We believe that today there are many individuals and companies involved in complicated and technical tax matters that require expertise and a specialized knowledge of the tax law.
Puerto Rico Tax Services
As the U.S. tax rates at both the federal and state levels continue to target successful entrepreneurs, innovators and other wealthy taxpayers, Puerto Rico remains the ideal destination for those seeking a lawful avenue to avoid or reduce U.S. federal and state taxes. Internal Revenue Code (IRC) Sections 933 allows residents of Puerto Rico a full exemption from U.S. tax on income derived from Puerto Rico sources. Instead, this U.S.-exempt Puerto Rico source income will only be subject to tax in Puerto Rico!
In early 2012, in order to attract business to their territory and spur growth, Puerto Rico’s legislature passed one of the most favorable tax incentive programs that our firm has ever seen. These tax incentives are commonly referred to as Act 20 and Act 22. The Act 20 law affords certain qualifying companies a 4% tax rate on all income earned and a dividend rate to the shareholder of the Act 20 company of 0%. The Act 22 law affords an individual a 0% tax rate on all Puerto Rico source income generated from investments (i.e. interest, dividends, and capital gains). While these incentives only apply for Puerto Rico income tax purposes, U.S. persons who become bona fide residents of Puerto Rico and take advantage of the tax incentive programs can reduce their worldwide tax rate by as much as 90%.
Act 60–2019 was signed into law on July 1, 2019, with an effective date of January 1, 2020. This Act, among other things, consolidated various tax decrees. These included Act 20, the Promotion of Export Services Act, Act 22, the Act to Promote the Relocation of Individual Investors to Puerto Rico, and Act 73, Economic Incentives for the Development of Puerto Rico.
To obtain these extraordinary tax savings, U.S. persons moving to Puerto Rico must navigate many complicated and often overlooked provisions of the Internal Revenue Code. The following items are some of the biggest issues we see taxpayers and their tax advisors failing to address, or inadvertently overlooking when advising U.S. individuals and their companies regarding a move to Puerto Rico.
Outbound Transfer of Intangibles
Some U.S. taxpayers that own significant intangible assets may transfer them offshore to their newly formed Puerto Rico Act 60 corporation. One method of accomplishing this is through an IRC 351 or IRC 361 intangible transfer, which can trigger a taxable transaction under IRC 367(d).
The general rule is that when a U.S. person transfers intangible property (“IP”) to a foreign corporation (Puerto Rico LLC’s by default are considered foreign corporations for U.S. tax purposes) pursuant to IRC 351 or IRC 361, IRC 367(d) requires that the U.S. transferor recognize a deemed sale of the IP in exchange for a continuing deemed annual royalty. The deemed royalty is characterized as ordinary income over the useful life of the property, not to exceed 20 years. If within the intangible’s useful life, the foreign corporation subsequently disposes of the property to an unrelated party then the U.S. transferor shall recognize gain equal to the difference between the FMV of the property and its adjusted basis. The appropriate toll charge for the deemed royalty must be determined in accordance with the provisions of IRC 482 of the Code and regulations, including both the arm’s length and commensurate with income standards.
IRC 367(d) defines intangible property to include any: patent, invention, formula, process, design, pattern, knowhow, trademark, trade name, brand name, franchise, license, contract, method, system or any similar item, which has substantial value independent of services of any individual.
The Anti-Inversion Rules
The anti-inversion rules of IRC 7874 were enacted to discourage U.S.-based multinationals from “inverting” (i.e., reincorporating the U.S. parent company outside the U.S.). However, these same rules can apply to a single U.S. corporation that reincorporates in Puerto Rico, even if the corporation is owned by a single individual.
The anti-inversion rules will apply if the Puerto Rico company is a “surrogate foreign corporation.” A foreign corporation is treated as a surrogate foreign corporation if, pursuant to a plan (or a series of related transactions), three conditions are satisfied:
- The foreign corporation completes the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation,
- At least 80% of the stock of the foreign corporation is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation, and
- After the acquisition, the expanded affiliated group that includes the foreign corporation does not have substantial business activities in the foreign country in which the foreign corporation is created or organized when compared to the total business activities of the expanded affiliated group.
Puerto Rico Companies Engaged in a U.S. Trade or Business
When a Puerto Rico employee performs services in the United States on behalf of a Puerto Rico Act 60 entity, unwanted U.S. tax issues can arise as detailed in IRC 864. Performing services in the U.S. on behalf of a Puerto Rico entity that is treated as a corporation for U.S. tax purposes will cause the Puerto Rico entity to be taxed as one engaged in a U.S. trade or business. This will result in two layers of federal tax. The Puerto Rico entity will first be subject to the U.S. corporate tax rate of 21% (and also the state corporate tax rate, if applicable). The Puerto Rico entity will then be subject to a branch profits tax of 30% in accordance with IRC 884(a).
Treating the Puerto Rico entity as a pass-through entity (i.e., a partnership or disregarded entity) for U.S. purposes will still result in the Puerto Rico resident being subject to U.S. taxes. The Puerto Rico resident will be subject to U.S. federal and state taxes related to the income attributable to the performance of services in the U.S. on behalf of the pass-through entity. Although the branch profits tax will not apply to a pass-through entity, the Puerto Rico resident will still be subject to a federal individual rate as high as 37% for any work performed in the U.S. The Puerto Rico resident will also be subject to the FICA tax and likely any applicable state income tax.
Related Party Transactions (i.e., Management Fees Paid by a U.S. Company to a Related Puerto Rico Company.)
Transfer pricing refers to the pricing of transactions between controlled entities. For example, when a Puerto Rico Company (PRCo) provides management services to its commonly controlled US company (USCo.), IRC 482 requires PRCo to charge an “arm’s length” fee to USCo. Under IRC 482, controlled entities should price transactions in the same way that uncontrolled entities would under similar circumstances. This is the “arm’s length” standard, which means that the price of the management fee that PRCo charges to USCo should be the same as it would charge to an unrelated party for the same product under similar circumstances. If the transfer price is not “arm’s length”, the IRS has the authority under IRC 482 to make adjustments by reallocating items of gross income, deductions, credits, or allowances in order to properly reflect income between the entities.
Failing to Comply with U.S. Reporting Obligations
U.S. persons establishing residency or operations in Puerto Rico will still have to comply with a myriad of U.S. reporting obligations. For most purposes of the Internal Revenue Code, Puerto Rico is treated as a foreign country and this results in a U.S. person falling under some very heavy information reporting requirements. Failure to comply with these obligations can result in very heavy penalties and will also cause a freeze on the commencing of the statute of limitations period for purposes of the IRS being able to initiate an examination of the taxpayer’s returns. Some of the commonly required forms required to be filed with the IRS are as follows:
- Form 926
- Forms 3520 and 3520-A
- Form 8858
- Form 8865
- Form 8621
- Form 5471
- Form 8621
- Form 8938
- Form 8898
- Form 1040-SS
Our firm has advised taxpayers since 2012 on how to properly establish operations in Puerto Rico without running afoul of US tax laws. We are one of the few firms in the country that specialize in US tax return preparation and IRS audit representation for residents of Puerto Rico.