Tax-Weary Americans Find Haven in Puerto Rico
Investors, traders, investment managers, and other high net worth individuals now have access to a tax haven custom-made for them. And this haven is even issuing its siren’s call to lure those in the cryptocurrency community-recently creating an advisory council specifically aimed at fostering blockchain business development on the island. So, just where is this haven?
Puerto Rico holds a unique position as an unincorporated U.S. territory. Under Internal Revenue Code (IRC) §933, Puerto Rico source income is excluded from U.S. federal tax. In 2012, enduring economic hardship and seeking a means to boost its economy, Puerto Rico enacted two laws, Act 20 and Act 22-intended as major tax incentives to promote foreign investment. While Acts 20 and 22 are only applicable for Puerto Rico income tax purposes, U.S. citizens willing to become bona fide residents of Puerto Rico (implicating IRC §933) stand to benefit tremendously. Revisions to these Acts in 2017 arguably made Puerto Rico an unmatched tax haven for qualifying U.S. citizens. Indeed, the news has spread, and a growing number of tax-weary U.S. citizens are considering Puerto Rico as their solution.
Bona Fide Resident
The tax benefits under Act 20 and 22 are very attractive for those U.S. citizens willing to become a bona fine resident of Puerto Rico. Although U.S. citizens are subject to worldwide taxation, from whatever source derived, IRC §933 provides an exception for residents of Puerto Rico. Under that section,bona fideresidents of Puerto Rico can exclude their Puerto Rico source income from U.S. federal tax. Generally, under IRS §937 and the regulations thereunder, a bona fide resident of Puerto Rico is an individual who:
- Is physically present in Puerto Rico for at least 183 days during the taxable year;
- Does not have a tax home outside of Puerto Rico during the taxable year; and
- Does not have a closer connection to the United States or a foreign country than to Puerto Rico.1
Act 20 provides incentives to companies exporting services from Puerto Rico. Specifically, a U.S. citizen who becomes a bona fide Puerto Rico resident and moves his or her business to Puerto Rico (thus, generating Puerto Rico sourced income) may benefit from a 4% corporate tax/fixed income tax rate, a 100% exemption on property taxes, and a 100% exemption on dividends from export services.2Act 20 applies to any entity engaged in an “eligible service”:
- Which has a bona fide office located in Puerto Rico,
- Performs services for non-resident and/or foreign entities without any nexus to Puerto Rico, and
- Which ensures that the eligible service provided is not related to the conduct of a trade, business or other activity in Puerto Rico.3
Services that are eligible for these incentives include:
- Research and development.
- Advertising and public relations.
- Economic, environmental, technological, scientific, managerial, marketing, human resources, computer, and auditing consulting services.
- Advise on issues related to any trade or business.
- Creative Industries defined by law as those business with potential for creating jobs and wealth, mainly through the export of creative goods and services in the following sectors: design (graphic, industrial, fashion, and interior design); arts (music, visual arts, performing arts, and publishing); media (application, video games, online media, digital, and multimedia content development); creative services (architecture and creative education).
- Drafting of construction plans and engineering, architectural, and project management services.
- Professional services, such as legal, tax and accounting services.
- Centralized management services.
- Electronic data processing centers.
- Computer program development.
- Voice and data telecommunications between persons located outside Puerto Rico.
- Call centers.
- Shared service centers that include, but are not limited to accounting, finance, tax, auditing, marketing, engineering, quality control, human resources, communications, electronic data processing, and other centralized management services.
- Storage and distribution centers of companies engaged in the business of transportation of items and products that belong to third parties, known as “hubs”.
- Hospitals and laboratory services.
- Investment banking and other financial services.
- Any other service that the Secretary, with the advice of the Secretary of the Treasury, determines that must be treated as an eligible service for understanding that it is in the best interest and for the social and economic wellbeing of Puerto Rico.4
Consider the following examples comparing a U.S. citizen creating a pass-through entity in Puerto Rico under Act 20 with the same pass-through set up in the United States:
Example 1: X is a U.S. citizen and a tax attorney. He wants to create a Puerto Rican pass-through entity, LLC, which would provide legal, tax and accounting services. He applies for the Act 20 exemption. X’s income from LLC the first year is $700,000. With the Act 20 exemption in place, LLC receives the 4% fixed income tax rate, and is exempt from federal taxes on Puerto Rico source income. Total tax is $28,000.
Example 2: Assuming no qualified business income implications and filing status of single, X creates LLC in Maryland and reports income for 2018 in the amount of $700,000. X pays tax of $150,689.50 plus 37% of the amount exceeding $500,000. Total federal tax is $224,689.50. Additionally, X will face Maryland state and county taxes, which may be over 8%, depending on the county rate that applies. So, total state tax at 8% would take another $56,000 away from X. X has paid $280,689.50 in taxes.
