An unincorporated territory of the United States since 1898, Puerto Rico's business infrastructure is very well developed and provides the necessary legal framework to conduct business on the island. In particular, Puerto Rico provides great legal and financial certainty with regards to transactions conducted on the island.
Pursuant to Section 734 of Title 28 of the United States Code (USC), Puerto Rico has an independent tax-levying authority. To this effect, the main body of domestic statutory tax law in Puerto Rico is the Internal Revenue Code of 2011, as amended (PR Code or PRIRC). The PR Code applies to income tax, payroll taxes, gift taxes, estate taxes, sales tax and statutory excise taxes.
Puerto Rico's tax system is greatly influenced by that of the United States. However, several differences exist that make Puerto Rico more attractive to foreign investors seeking to invest in other countries. Puerto Rico currently offers foreign investors considerable tax advantages to relocate there and to bring in their capital.
II COMMON FORMS OF BUSINESS ORGANISATION AND THEIR TAX TREATMENT
Foreign investors can conduct business in Puerto Rico through domestic or foreign entities. If an investor decides to establish its business through a local entity, several alternatives are available. Most commonly, investors use corporations or limited liability companies (LLCs). Limited liability partnerships (LLPs) may also be established to conduct business in Puerto Rico. The type of entity chosen depends on various factors, including the type of business to be conducted, who the owner is and the tax treatment of the entity.
Regardless of the place of formation, depending on the type or characteristics of the entity chosen, the tax treatment can be at the entity's level or at the owners' level. If the entity is taxed at its own level, its owners may also be subject to taxation at their level for distributions made by the entity to the owners.
The majority of businesses decide to adopt a corporation form to conduct their business. However, new companies are now utilising LLCs more frequently as their choice of entity type. Ordinarily, both forms of entity are treated the same for tax purposes. The main reason to use an LLC is that it does not require compliance with as many formalities and annual reporting requirements as corporations do.
From an inbound investment perspective, the most commonly used form of business organisation in Puerto Rico is the LLC, which is preferred owing to its less arduous corporate governance requirements. Investors also have the option to conduct their business in Puerto Rico through a corporation.
The formation of both the above types of entities is simple, quick and, in most cases, very cost-effective. Both provide limited liability to their owners to the extent of the capital they have invested in the entity, and no minimum capital requirement exists.
To form a corporation in Puerto Rico, an incorporator must file articles of incorporation with the Department of State of Puerto Rico. The articles of incorporation must include:
- the name of the corporation, which must include a designation identifying the entity as a corporation (i.e., 'inc' or 'corp');
- the physical and mailing address of the corporation;
- the purpose of the corporation;
- the name and contact information of the incorporators, and whether their involvement with the corporation ends incorporation of the corporation;
- the name and contact information of the corporation's resident agent; and
- the amount and type of shares the corporation may issue, any restriction imposed on the shares and the par value of the shares, if any.2
Other information may be included in the articles of incorporation, but is not required.3 Once the articles of incorporation are filed and the incorporation fee is paid (US$150), the corporation is duly incorporated and has its own legal personality.4
Once incorporated, corporations must hold a shareholders' meeting at least once a year.5 During such meeting, the shareholders elect a board of directors that is responsible for carrying out the day-to-day operations of the entity.6 Directors are required to be natural persons of legal age.7 The number of directors and their duties and responsibilities are determined in the corporation's by-laws.
Corporations must also file an annual report that includes information about the corporation's finances, identifies the corporate officials and includes other information that the Secretary of State may require.8 If a corporation's business volume is more than US$3 million, audited financial statements must be filed with its annual report. The annual report must be accompanied by a filing fee of US$150. Not filing an annual report exposes corporations to a fine of US$750. If a corporation does not file an annual report for two consecutive years, the Secretary of State may cancel the corporation's certificate.9
To organise an LLC in Puerto Rico, an authorised person must file articles of organisation with the Department of State. The articles must include information very similar to the information provided in the articles of incorporation of a corporation. The most notable differences are that the name of the entity must use a designation that identifies it as an LLC (i.e., 'LLC' or 'CRL'), and the organisation fee is higher (US$250). Instead of shares, LLCs may issue units or participations, and the incorporators are named authorised persons.
Upon organisation, members of LLCs may execute an operating agreement, which is a contract that establishes how the entity is going to be managed and administered. The contents of the LLC agreement are extremely flexible as long as the terms contained therein are not contrary to local law.
LLCs must pay an annual fee of US$250. The payment of the annual fee requires submitting some information, but not in as detailed and rigorous a manner as the information in a corporation's annual report.
From a tax perspective, corporations and LLCs are subject to Puerto Rico corporate income taxation on their income. However, in some instances, and if certain requirements are met, these entities can be treated as fiscally transparent entities, avoiding taxation at the corporate (entity) level. If this is not the case, stockholders or members may be taxed separately on distributions received from corporations or LLCs, respectively.
Another type of structure that investors may choose to conduct their business in Puerto Rico is a partnership. Three types of partnership are available in Puerto Rico: general partnerships (GPs), limited partnerships (LPs) and LLPs.
A partnership is defined as an agreement between two or more natural persons or juridical entities to carry on a business for profit pursuant to a partnership agreement. Partnerships may be organised under the Civil Code, the Commercial Code or the Limited Liability Partnership Law. The Civil Code treats a GP as a juridical entity separate from its owners. However, the Civil Code does not provide any limited liability to the partners of a GP.
The only difference between a GP and an LP is that the contract governing the latter must identify the regular partners from the limited partners. Limited partners are only required to make capital contributions and are shielded from liability. However, a limited partner must indemnify the limited partnership from any harm resulting from an abuse of the partner's position or negligence. Regular partners, on the other hand, are in charge for the day-to-day operations of the partnership and are responsible, through their patrimony, for the obligations and debts of the LP.
