In the midst of a complicated fiscal situation, Puerto Rico continues to attract investors and companies through two extant tax incentive packages: Puerto Rico’s Act 20 – the Promotion of Export Services Act – and Act 22 – the Act to Promote the Relocation of Individual Investors to Puerto Rico.
Act 20 and Act 22 were enacted in Puerto Rico in 2012 to promote the exportation of services by companies and individuals providing such services from Puerto Rico and the relocation of high-net-worth individuals to Puerto Rico. Both laws aim to provide attractive incentives to encourage investors to relocate to Puerto Rico, while also encouraging local service providers to expand their businesses by offering their services to clients located outside Puerto Rico. The laws strive to contribute to the growth of the Island’s economy and, since their enactment over four years ago, have been embraced on a bipartisan basis on the Island as an important part of the government's economic development plan.
At the heart of these incentives is Puerto Rico’s unique tax status: even though Puerto Rico is a territory of the United States (and generally subject to all US. federal laws), it is treated as a “foreign country” for US federal income tax purposes, and a special tax treatment applies to its residents. This unique situation has allowed Puerto Rico to enact tax incentives that are geared to promote its economic development and that may be attractive to US persons. These incentives promote the establishment of manufacturing operations, tourism activities, international banking operations, international insurance operations and production of films in Puerto Rico, among others.
In this alert, we summarize the tax benefits available under Act 20 and Act 22 that may be of interest to individuals and companies seeking a general understanding of the potential tax benefits of moving to or relocating all or part of their operations to Puerto Rico.
PUERTO RICO TAX CONSIDERATIONS
Act 20 provides tax incentives for companies that establish and expand their export services businesses in Puerto Rico. Under Act 20, income from eligible services rendered for the benefit of non-resident individuals or foreign entities (Export Services Income, or EIS) is taxed at a reduced tax rate of 4 percent. Moreover, dividends or benefits distributed out of EIS are 100 percent exempt from Puerto Rico taxation.
Some “eligible services” are:
- Research and development
- Advertising and public relations
- Data processing centers
- Call centers
- Scientific, management, information technology and marketing consulting services
- Professional services
- Development of computer programs
- Shared management services
- Educational and training services
- Hospital and laboratory services
- Investment banking and other financial services and
- Any other service that the Secretary of Economic Development and Commerce determines, after consulting with the Secretary of the Treasury, that should qualify as an eligible export service, based on factors such as jobs to be created, payroll generated and proposed investment in Puerto Rico.
The eligible services covered, as well as any other terms and conditions of the exemption, will be included in a grant of tax exemption (Act 20 Decree) issued to the individual, entity or entities that will engage in the eligible services. The entity must have three full-time Puerto Rico-resident employees within six months of commencing operations, and five employees within two years of commencing operations. An application for an Act 20 Decree would have to be filed disclosing, among other things, the eligible services proposed to be rendered in Puerto Rico, including estimated volume of business, number of employees, payroll, etc. The application for an Act 20 Decree must include the payment of a $750 filing fee.
Act 22 seeks to attract new residents to Puerto Rico by providing a total exemption from Puerto Rico income taxes on all interest and dividends realized after the individual becomes a bona fide resident of Puerto Rico. An individual who was not a resident of Puerto Rico from January 17, 2006 through January 17, 2012 may request a decree of tax exemption (an Act 22 Decree) under Act 22, and qualify for the following benefits:
- 100 percent tax exemption with respect to interest and dividends derived after becoming a resident of Puerto Rico and through December 31, 2035
- 100 percent exemption with respect to gains from the sale of property acquired after the individual became a resident of Puerto Rico, if the sale takes place before January 1, 2036. If the sale takes place after December 31, 2035, any gain will be taxed at the regular capital gains rate (which currently is 15 percent, if the property has been held for more than one year) and
- Special rules applicable to the gain from the sale of securities acquired prior to the establishment of residence in Puerto Rico.
The application for an Act 22 Decree must include the payment of a $750 filing fee as well as the payment of an additional $5,000 upon the issuance of the Act 22 Decree. The benefits of Act 22 are also conditioned on the individual complying with the requirements of acquiring residential property in Puerto Rico and opening a bank account in Puerto Rico.
An important point that potential clients tend to overlook is that these rules only apply for Puerto Rico income tax purposes. Clients need to be aware that the US federal income tax treatment of interest, dividends and capital gains is determined under a different set of rules that also need to be taken into account.
Both the Act 20 Decree and the Act 22 Decree are considered a contract between the individual or the entity (and its shareholders), as applicable, and the government of Puerto Rico. Thus, under the Contracts Clause, the constitutional prohibition against the impairment of contracts should protect the awarded tax benefits from any potential revocation or amendment by subsequent legislation.
UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS
As noted above, Act 20 and Act 22 only apply for Puerto Rico income tax purposes. From a US income tax perspective, a US citizen may consider the benefits of Act 20 and Act 22 to be attractive if (a) the individual is able to become a bona fide resident of Puerto Rico, and (b) the amount of income the individual may generate from sources within Puerto Rico under Act 20 or Act 22 (or both) is an amount that may justify a move of this nature.
Bona fide resident of Puerto Rico
Under the US Internal Revenue Code (IRC), citizens of the United States are generally taxed on all of their income, from whatever sources derived. US IRC Section 933, however, provides an exception with respect to Puerto Rico residents: individuals who are bona fide residents of Puerto Rico for the entire taxable year, other than federal employees, can exclude from gross income for federal income tax purposes, and are therefore exempt from federal income taxes on, income from sources within Puerto Rico. In order to qualify for the exclusion for a taxable year, then (1) the individual must qualify as a bona fide resident of Puerto Rico for the entire taxable year for purposes of the US IRC and (2) the income must constitute Puerto Rico source income under the US IRC.
It is important to note that income derived from sources without Puerto Rico by a bona fide resident of Puerto Rico will nonetheless be subject to US federal income taxation. This is important and should be taken into account by those individuals who have a portfolio of investments that generate income from sources without Puerto Rico. Even though this income may be exempt from Puerto Rico income taxes under Act 22, it will continue to be subject to US federal income taxation. Special rules apply to gains that may be derived by an individual with respect to the sale of securities held at the time of becoming a bona resident of Puerto Rico.
The determination of whether or not an individual is a bona fide resident of Puerto Rico for a taxable year is made pursuant to rules set forth in the regulations issued under Section 937(a) of the US IRC. There are various tests, all of which must be met by the individual in order to qualify as a “bona fide resident of Puerto Rico.” These tests are fact-intensive and take into account a variety of factors. Therefore, individuals seeking to avail themselves of these benefits should consult with their tax attorneys.
Estate and gift planning. Puerto Rico has family and inheritance law provisions with respect to the transfer of property by death or gift which may apply to an individual who establishes residence in Puerto Rico. These provisions could differ significantly from any planning techniques that you may have already implemented. That is, when weighing the decision to move to Puerto Rico, it is useful to revisit estate and gift strategies in addition to weighing other factors.