Act 20 requires that the service provider obtain a tax exemption decree, signed by the Secretary of the Department of Economic Development and Commerce of Puerto Rico. Significantly, as a contract with the Puerto Rico Government, not subject to legislative change, this decree will have a guaranteed 20-year term, renewable for 10 additional years if certain criteria are met.
Act 22 entices individual investors to move to Puerto Rico. Significantly, new qualifying residents have 100% tax exemption from Puerto Rico taxes on all dividend and interest income and long-term capital gains accrued after becoming a qualifying new resident.5
Puerto Rico source passive income is completely exempt from federal taxation under IRC §933; however, new qualifying residents may even reduce the tax rate on non-Puerto Rico source passive income to 0% (for interest) and 10% (for dividends) by using Puerto Rico investment vehicles.
All capital gains accrued after establishing qualifying residency are 100% exempt.6As for prior unrealized capital gains, the statute provides that:
The total net long-term capital gain generated by a resident individual investor related to the appreciation of the securities owned by such resident individual investor before becoming a resident of Puerto Rico, which appreciation is recognized ten (10) years after he/she became a resident of Puerto Rico and before January 1st, 2036, shall be subject to a five percent (5%) tax, in lieu of any other tax imposed under the Code. If such appreciation is recognized at any other time, the net long-term capital gain with respect to said securities shall be subject to the payment of income taxes in accordance with the tax treatment provided by the Code. The amount of the net long-term capital gain shall be limited to the portion of the gain related to the appreciation of the securities while the resident individual investor resided outside of Puerto Rico.7
Consider the following examples to help illustrate the treatment of capital gains:
Example 3: One day after becoming a resident of Puerto Rico, X (a U.S. citizen), buys shares in ABC Corp for $50,000. Five years later (before January 1, 2036), X sells all of his stock for $100,000, resulting in a $50,000 gain. X pays 0 tax to Puerto Rico and 0 tax to the United States.
Contrast this result with that where X doesnotmove to Puerto Rico. For tax years 2018-2025, assuming X is in the highest tax bracket, X is subject to an effective tax rate of 23.8% (the long-term capital gains tax rate of 20% plus the net investment income tax rate of 3.8%) on the $50,000 of gain. X pays $11,900 in tax.
Example 4: Assume instead that X bought ABC stock for $50,000 in Year 1. In Year 4, X moves to Puerto Rico. The ABC shares are worth $100,000 the day that X moves to PR. In Year 5, X sells the stock for $200,000.
X has a capital gain of $150,000 ($50,000 of which accrued before PR residency and $100 of which accrued after PR residency). X will be subject to US tax on the $50,000 gain (accrued before PR residency) at the effective tax rate of 23.8%.8Additionally, the same $50,000 gain will be subject to Puerto Rico’s regular individual long-term capital gains rate (15%), because it was sold during the first 10 years of residency (if sold after 10 years of residency, the 5% rate would apply).
However, the $100,000 capital gain that accrued from Year 4 through Year 5 is exempt from both US tax (X was a resident of Puerto Rico that entire period) and Puerto Rico tax (under Act 22).
Planning tip: Benefit from both Act 20 and Act 22 by moving a potentially successful company to Puerto Rico early on in the game (before it’s worth any money) in order to source the largest amount of post-move appreciation possible to Puerto Rico.
Note that for purposes of Act 22, a qualifying resident does not include anyone who was a resident of Puerto Rico during the 15 years preceding the enactment of Act 22. Furthermore, the individual must become a resident of Puerto Rico before January 1, 2036.
Like the service provider under Act 20, individuals wishing to benefit from Act 22 must also secure a tax exemption decree.
Puerto Rico has enacted aggressive legislation in order to attract new businesses and high net worth individuals. As a U.S. territory, Puerto Rico is uniquely able to offer incentives unavailable anywhere else in the world now. If you are willing to establish bona fide residency in Puerto Rico, you can significantly decrease income, capital gains and dividend taxes.
If you have tax questions or concerns, contact Frost & Associates, LLC today at 410-497-5947.
1Each of these requirements require careful consideration of various factors. It is beyond the scope of this article to present a detailed analysis of these three tests. Consultation with a tax professional is highly recommended.
213 L.P.R.A. §10832, §10833, §10834. Note that the 100% exemption on property taxes applies to select §10831(k) businesses, including creative industries, call centers and shared services centers, and is limited to the first five years of operations. After the five-year period, a 90% exemption applies.
313 L.P.R.A. §10831(f).
413 L.P.R.A. §10831(k).
513 L.P.R.A. §§10852, 10853.
613 L.P.R.A. §10853(b).
713 L.P.R.A. §10853(a).
8Although the United States will provide a credit for the Puerto Rican tax, the effective rate of tax will be the higher U.S. tax rate-resulting in no shelter effect for that appreciation.
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