An LLP may be formed by two or more natural persons pursuant to the provisions of Act No. 154 of 20 August 1996. Generally, LLPs are established for the rendering of professional services. A partner of an LLP are ordinarily not personally liable for the debts and obligations of the partnership or for negligent or unlawful acts of another partner or employee not supervised by that partner, provided he or she had no prior knowledge of such acts.10 However, a partner may be held personally liable for partnership debts and obligations that arise out of an error, omission, negligence, incompetence or illegal act committed by that partner or in which that partner was involved, directly or through any person under his or her control or supervision, or of which such partner had notice or knowledge.11 The name of LLPs must include one of the following at the end of their name: 'Sociedad de Responsabilidad Limitada' or limited liability partnership, or the initials 'SRL' or 'LLP'.12
Partnerships are considered transparent for Puerto Rico tax purposes. Thus, the income of a partnership is not taxed at the level of the entity (partnership), but rather attributed to its partners and subject to their applicable income tax rate, regardless of whether a distribution was made. However, partnerships existing on or prior to 1 January 2011 may elect to continue to be treated as a corporation. In that case, partnerships and their partners are subject to tax at the entity level and again at the partner level to the extent the partnership makes any distributions.
Rarely used, foreign investors may choose to conduct their business through a trust. Trusts are created by virtue of public deeds authorised by notaries public. This type of entity is regulated by the Trust Funds Act.13
Generally, trusts are taxed as individuals. The tax is to be paid by the trust itself.
III DIRECT TAXATION OF BUSINESSES
As previously mentioned, Puerto Rico's tax system is greatly influenced by that of the United States. Puerto Rico taxes domestic entities and their residents on their worldwide income. Like the United States, Puerto Rico allows these taxpayers to claim a credit for certain taxes paid by them to the United States or foreign countries.14
Foreign corporations engaged in trade or business in Puerto Rico are taxed like domestic corporations in relation to income generated from being engaged in trade or business in Puerto Rico.
i Tax on profits
Determination of taxable profit
Puerto Rico residents and domestic entities are subject to taxation on their worldwide income. However, not all income is taxable. The PRIRC prescribes a formula to determine what amount of income is subject to taxation. Thus, to determine taxable income, taxpayers are required to compute gross income, gross income less exemptions, adjusted gross income and net taxable income.
Gross income includes:
- all gains, wages and compensation for services performed;
- income from professions, trades and businesses;
- sales and dealings in properties;
- partnership profits;
- transactions in securities; and
- gains, profits and income derived from any source.
Gross income excludes those items listed in PRIRC Section 1031.01(b).15
After computing gross income, taxpayers must compute gross income less exemptions. These exemptions are contained in Section 1031.02 of the PRIRC.16 The taxpayer must next identify income subject to other rates of taxation and other allowable deductions, and subtract said amounts from the gross income. This is known as adjusted gross income.17
Finally, net income is determined by deducting from gross income allowable business deductions, and a few possible special deductions directly from 'gross income less exclusions and exemptions'.18
Corporations are not eligible for the deductions from adjusted gross income allowed to individuals, or personal and dependency exemptions.
Foreign entities and non-residents
Foreigners, corporations, pass-through entities and non-residents that are engaged in trade or business in Puerto Rico are subject to Puerto Rico taxation on their income that is effectively connected with the conduct of such trade or business. The rules to determine if income is 'effectively connected income' (ECI) are found in Sections 1123 (f) and (h) of the Regulation of the PRIRC of 1994, which are still in full force and effect.19
In general terms, ECI includes:
- all income from sources within Puerto Rico, and income attributable to an office or fixed place of business in Puerto Rico;20
- the following:
- rents or royalties derived from the use outside Puerto Rico of intangibles such as secret processes, formulae, patents, trademarks, franchises and copyrights;
- dividends, interest, gains or losses from the sale or exchange of stocks or bonds or other evidence of indebtedness that are either derived from a banking or financing business or from a corporation trading in stocks or securities for its own account; and
- gains or losses derived from the sale or exchange of personal property outside Puerto Rico through the corporation's office or fixed place of business in Puerto Rico (except gains or losses from the sale of personal property that is manufactured outside Puerto Rico and is to be used, consumed or disposed of outside Puerto Rico);21
Capital and income
Taxpayers may elect to treat income derived from the sale or exchange of their capital assets at a fixed preferential income tax rate, and to have their other income taxed in the regular manner; or included as part of their gross income, and taxed at the corresponding ordinary income tax rate. Currently, the long-term capital gains fixed income rate is 15 or 20 per cent for individuals and corporations, respectively.24 To qualify as a long-term capital gain, the asset sold must be a capital asset and must have been owned by the taxpayer for more than one year.25 As in the United States Internal Revenue Code, capital assets are defined by establishing what does not constitute a capital asset.26
The PRIRC allows taxpayers to deduct net operating losses (NOLs). NOLs are equal to the excess of deductions over gross income, subject to certain exclusions.27 NOLs have a carryover period of 10 years,28 and the deduction is limited to 80 per cent of net income.29 NOLs do not include expenses paid to a related person or home office located outside of Puerto Rico.30
If a corporation is acquired, the NOL of said corporation can only be used to reduce the net income of the acquiring corporation derived from the same commercial activity or trade or business that generated the loss.31 In addition, if a corporation undergoes a change in ownership as defined by the PRIRC, the use of NOLs in subsequent years may be subject to certain limitations.32
If a corporation has net capital losses, it can carry over such losses for a period of five years after the year of such losses.33 However, when capital losses are carried into another year, they are treated as short-term capital losses. If a corporation claims the deduction, the loss is limited to 80 per cent of net income.34 All other taxpayers can claim capital losses up to the amount of gains in the same taxable year.35
Currently, the corporate income tax comprises a 20 per cent tax rate plus a graduated surtax computed on the 'surtax net income'.36 The 'surtax net income' is basically the net taxable income subject to regular tax less a surtax deduction amounting to US$25,000. The graduated surtax rates are as follows:
|Up to US$75,000||5 per cent|
|From US$75,001 to US$125,000||US$3,750 plus 15 per cent of surtax net income from US$75,001 to US$125,000|
|From US$125,001 to US$175,000||US$11,250 plus 16 per cent of surtax net income from US$125,001 to US$175,000|
|From US$175,001 to US$225,000||US$19,250 plus 17 per cent of surtax net income from US$175,001 to US$225,000|
|From US$225,001 to US$275,000||US$27,750 plus 18 per cent of surtax net income from US$225,001 to US$275,000|
|From US$275,001 and above||US$36,750 plus 19 per cent of surtax net income from US$275,001 and above|
The applicable surtax rate is determined on a consolidated basis for controlled groups and related companies, and the net taxable income of all the entities subject to tax in Puerto Rico within the groups are combined for the determination of the applicable surtax rate.
