services, but the higher capital requirement for Financial Entities and Insurance companies and the tax-credits for other companies. The following paragraphs present a high-level overview of the most relevant Acts. Act 273 on International Financial Entities. The goal is to make Puerto Rico an international banking and financial center under the supervision of the Office of the Commissioner of Financial Institution by providing tax incentives for new banking and financial activity offered to clients outside of Puerto Rico. Any financial institution based in Puerto Rico would be regulated by all the federal laws and regulations of the US (Bank Secrecy Act, Office of Foreign Asset Control, etc.), but not the US International Banking Act that imposes required reserve ratios.
Act 399-400 on International Insurance. Puerto Rico is considered a US jurisdiction for insurance related matters where the local regulator (Office of the Commissioner of Insurance) assumes primary jurisdiction with exceptions according to US federal legislations applicable to all the States. The transactions authorized for international insurance in Puerto Rico are alternative risk management strategies through the organization of captive entities, insurance and reinsurance vehicles to tap the Latin American and US markets, and corporate restructuring under a holding company.
Act 73 on Economic Incentives for the Development of Puerto Rico. The law is targeted mainly to corporations established to manufacture products on a commercial scale not only for export outside of Puerto Rico, but also for the local market. On the top of tax incentives similar to the ones available for the Export Service Act, the law provides also atax credit for the purchase of products manufactured locally up to 25% of the cost and a tax credit on Research & Development expenses up to 50% of the investment. The key disadvantage of production of goods in Puerto Rico for export is the Cabotage Law (Jones Act of 1920) with the US that imposes high freight cost, but it could be eliminated in the near future as part of the Puerto Rico restructuring plan.
Act 74 on Tourism and Hospitality Development. The law covers hotel, condo-hotels, timeshare and vacation clubs, guest-houses, theme parks, golf courses operated by hotel, marinas with tourism purpose, businesses that uses natural resources as a source of entertainment. Casino operations are not included. Because of the different nature of this business, tax benefits are limited to 10 years and consist of 10% tax credit of the minimum between the total project cost or 50% of the cash put by the investor, 100% exemption on municipal taxes and licenses, 100% exemption on sales taxes, 90% exemption on income tax and property tax.
Act 82-83 on Energy Diversification Policy and Green Energy Incentive. The law includes production and sales of renewal energy, operating renewable energy productions units and businesses involved in the assembly of renewable energy equipment. Apart for the tax incentives similar to the ones available for the Export Service Act, the law provides also tax credits on
multiple items (purchases, job creation, Research & Development, royalties on intangible property) and a rebate program incentive to stimulate the adoption of renewable energy.
Act 27 on Film Industry Development. The law includes any kind of video and music production, including recorded live performances and original sound track recording and dubbing. Because of the different nature of this business, tax benefits are limited to investment above $5 million and to tax credits on 40% of all payments to Puerto Rico resident company and individuals, 20% of all payments to non-resident above-the-line expenses (producers, directors, writers, actors), and 25% on infrastructure investment.
Act 22 on Individual Investor Incentives
Act 20 was designed to attract new residents to Puerto Rico by providing a total exemption from Puerto Rico-sourced passive income taxes on all income realized or accrued after such individuals become bona-fide resident of Puerto Rico. The goal is to increase local investment in real estate, develop the consumption of local services and products, and provide capital injections to the local banking industry. The bona-fide residency requirement make this law interesting only to individuals who can spend at least half of the year in Puerto Rico. Until June 2015, more than 500 individuals have moved to Puerto Rico under Act 22, mainly managers of private equity or hedge funds and family offices, traders, lawyers, physicians and radiologists, architects and engineers, publishers, and IT developers.
Benefits and Terms. Act 22 provides 100% tax exemption valid until 2035 to eligible individuals who decide to be bona-fide residents in Puerto Rico and submit the exemption application. The tax exemption applies to both US citizens and foreign nationals from any country interested in
becoming US temporary or permanent residents and/or citizens in Puerto Rico. The 100% tax exemption is on interest income, dividends, and capital gains that accrue after the relocation to Puerto Rico instead of the at least 23% average state and federal tax rate in the US.
Requirements. Three main factors determine bona-fide residents in Puerto Rico as established by Section 937 of the US Internal Revenue Code. The first factor is the physical presence that requires spending in Puerto Rico at least 183 days per year counting also the days in which the individual is arriving to or leaving from Puerto Rico. The second factor is the tax home that determines that the majority of the business of the individual must be run from Puerto Rico. The third factor is the
closer connection that evaluate a set of qualitative elements in an attempt to determine if the
individual is really residing in Puerto Rico and may include location of voting right, driving license, bank accounts, family residence, etc.
Disclaimer
The materials contained in this article were written on June 30, 2015 and are for general information purpose only. They do not constitute legal or investment advice or other professional advice and the reader may not rely on the contents of this article as such. Paolo Stefanini assumes no liability on accuracy, completeness, or usefulness of any information contained in this article and expressively disclaim all liability for damages of any kind arising out of use, reference to or reliance on any information provided in this article.
Note on the Author
Paolo Stefanini is a citizen of the European Union and has been resident in the United States during the last 12 years. He used to live since 2003 to 2010 in Puerto Rico and from 2010 to 2012 between Chicago and New York, while he is
currently living in Miami since 2012. Paolo is currently an advisor in multiple private companies and a Board Member of the Italian-American Chamber of Commerce of the South-East (he led the creation of the Chamber chapter in Puerto Rico). From 2005 to 2015, Paolo held executive positions at Banco Popular as Senior Vice President, first managing the Consumer Credit Division in Puerto Rico and then directing the Strategy and Administration Group in the United States.
Previously, Paolo worked at McKinsey and Company, starting his consulting career in the Italian and Spanish offices and then transferring to Puerto Rico to open the premise for the Caribbean Basin of the same company as Associate Partner. He has an MSc in Industrial Engineering with Major in Production Management from Politecnico of Milano, Italy and an MBA with Major in Finance from INSEAD, France.
