In an effort to increase revenues and to set up the basis for an upcoming restructuring of our tax system, the Puerto Rico Governor signed into law Act 77 of July 1, 2014 (Act 77). Act 77 amends various tax legislation, including the Puerto Rico Internal Revenue Code of 2011 (the New PR Code).
Act 77 amends the New PR Code to provide, among other things, a reduced tax to individuals, estates and trusts on the gain derived from the sale of capital assets or pre-pay the tax on the total or partial increase in value of certain assets. Act 77 provides for a reduced tax of 8% for “long term capital assets,” and of 15% for “included assets,” the income of which is taxable as ordinary income under the New PR Code. Retirement plans, whether qualified or not, are classified as included assets and, therefore, generally are subject to the 15% reduced tax rate.
As a result of Act 77, participants in retirement plans (whether qualified or not) may pre-pay – during a window period that starts on July 1, 2014 and ends on October 31, 2014 – at a reduced tax rate of 15% part or the total amount accumulated under the plan which is not currently distributable. The participant`s tax basis will be increased by the amount of the pre-payment and only the taxable portion of such distribution which has not been pre-paid will be subject to tax at the time of distribution. Act 77 further provides that qualified retirement plans allowed for in-service distributions to satisfy this pre-payment will not be disqualified under Section 1081.01(a) of the New PR Code.
Notwithstanding the above, Act 77 is silent on whether allowing for in-service distributions in order to satisfy this pre-payment is mandatory to all qualified retirement plans. If it is mandatory, it is still uncertain whether plan sponsors are required to amend the plans accordingly. Note that retirement plans qualified both under the provisions of the New PR Code and the United States Internal Revenue Code (the U.S. Code) of 1986, as amended, generally cannot be amended for this purpose because in-service distributions to pre-pay Puerto Rico income taxes are not a permissive distribution under the U.S. Code.
Act 77 is also silent on whether amounts distributed during the window period (i.e., lump sum distributions from qualified plans, or other types of distributions either from qualified or non-qualified plans after the separation from service for any reason or plan termination) also will be subject to a reduced tax and, if so, which withholding tax will be applicable for each of these distributions.
Along these lines, the New PR Code provides that lump sum distributions from qualified plans are considered as a long-term capital gain, currently subject to a 20% withholding and tax, while other distributions from qualified plans (i.e., annuity payments and periodic payments) are considered as ordinary income subject to the regular income tax rates and generally subject to a 10% withholding tax. In addition, distributions from non- qualified plans are generally treated as ordinary income subject to the regular wage withholding. Consequently, guidance is necessary as to the corresponding tax and withholding rates that should be applied to these distributions during the window period.
Furthermore, since lump sum distributions from qualified plans are generally treated as long term capital assets, it is also unclear whether these distributions should be subject to the reduced tax rate assigned to “long term capital assets” (8%) instead of the 15% applied to “included assets” subject to ordinary tax treatment.
Due to Act 77’s ambiguities and the short window period, it is expected that Puerto Rico’s Treasury Department will soon issue guidance and provide instruction on these issues, including the implementation of the window period.