Corporations are also subject to an alternative minimum tax to the extent that this tax exceeds the regular corporate tax.
Foreign entities and individuals are taxed depending on whether they are engaged in trade or business in Puerto Rico. If they are, their income effectively connected with their Puerto Rico trade or business is taxed as it would be if they were domestic taxpayers.37 If these taxpayers are not engaged in trade or business in Puerto Rico, Puerto Rico-source passive income received or deemed received is taxed at the following rates:
|Type of income||Individuals*||Corporations†|
|Interest received by a related person, rents, royalties, salaries, annuities, compensations, remunerations, emoluments, distributions by certain types of entities related to real estate,‡ income pertaining to the distributive share of a partner's interest in a partnership, special partnership, LLC, net capital earnings, or other fixed or determinable annual or periodical gains, profits and income (other than insurance premiums or interests)||29 per cent||29 per cent|
|Dividends||10 per cent||10 per cent|
|Income pertaining to the distributive shares of a stockholder in a corporation of individuals||33 per cent||N/A|
|* Section 1091.01(a) of the PRIRC, PRLA T13 Section 30431
† Section 1092.01(a) of the PRIRC, PRLA T13 30432
‡ Specifically, homeowner associations and any entity created or organised under the laws of the United States, or those of any state of the United States, which, during the taxable year, qualifies as a registered real estate investment company or investment trust under the United States Internal Revenue Code of 1986
Interest paid to an unrelated foreign corporation not engaged in trade or business in Puerto Rico is not taxable in the hands of the foreign corporation and is not subject to withholding.38
The tax rates applicable to individuals for years commencing after 31 December 2015 are as follows:39
|Taxable net income||Tax rate|
|Net taxable income less than US$9,000||Zero per cent|
|Over US$9,000 but less than US$25,000||7 per cent of the excess over US$9,000|
|Over US$25,000 but less than US$41,500||US$1,120plus 14 per cent of the excess over US$25,000|
|Over US$41,500 but less than US$61,500||US$3,430 plus 25 per cent of excess over US$41,500|
|Over US$61,500||US$8,430 plus 33 per cent of excess over US$61,500|
Understanding the tax rates of individuals is necessary owing to their applicability to certain business that are pass-through entities.
Based on the principle of self-assessment, taxpayers are required to file tax returns on the 15th day of the fourth month after the closing of their fiscal year.40 Generally, corporations adopt a calendar year. However, they may elect to have a different fiscal year. A three-month extension to file a return is available.41 The payment of tax is due on the 15th day of the fourth month after the closing of the taxpayer's fiscal year.42 Taxpayers may request a six-month extension to pay the taxes owed.43 The Secretary of the Treasury of Puerto Rico may grant said request, but is not required to do so.44
Some taxpayers may be required to file personal property tax returns by 15 May of each year and volume of business declarations by the fifth business day after 15 April.
From a central government perspective, the Department of the Treasury is in charge of collecting taxes in Puerto Rico. The Municipal Collection Revenue Center (CRIM) collects property taxes. Finally, the department of finance of each municipality may impose and collect, subject to the authorisation of the government, additional taxes and fees such as construction fees and the municipal licence tax.
Ordinarily, a four-year statute of limitations after the return is filed applies for the Department of the Treasury to assess income, payroll, withholding, and sales and use taxes.
If a taxpayer assumes a position with respect to certain tax issues, and the Department of the Treasury, CRIM or the department of finance of a municipality disapproves of such position, the taxpayer may challenge the position taken by the tax authority. The process to challenge the tax position taken by the taxing authority varies on the type of tax at issue. However, in general terms, the taxpayer requests an administrative proceeding and then, if he or she disagrees with the outcome of such proceeding, the taxpayer may challenge it in the court system.
Prior to assuming a tax position, taxpayers may, if certain requirements and formalities are met, request the Department of the Treasury to rule on a particular issue.45 The ruling issued by the Department will be binding for both the taxpayer and the Department.46
No tax grouping rules exists in Puerto Rico. Therefore, consolidated returns cannot be filed by corporations.
ii Other relevant taxes
Sales and use tax
Puerto Rico imposes a sales and use tax of 10.5 per cent on the sale, use, storage or consumption of a taxable item.47 This tax is paid by consumers; however, it is collected and remitted to the Department of the Treasury by merchants, who act as withholding agents for Puerto Rico.
Real property tax
Puerto Rico real property is subject to an annual real property tax. This tax is computed based on property values that date back to the fiscal year 1957–1958 (which was the last time that a general appraisal was conducted by the government). The tax assessment is made as of 1 January of each year by CRIM by discounting the current fair market value of the property to the 1957–1958 values. The applicable tax rates range from 8.03 to 11.83 per cent depending on the municipality where the property is located. Property taxes collected by CRIM are deposited into a trust fund at the Government Development Bank for Puerto Rico.
