On September 29, 2014, the Puerto Rico Treasury issued Tax Policy Circular Letter No. 14-02 (“CL 14-02”) to provide answers to the most frequent questions made by plan sponsors and plan administrators of retirement plans in connection with the pre-payment rules and procedures originally established through Administrative Determination No. 14-16 of August 6, 2014 (“AD 14-16”).  This new guidance overrides and clarifies prior understandings under AD 14-16 with respect to the discretion of the plan administrator or sponsor to recognize pre-payments under the plan.  As such, employers may be required to take new measures in order to comply with the new pre-payment rules.

Background and Summary of Changes

By way of background, Act 77 of July 1, 2014, amended the Puerto Rico (“PR”) Code to give participants in retirement plans (both qualified and non-qualified) a window to voluntarily prepay, at a preferential tax rate, the Puerto Rico income taxes on a participant’s vested undistributed balance in the plan.  The window period to make such prepayment of Puerto Rico income taxes is from July 1 through October 31, 2014. 

Pursuant to AD 14-16, it was generally understood that because the pre-payment window was totally voluntary, it was discretionary for a plan’s sponsor to allow for the distribution of plan assets to satisfy the prepayment of taxes under the retirement plan and/or maintain the accounting of the prepayments made by the participants’ own funds.  Consequently, the employer was not obligated to amend the plan to allow for the distribution of plan assets to make the prepayment or to record-keep any prepayments made by the participants’ own funds. 

With the new CL 14-02, the PR Treasury overturns this position. Although it continues to be voluntary for a plan sponsor to amend the plan to allow for the prepayment using the plan’s funds, the plan sponsor is now required to take the necessary measures to maintain records if the participant pays with his own funds and complies with the prepayment process established under AD 14-16 in order to avoid further taxation on a subsequent plan distribution.  Furthermore, to the extent the plan allows for in-service distributions and/or partial withdrawals, the plan sponsor must allow participants to make such withdrawals in order to make the prepayment with plan funds, so long as the participant complies with the requirements provided in the plan for in-service withdrawal or partial distribution. Moreover, the Plan sponsor, besides being obligated to record keep such prepayment to the extent the participant has complied with AD 14-16, it must also report the withdrawal/ distribution to the PR Treasury as nontaxable. 

The guidance set forth in CL 14-02 constitutes a change in policy by the PR Treasury regarding the prepayment process, and although it can be argued that ERISA preempts the new obligations required to be taken by plan sponsors with respect to the prepayment process, plan sponsors may nonetheless be required to take the necessary measures under their PR retirement plans (both defined contribution and defined benefit) to comply with these new requirements. 

CL 14-02 also clarifies the rules applicable to both plan distributions made during the window period and the required tax rate, which may require the plan sponsor to confirm with the paying agent/trustee that these new rules are implemented.

Breakdown of Detailed Changes and/or Clarifications

The following is a more detailed description of the guidance provided by the PR Treasury through CC 14-02:

  • Amendment to the plan to allow plan funds to be used for the prepayment and recordkeeping of prepayments. Plan sponsors are not required to amend their plans to allow distributions to satisfy the prepayments. However, to the extent a participant pays with his or her own funds and complies with the prepayment process, a plan sponsor is now required to maintain records of such prepayments in order to avoid further taxation on a subsequent plan distribution.
  • Partial or in-service withdrawals used to satisfy the prepayment. Plans allowing partial distributions or in-service withdrawals must allow participants to make the prepayment with plan funds, as per the participant’s request, provided a participant complies with the requirements provided in the plan to receive a partial distribution or an in-service withdrawal.  Such plans are not required to make the prepayment on behalf of the participant, but if a participant complies with the prepayment process (which includes the filing with the service provider evidence of the prepayment), the plan will have to report the withdrawal/ distribution as nontaxable.
  • Enforcement of participants rights. A participant whose employer or service provider refuses to make the distribution for a prepayment (when the participant understands that the plan provides for in-service withdrawals and/or partial distributions and that he or she is eligible for such withdrawal), may enforce his or her right by submitting a claim pursuant to procedures provided in the plan’s Summary Plan Description, contact the U.S. Department of Labor, or consult or submit a claim with the Employee Benefits Security Administration.
  • Notice to plan participants. Plan sponsors or service providers are not legally required to notify plan participants about the prepayment and the procedure to make such prepayment.
  • Tax rate applicable to withholding tax at source on distributions made from plans under the window period.  The tax rate for distributions on qualified plans is 8% and for non-qualified plans is 15%.  The CL 14-02 clarifies that distributions made during the window period must comply with the prepayment requirements pursuant to DA 14-16.  In such cases, the participating employer can either withhold the amount of the prepayment and process the prepayment on behalf of the participant or issue two checks (one payable to the Secretary of the Treasury with the amount of the prepayment and other for the rest of the amount payable to the participant).  In the latter case, the participant must follow the prepayment process provided in Section II (D) (1) of AD 14-16.
  • Amounts distributed from the plan where the withholding tax at source was higher than the applicable special tax. If a participant who receives plan distributions during the prepayment window period in which the employer or service provider applied a higher rate than the special tax (8% for PR qualified plans and 15% for non-qualified plans), the participant may request a reimbursement with the PR Treasury in his or her 2014 income tax return of the amount withheld in excess provided certain documentation is included with the return.
  • Method to make the prepayment.  The PR Treasury has made the prepayment process easier for institutions, investment companies or insurance companies by allowing them to make the prepayment with a non-certified check from the company’s account.  Any other person or entity must make the prepayment in any Tax Collector’s Office in cash, certified check, cashier’s check, money order or debit or credit card.
  • Due dates to make the prepayment.  CL 14-02 also reiterates the following prepayment deadlines:
    • If prepayment is made by the participant, the deadline for the participant to file in a Tax Collector’s Office the original of the prepayment form with a copy of the account statement and the corresponding payment is October 31, 2014;
    • If payment is made by the service provider, the deadline for the participant to submit to the service provider the prepayment forms is October 31, 2014, and the deadline for the service provider to deposit the prepayment with the PR Treasury is November 15, 2014.
  • Documents that can be used as account statements to make the prepayment.  Either a copy of the account statement indicating the balance or any document related to the administration of the plan (such as an employer or service provider’s certification, a computer printout of the participant’s account) can be used as an account statement for purposes of the prepayment.  The PR Treasury further clarifies that in the event the plan valuation does not allow for the issuance of a statement within 30 days prior to the prepayment, the participant can include a copy of the most recent valuation statement, however, the prepayment cannot exceed the total amount of the account, as reflected in such valuation statement.
  • Actuarial assumptions used to determine the benefit accumulated under a defined benefit plan. For defined benefit plans, plan administrators must use the actuarial assumptions provided in Section 417(e)(3) of the US Code to make the conversion in order to determine the amount of the prepayment.

The provisions of CL 14-02 will continue to be in effect during any extension period that may be granted.  In this regard, Senate Bill 1189 was submitted on September 17, 2014 to extend the window period, and if enacted, the window period will be extended until December 31, 2014.