Recent changes to Puerto Rico’s tax treatment of certain retirement plans have taken effect. Act No. 106 of August 23, 2017 (“Act 106”) amended Section 1081.01 of the Puerto Rico Internal Revenue Code as amended, (the “PR Code”), to reflect changes in the rules governing Puerto Rico qualified retirement plans. Employee benefit practitioners, service providers, as well as the Pension Plan Section at the Puerto Rico Department of the Treasury (the “PR Treasury”) were taken by surprise by these amendments, as they revised legislation designed to guarantee payment to government retirees and to establish a new defined contribution plan for government employees. Act 106 amended the PR Code (i) to eliminate the annual limits imposed by Act 9 of February 8, 2017 (“Act 9”) to defined contributions plans and to reinstate the previous annual limitations based on Section 415(c) of the United States Internal Revenue Code of 1986, as amended (the “U.S. Code”); (ii) to provide new rules for dual qualified plans pertaining to coverage testing; and (iii) to modify significantly the tax treatment of lump sum distributions. The following is a summary of the most important changes:
Changes Made by Act 106
1. Limitation on Annual Plan Contributions Applicable to Defined Contribution Plan
Act 106 eliminated the incomprehensible annual contribution limits imposed by Act 9, reinstating the annual limit based on U.S. Code Section 415(c). As a result of this change, the applicable annual limit on plan contributions for a defined contribution plan will continue to be the lesser of the applicable limit under U.S. Code Section 415(c) ($54,000 for year 2017 and $55,000 for year 2018) or 100% of the participant’s compensation paid by an employer during a calendar year or a plan year, as selected by the employer.
2. Tax Treatment of Total Distributions (“Lump-Sum Distributions”)
Changes to the tax treatment of lump-sum distributions are in effect for distributions made after December 31, 2017. The PR Code defines a lump-sum distribution as a distribution of the total benefits under a plan to a participant or a beneficiary within one taxable year due to the participant’s separation from service for any reason or due to plan termination.
a. Lump-sum distributions made before January 1, 2018 – Remain the same. In general, lump-sum distributions will generally be considered a long-term capital gain subject to a 20% tax rate (10%, if certain requirements are met related to investment in property located in Puerto Rico, pursuant to PR Code Sections 1081.01(b)(1)(A)(i) and (ii))).
b. Lump-sum distributions made after December 31, 2017 – In general, lump-sum distributions will be considered ordinary income, subject to the applicable tax rates for individuals (currently, from 7% to 33%). Notwithstanding the above, for lump-sum distributions compliant with the tax withholding and deposit obligations under the PR Code, in lieu of the normal tax rates applicable to individuals, a 20% tax rate will apply. Therefore, the 20% tax rate will continue to apply to lump-sum distributions, but only to the extent the withholding and deposit obligations are satisfied (10%, if certain requirements are met related to investment in property located in Puerto Rico, pursuant to PR Code Sections 1081.01(b)(1)(A)(i) and (ii)).
c. Obligation to withhold and deduct –
● For lump-sum distributions made before January 1, 2018 – The rules remain the same—lump-sum distributions are subject to tax withholding at a 20% rate.
● For lump-sum distributions made after December 31, 2017 – The tax withholding rate is reduced to 10% (from 20%). This change may impact participants receiving lump-sum distributions, since the withholding tax rate may not be sufficient to cover the participant’s tax responsibility on these types of distributions.
3. Special Rules for Dual-Qualified Plans
Dual-qualified plans will be deemed to have complied with the coverage testing under the PR Code, to the extent the plan, with respect to all participants, including Puerto Rico residents, has satisfied the coverage testing under U.S. Code Section 410(b). This is excellent news for dual-qualified plans, since they do not have to do additional coverage-testing for Puerto Rico resident participants under the PR Code.
Note that Act 106 did not amend the definition of “highly compensation employee” (“HCE”), previously amended by Act 9. Therefore, effective for years 2017and thereafter, officers will be excluded from the definition of HCE and the compensation limitation is $150,000. Although the PR Treasury recently announced the retirement plan limits for 2018 under the PR Code, they announced that the compensation limit for HCE for 2018 is $120,000 (as provided under the U.S. Code,) disregarding the $150,000 limitation imposed by Act 9. We expect clarification from the PR Treasury in connection with this limitation.
It is important to note that pursuant to PR Treasury Tax Policy Circular Letter No. 16-08 (“CC 16-08”), “qualification amendments” are required to be submitted for qualification with the PR Treasury. An amendment to change the definition of HCE pursuant to Act 9 is considered a “qualification amendment.” Therefore, pursuant to CC 16-08, such an amendment must be submitted for qualification with the PR Treasury. However, it is not yet certain whether the PR Treasury will waive this requirement and only require plan sponsors to amend their plans, if needed. We expect some guidance in connection with this matter.