Personal property tax
CRIM requires the filing of a personal property tax return every year by 15 May. The rate varies from approximately 5.8 to 9.5 per cent of the reported value depending on the municipality, and may change from year to year.
In Puerto Rico, payroll taxes are imposed in the form of income taxes, Federal Insurance Contributions Act taxes, federal unemployment taxes, Puerto Rico employment security taxes, disability taxes, workmen's compensation premiums and chauffeurs' insurance premiums.
Puerto Rico employees are subject to income tax withholding on their payroll.48 They must also pay US social security and Medicare taxes.49 The obligation to withhold these taxes and remit the payment to the appropriate government entities belongs to the employer.
Puerto Rico unemployment tax is paid by the employer. This tax is imposed on the first US$7,000 of total wages paid to each employee during the calendar year, based on an experience rating system. Moreover, the employer must also pay a 1 per cent special tax on the wages subject to unemployment tax. However, the special tax together with the experience-based tax cannot exceed 5.4 per cent.
Puerto Rico provides all employees with disability insurance. This insurance is funded by imposing a contributory tax on the first US$9,000 of the total wages paid during the year (0.6 per cent). Half of this tax is paid by the employer and the other half is paid by the employee.
Employers are also responsible for paying the premiums for workmen's accident compensation insurance. This insurance is compulsory, and is for employees who suffer injury, become disabled or lose their lives owing to a job-related accident. The premium is based on total wages paid during the government's fiscal year. The applicable rates vary among industry types. By paying the insurance, the employers enjoy immunity from work-related accidents.
An employer with one or more drivers is subject to the chauffeurs' social security tax. The tax is imposed on both the employer and the employee as follows: every employer must pay US$0.30 per week or fraction thereof for each covered employee; and every employee must pay US$0.50 per week or fraction thereof.
Municipal licence tax
Any individual or entity engaged in trade or business in Puerto Rico is subject to municipal licence tax. This tax is paid to all municipalities in which the individual or entity conducts business. If the business is non-financial, the tax may be as high as 0.5 per cent of the gross volume of business50 the company received or accrued during the year.
A separate tax return must be filed on or before 15 April of each year. This return is filed with each of the departments of finance of the municipalities where the entity is engaged in business, and reflects the volume of business realised by the corporation during the accounting year prior to the filing of the return. An extension of the time period for the filing of the returns is available, but an estimated payment must accompany such request.
Some products are subject to a special excise tax, including cigarettes, fuels, crude oils, vehicles, alcoholic beverages, cement, sugar and plastic products. The applicable tax depends on each product.
Act 154 of 2010 adopts new source income rules and imposes a temporary excise tax on certain purchases by non-resident individuals, corporations or partnerships of products manufactured in Puerto Rico; and services related to said products by entities affiliated with the purchaser.
Construction excise tax
The municipalities may impose an excise tax on construction. The construction excise tax rate varies from municipality to municipality, but is generally around 4 or 5 per cent of the cost of the project. Costs of the project incurred for work performed outside Puerto Rico should not be subject to the construction tax, and the construction of certain projects is not taxable.
IV TAX RESIDENCE AND FISCAL DOMICILE
i Corporate residence
Corporate residence is based on the place of incorporation, and not on where corporations are managed or controlled. Under the PRIRC, foreign corporations are deemed those not organised under the laws of Puerto Rico.51
The PRIRC does not define the term 'engaged in trade or business'. However, the Regulations issued pursuant to the Puerto Rico Internal Revenue Code of 1994 provide that said term includes the rendering of services in Puerto Rico at any time during the taxable year, and does not include transactions in shares of stock, securities or exchange commodities through a resident broker, resident agent or resident custodian.52 It should be noted that the definition of 'engaged in trade or business' of the courts of the United States is used consistently by the Puerto Rico Department of the Treasury.
Any partner of a partnership engaged in trade or business in Puerto Rico shall be deemed engaged in a trade or business in Puerto Rico with respect to his or her distributive share of the partnership's income, gains, losses, deductions and credits.53
ii Branch or permanent establishment
As previously mentioned, foreign investors may conduct business in Puerto Rico through foreign or domestic entities. If they decided to conduct their business by establishing a branch in Puerto Rico, they may be subject to a branch profit tax (BPT).
A foreign corporation that derives less than 80 per cent of its gross income from sources within Puerto Rico and from income effectively connected to its trade or business in Puerto Rico, is subject to a BPT of 10 per cent of the dividend equivalent amount for the taxable year.54 This tax is imposed on the amount of earnings and profits not reinvested in activities in Puerto Rico. Net equity is equal to the excess of the basis of Puerto Rico assets owned by the foreign branch that are treated as effectively connected to its trade or business in Puerto Rico over the liabilities of the Puerto Rico branch effectively connected to its trade or business in Puerto Rico.55
The dividend equivalent amount is equal to the earnings and profits of the foreign branch derived from the effectively connected income relating to the trade or business in Puerto Rico reduced, but not below zero, by the increase in Puerto Rico net equity, and increased by the reduction in Puerto Rico net equity.56 The increases and decreases are determined by comparing the Puerto Rico net equity at the beginning of the year with the Puerto Rico net equity at the end of the year.57
To determine earnings and profits relating to ECI, the dividends distributed by a foreign corporation operating as a branch-out of earnings derived from sources within Puerto Rico are not taken into account.58 However, said earnings and profits include the excess of the accelerated depreciation deduction over the amount of the depreciation deduction that would result from application of the straight-line method, and certain interest excluded from gross income. Earnings and profits are reduced by the Puerto Rico income tax paid with respect to that year, excluding the BPT for the year, and business-related meals and entertainment expenses that were not deducted owing to the statutory limitation.
It is more advantageous to operate a subsidiary than a branch. First, the 10 per cent dividend tax is applied only when dividends are actually paid, while the BPT (when applicable) is automatically applied. Second, in the case of a subsidiary, the assets of the parent will generally not be exposed to possible claims originating from activities in Puerto Rico.
V TAX INCENTIVES, SPECIAL REGIMES AND RELIEF THAT MAY ENCOURAGE INWARD INVESTMENT
Puerto Rico offers foreign investors several tax incentives to engage in and operate business in Puerto Rico. These incentives are structured either as tax credits or as a reduction in the applicable tax rates.
i Act 73
Designed to stimulate employment and productivity, research and development, capital investment, reductions in the cost of energy, and increased purchases of local products, the Economic Incentive for the Development of Puerto Rico Act (EIDA) allows companies qualifying under Act 73 to benefit from a simplified income tax system. To accomplish this, it applies an income tax rate of 4 per cent and a withholding tax rate of 12 per cent. Alternatively, the income tax can be lower if the income generated is from certain sources. For example, there is 100 per cent tax exemption on income generated from interest payments on assets held in Puerto Rico financial institutions.
EIDA also provides that special rates apply to projects located in low and mid-development zones, certain local projects, certain small and medium-sized businesses, and pioneering activities. (An income tax rate of 1 per cent, but for those using intangible property created or developed in Puerto Rico the income tax rate may be zero per cent).
Moreover, EIDA grants a 90 per cent exemption from property taxes, a 100 per cent exemption from municipal licence taxes during the first three semesters of operations and at least 60 per cent thereafter, and a 100 per cent exemption from excise taxes, and sales and use taxes with respect to the acquisition of raw materials and certain machinery and equipment used in the exempt activities.
Pursuant to EIDA, passive income derived by exempted businesses from the investment of eligible funds in Puerto Rico financial institutions, the obligations of Puerto Rico and other designated investments is exempt from income taxation as well as municipal licence taxes. Companies can also repatriate or distribute their profits free of Puerto Rico dividend taxes. Gains from the sale or exchange of shares of an exempted business by its shareholders during the exemption period that is otherwise subject to Puerto Rico income tax would be subject to a special Puerto Rico income tax rate of 4 per cent.
To obtain these benefits, companies must apply for a tax grant issued by the Office of Industrial Tax Exemption and the Department of Economic Development and Commerce.59 Tax grants issued to a qualifying business are for a term of 15 years.60
ii Tourism tax incentives
The Tourism Development Act of 2010 (TDA 2010) was enacted to substantially increase the country's tourism industry and thereby create more balanced economic development. To accomplish this objective, the TDA 2010 offers economic incentives to developers, operators and investors in hotels and other tourism-related projects. Some of these incentives are tax-related.
A business devoted to tourism-related activities that is not covered under a tax incentive decree under another applicable law or, if so covered, surrenders such decree, may qualify for a grant of tax incentive under the TDA 2010. The term 'tourism-related activities' includes:
- the ownership and management of hotels, condo hotels, inns and guest houses;
- the ownership and management of theme parks operated by or associated with an exempt hotel and golf courses operated within a resort;
- the ownership and management of tourist marinas, port area facilities and other facilities that constitute an inducement to tourism;
- the operation of a business devoted to leasing property to a business devoted to any of the above-listed activities (excluding financial leasing contracts);
- the development and management of natural resources used as passive or active entertainment or amusement, such as caves, forests, natural reserves, lakes and canyons; and
- the ownership and management of agro-inns to provide rooms for transient visitors for the enjoyment of nature and for participating in agricultural or Puerto Rican handicraft activities.
The income derived from qualifying tourism-related activities will be partly or completely exempt from taxation subject to the following:
- the percentage of income tax exemption offered to qualifying tourism-related activities not established on the islands of Vieques or Culebra may reach 90 per cent;
- for qualifying tourism-related activities established on the islands of Vieques or Culebra, the percentage of income tax exemption may reach 100 per cent; and
- a 100 per cent exemption will be applicable to dividend or profit distributions, and distributions in liquidations. The income covered by a tourism decree issued under the TDA 2010 is also exempt from corporate alternative minimum tax, corporate surtax on improperly accumulated income and individual alternative minimum tax.
iii Free trade zones
Puerto Rico is within the customs jurisdiction of the United States. Therefore, imports into Puerto Rico from foreign countries are subject to applicable duties under corresponding US customs and imports laws.
US customs laws provide for the establishment of free trade zones (FTZs). There are four FTZs in Puerto Rico:
- FTZ No. 61 located in the metropolitan area near the San Juan port facilities;
- FTZ No. 163 located near the port facilities in Ponce;
- FTZ No. 7 located in Mayaguez; and
- sub-zones located throughout the island in certain Puerto Rico Industrial Development Company industrial parks.
From a federal tax perspective, goods, except those specifically excluded by US customs laws, may be introduced into an FTZ, and may be stored, sold, exhibited, broken up, repacked, assembled, distributed, sorted, graded, cleaned, mixed with other merchandise, used in a manufacturing process, exported or destroyed exempt from US customs duties.
The goods imported directly into an FTZ in Puerto Rico are exempt from Puerto Rico excise tax during the time they remain in the FTZ. Goods sold to a buyer in a foreign country and shipped directly from the Puerto Rico FTZ area are not subject to Puerto Rico excise tax.
Goods destined only for foreign markets located in a foreign trade zone are pre-empted from state local ad valorem taxes. Furthermore, the Municipal Property Tax Act of 1991, as amended, provides in part that 'property exempt from the payment of taxes by the laws of the United States' is exempt from personal and real property taxes.
Gross income derived from the exporting activities of a business located in a FTZ is exempt from municipal licence tax. All other income derived from other activities conducted by a business located in an FTZ is subject to municipal licence tax.
Businesses located in an FTZ in Puerto Rico are subject to Puerto Rico income tax. However, a business that is operating under an industrial tax exemption grant is entitled to the Puerto Rico income tax benefits offered under the terms of such grant.
iv Act 20
Enacted in 2012, the Act to Promote the Exportation of Services provides tax incentives to individuals or corporations with a bona fide office or establishment located in Puerto Rico that is or may be engaged in an 'eligible business', defined as persons that provide 'eligible services,' which in turn are considered for foreign markets or promotion services.
The term 'eligible services' includes:
- research and development;
- advertising and public relations;
- economic, environmental, technological, scientific, management, marketing, human resources, information and audit consulting;
- advisory services on matters relating to any trade or business;
- commercial arts and graphic services;
- production of construction drawings, architectural and engineering services, and project management;
- professional services such as legal, tax and accounting;
- corporate headquarters;
- electronic data processing centres;
- development of computer programs;
- voice and data telecommunications between persons located outside of Puerto Rico;
- call centres;
- shared services centres ('shared services'), including but not limited to accounting, finance, taxes, auditing, marketing, engineering, quality control, human resources, communications, electronic data processing and other centralised management services;
- storage and distribution centres ('hubs');
- educational and training services;
- hospital and laboratory services;
- investment banking and other financial services; and
- any other service that the government later determines must be treated as an eligible service.
Act 20 provides a 4 per cent flat income tax rate on export services income, 100 per cent tax-exempt distributions from earnings and profits derived from export services income, a 90 per cent exemption from property taxes (a 100 per cent exemption during the first five years of operations in the case of certain eligible services) and a 60 per cent tax exemption on municipal licence taxes. To be able to obtain these tax benefits, a service provider must apply for and obtain a tax exemption decree. This decree, if granted, will have a term of 20 years, renewable for 10 additional years, if certain conditions are satisfied. To be eligible for these tax benefits, the service provider must receive a certificate of compliance from the Department of Economic Development and Commerce annually.
v Act to Promote the Relocation of Individual Investors to Puerto Rico (Act 22)
Act 22 was enacted in 2012. This Act provides a 100 per cent tax exemption from Puerto Rico income tax on interest and dividends that qualify as Puerto Rico-source income received by a 'resident individual investor'. A resident individual investor is an individual who has not been a resident of Puerto Rico for the past six years before his or her first year of residence in Puerto Rico. Individuals applying for an Act 22 tax grant must own residential property in Puerto Rico and have a personal business account at a Puerto Rico bank or credit union.
Act 22 provides a preferential income tax rate for capital gains derived by the resident individual investor. If such gain was deemed accrued prior to becoming a Puerto Rico resident and is recognised within 10 years after the date residence is established in Puerto Rico, it will be taxed at a 10 per cent income tax rate, and at a 5 per cent income tax rate if such gain is recognised after said 10-year period but prior to 1 January 2036. Gains related to investment appreciation considered accrued after becoming a Puerto Rico resident will be 100 per cent exempted from Puerto Rico income taxes.
vi Other tax incentives
Act 168 of 30 June 1968, as amended, provides tax benefits to natural or juridical persons engaged in the operation of hospital units.
A tax credit is also available to investors to induce investment in the construction of facilities for the treatment and disposal of solid waste.
Act No. 135 of 9 May 1945 offers public air carriers an exemption from commonwealth and municipal property taxes on all real and personal property owned by the carrier.
Farmers are offered various tax incentives such as an excise tax exemption for certain machinery and products used in farming operations, a property tax exemption for land used intensively in raising certain agricultural crops and a 90 per cent exemption from income tax with respect to income derived from agricultural business.
To promote the construction and rehabilitation of social interest housing and middle class housing, Puerto Rico offers an exemption of up to US$5,000 of the gain from the sale of each unit of social interest housing units; and an exemption of up to US$2,500 of the gain from the sale of each unit of middle-class housing units.
Puerto Rico also offers the film industry significant tax advantages if they film their projects on the island. To this effect, on 4 March 2011, the Economic Incentives for the Film Industry Act was passed into law (Act 27). Act 27 offers significant tax benefits to certain persons engaged in, or responsible for, managing, developing, promoting or furthering an eligible film project or an infrastructure project.
vii Holding company regimes
Puerto Rico does not have a holding company regime in place.
viii IP regimes
Currently, Puerto Rico has no IP regime in place. However, individuals who qualify under Act 22, 2012 can reduce their income derived from royalties.
ix State aid
Puerto Rico offers state aid only under certain circumstances.
VI WITHHOLDING AND TAXATION OF NON-LOCAL SOURCE INCOME STREAMS
i Withholding on outward-bound payments (domestic law)
Foreign corporations and non-residents not engaged in trade or business in Puerto Rico are subject to a 29 per cent withholding on interests received by a related person, rents, royalties, salaries, annuities, compensations, remunerations, emoluments, distributions of certain types of entities related to real estate,61 income pertaining to the distributive share of a partner's interest in a partnership, special partnership, LLC, net capital earnings, or other fixed or determinable annual or periodical gains, profits and income (other than insurance premiums or interest). This may include income received by related persons. However, a 10 per cent withholding rate applies if the payment is a dividend.
ii Domestic law exclusions or exemptions from withholding on outward-bound payments
If income is derived from interest payments on various credit facilities then the withholding rate does not apply.62
iii Double tax treaties
Owing to its political situation, Puerto Rico may not sign any treaty by itself. However, tax treaties entered into by the United States may be applicable to Puerto Rico. Pursuant to an opinion of the Puerto Rico Supreme Court, any Puerto Rico resident that is a citizen of the United States can claim the benefits of the tax treaty between the United States and the United Kingdom, and the terms of such treaty supersede any provision of Puerto Rico Law.63
VII TAXATION OF FUNDING STRUCTURES
Corporations can be funded through equity or liabilities. Ordinarily, no income is recognised by a Puerto Rico corporation on the original issuance of its stock. The PRIRC also provides that no gain or loss will be recognised if property transferred by a shareholder is solely in exchange for stock or securities of a corporation and if, immediately after such exchange, the corporation is controlled by the shareholder.64 Transfers made to investment companies, as defined by the Secretary of the Treasury, are not covered by this non-recognition provision.
If a corporation assumes liabilities of the transferor or receives property from the transferor subject to liabilities, such assumed liability is not treated as a receipt of money or other property by the transferor in determining whether the transfer is 'solely in exchange of stock or securities.' For the transferor, the basis of the stock received is reduced by the amount of money received, increased by the amount of gain recognised, and decreased by the amount of loss recognised by the transferor. For this purpose, the liability assumed by the corporation is treated as money received by the transferor.65
i Thin capitalisation
Puerto Rico does not have specific thin capitalisation rules.
ii Deduction of finance costs
As a general rule, finance costs can be deducted from gross income to determine the taxable income. However, this deduction is only allowed if it is ordinary and necessary in the course of business.66 In general, interest payments are deductible for non-individual taxpayers.67 The only limitation is that the debt for which the interest deduction is claimed is not used to purchase certain bonds and obligations, which income is tax free.68
iii Restrictions on payments
Dividends must be declared by the board of directors of the corporation.69 Dividends can be declared charged to the corporate surplus or, in absence of such surplus, charged to the net profits of the fiscal year in which the dividend is declared or of the preceding fiscal year, or of both years.70 If the dividend is declared and the corporation does not have a corporate surplus or net profits, the directors of the corporations may be liable.71
iv Return of capital
The Puerto Rico General Corporate Act governs the ability of a corporation to declare and pay dividends. To this effect, Article 5.18 prescribes that dividends can only be declared and paid out of the corporate surplus or, in the absence of such surplus, charged to the net profits of the fiscal year in which the dividend is declared or of the preceding fiscal year, or of both years.72
From a tax perspective, dividends are taxed at a preferential tax rate. If dividends are paid to foreign corporations or partnerships not engaging in trade or business in Puerto Rico, the dividend is subject to a 10 per cent tax rate.73 Dividends paid by a Puerto Rico corporation or partnership, to a non-Puerto Rico corporation that has gross income connected to a trade or business in Puerto Rico of which amounts to at least 80 per cent of the total gross income for the past three full taxable years, to trusts and estates or individuals, whether residents or non-residents of Puerto Rico, are generally subject to a flat 15 per cent tax.74 If the divided is paid to a domestic corporation by a controlled domestic corporation, then 100 per cent of the dividend paid is excludable from net income for the corporation receiving the dividend.75
VIII ACQUISITION STRUCTURES, RESTRUCTURING AND EXIT CHARGES
Ordinarily, from a buyer's perspective, the acquisition of a Puerto Rican business does not give rise to a taxable event. Thus, for buyers, the acquisition of a business is non-taxable at the time of the acquisition.
Buyers may structure the acquisition as they see fit – that is, buyers are free to secure credit facilities or use equity to purchase an existing business. The use of a local entity is highly suggested; however, it is not required.
Puerto Rico provides business great flexibility, from a tax perspective, to merge or demerge. In fact, the majority of these transactions can be completed without giving rise to a taxable event.76 Merging with a non-local entity is allowed by the Puerto Rico General Corporations Act, subject to compliance with certain requirements and filings with the Department of State.77
From a tax perspective, reorganisations follow very closely (but not identically) the United States Internal Revenue Code. As in the United States, the underlying principle is that no gain or loss should be recognised owing to the fact that the new corporate structure is simply a continuation of the previous corporate structure.
If the reorganisation involves a foreign entity, transfer of property into a foreign entity in exchange for its stock or a complete liquidation of a controlled corporation into its foreign parent corporation in which no gain or loss is recognised, a ruling must be requested from the Secretary of the Treasury within 183 days after such an exchange to the effect that the corresponding transaction does not have the purpose of avoiding the payment of income taxes to Puerto Rico.78
As a general rule, there are no tax penalties for relocating.
IX ANTI-AVOIDANCE AND OTHER RELEVANT LEGISLATION
i General anti-avoidance
Puerto Rico does not have specific anti-avoidance rules.
ii Controlled foreign corporations (CFCs)
There are no controlled foreign corporation rules applicable in Puerto Rico.
iii Transfer pricing
Currently, Puerto Rico does not have transfer pricing rules in place. However, the Department of the Treasury has published proposed regulations to this effect. In general terms, said regulations follow the general principles of transfer pricing adopted by the United States.
iv Tax clearances and rulings
Prior to engaging in a transaction, taxpayers can request the Department of the Treasury to rule on the tax treatment of the transaction. The process to request such a ruling is outlined in Circular Letter 99-01. Tax clearance is not required for the acquisition of a Puerto Rican business.
X YEAR IN REVIEW
President Trump signed the Tax Cuts and Jobs Act (the Act) into law. The Act introduces important changes to the federal tax regime affecting individuals, corporations, partnerships and businesses in general. The legislation will also have an impact on business operations in Puerto Rico. The extent of the impact to Puerto Rico business operations is being analysed.
XI OUTLOOK AND CONCLUSIONS
Overall, Puerto Rico provides great tax advantages for investors to conduct their business. More so, Puerto Rico also offers something that no other country in the world can offer: the certainty of the United States legal system and currency.
1 Miguel A Santiago Rivera is a capital member and Alberto J E Añeses Negrón is an associate at Casillas, Santiago & Torres, LLC. This chapter is accurate as of January 2018.
2 See Article 1.02 of the Puerto Rico General Corporations Act.
3 For example, majority vote requirements for certain decisions and restrictions on the transfer of shares may be included in the articles of incorporation.
4 See Article 1.05 of the Puerto Rico General Corporations Act.
5 See Article 7.01 of the Puerto Rico General Corporations Act.
7 See Article 4.01 of the Puerto Rico General Corporations Act.
8 See Article 15.01 of the Puerto Rico General Corporations Act.
9 See Article 15.02 of the Puerto Rico General Corporations Act.
10 Article 8 of Act No. 154 of 20 August 1996, Puerto Rico Laws Annotated (PRLA) T10 Section 1867.
12 Article 4 of Act No. 154 of 20 August 1996, PRLA T10 Section 1863.
13 Act. No. 210 of 31 August 2012, PRLA T10 32 Sections 3351–3355a.
14 Section 1051.01 of the PRIRC, PRLA T13 Section 30201.
15 See Section 1031.01(a) of the PRIRC , PRLA T13 Section 30201. Some of the exclusions are, inter alia, proceeds from life insurance policies, annuity income received, and compensation for injuries and sickness.
16 Section 1031.02(a) of the PRIRC, PRLA T13 Section 30102.
17 Section 1031.03 of the PRIRC, PRLA T13 Section 30103.
18 Section 1031.05 of the PRIRC, PRLA T13 Section 30105.
19 Section 1092.01(b) of the PRIRC, PRLA T13 Section 30441.
20 Section 1123(f)(2) of the PRIRC of 1994, PRLA T13 Section 8523(f)(2).
21 Section 1123(f)(3) of the PRIRC of 1994, PRLA T13 Section 8523(f)(3).
22 Section 1123(f)(5) of the PRIRC of 1994, PRLA T13 Section 8523(f)(5).
23 Section 1123(f)(6) of the PRIRC of 1994, PRLA T13 Section 8523(f)(6).
24 Section 1023.02 and 1023.03 of the PRIRC, PRLA T13 Sections 30082 and 30083.
25 Section 1034.01(a) of the PRIRC, PRLA T13 Section30141(a).
27 Section 1033.14(a) of the PRIRC, PRLA T13 Section 30134(a).
28 Section 1033.14(b)(1)(C) of the PRIRC, PRLA T13 Section 30134(b)(1)(C).
29 Section 1033.14(b)(1)(D) of the PRIRC, PRLA T13 Section 30134(b)(1)(D)
30 Section 1033.14(d)(6) of the PRIRC, PRLA T13 Section 30134(d)(6)
31 Section 1033.14(b)(2) of the PRIRC, PRLA T13 Section 30134(b)(2).
32 Section 1034.04 of the PRIRC, PRLA T13 Section 30144(u).
33 Section 1034.04 of the PRIRC, PRLA T13 Section 30141(d).
34 Section 1034.01(c)(1) of the PRIRC, PRLA T13 Section 3014(c)(1).
35 Section 1034.01(c)(2) of the PRIRC , PRLA T13 Section 30147(c)(2),
36 Section 1022.02 of the PRIRC, PRLA T13 Section 30072.
37 Section 1091.01(b) and 1092.01(b) of the PRIRC, PRLA T13 Section 30431.
38 Section 1092.01(a)(a)(A)(i) of the PRIRC, PRLA T13 Section 30441.
39 Section 1021.01(a)(3) of the PRIRC, PRLA T13 Section 30061.
40 Section 1061.16 of the PRIRC, PRLA T13 Section 30256.
42 Section 1061.17 of the PRIRC, PRLA T13 Section 30257.
43 Section 1061.17(c) of the PRIRC, PRLA T13 Section 30257(c).
45 Department of the Treasury Circular Letter 99-01.
47 Sections 4020.01 and 4020.02 of the PRIRC, PRLA T13 Sections 32021 and 32022.
48 Section 1062.01 of the PRIRC , PRLA T13 Section 30271.
49 Section 3102, 3111 and 3301 of the US Internal Revenue Code, 26 USC Sections 3102, 3111 and 3301.
50 Volume of business is defined as gross receipts.
51 Section 1010.10(a)(6), (7) of the PRIRC, PPRLA T13 Section 30041.
52 Regulation 6252 of 27 December 2000, Section 1231-2(c)(3).
53 Section 1071.01 of the PRIRC, PRLA T13 Section 30331.
54 Section 1092.02(a) of the PRIRC, PRLA T13 Section 30442(a).
55 Section 1092.02(c)(1), (2) of the PRIRC, PRLA T13 Section 30442(c)(1), (2).
56 Section 1092.02(b) of the PRIRC, PRLA T13 Section 30442(b).
58 Section 1092.02(d) of the PRIRC, PRLA T13 Section 30442(d).
59 PRLA T13 Section 10652(b).
60 Section 10(a) of Act 73.
61 Specifically, homeowner associations and any entity created or organised under the laws of the United States, or those of any state of the United States, which, during the taxable year, qualifies as a registered real estate investment company or investment trust under the United States Internal Revenue Code of 1986.
62 See Section 1092.01(a)(2) of the PRIRC, PRLA T13 Section 30441.
63 Greig v. Secretario de Hacienda, 86 DPR 345 (1962).
64 Section 1034.04(o) of the PRIRC, PRLA T13 Section 30142.
65 Section 1034.02(a)(6) of the PRIRC, PRLA T13 Section 30142.
66 Section 1033.01 of the PRIRC, PRLA T13 Section 30121.
67 Section 1033.03 of the PRIRC, PRLA T13 Section 30123.
69 Article 5.18 of the Puerto Rico General Corporations Act. PRLA T14 Section 3598.
71 Article 5.22 of the Puerto Rico General Corporations Act PRLA T14 Section 3602.
73 Section 1062.11 of the PRIRC, PRLA T13, PRLA T13 Section 30281.
74 Section 1023.06 of the PRIRC, PRLA T13 Section 30086.
75 Section 1033.19(a)(1)(D) of the PRIRC, PRLA T13 Section 30139.
76 See Section 1034.04 of the PRIRC, PRLA T13 Section 30144.
77 See Article 10.02 of the Puerto Rico General Corporate Act of 2011.
78 Section 1034.04(i) of the PRIRC, PRLA T13 Section 30144.