U.S. International Tax Planning for Bona Fide Residents of Puerto Rico
United States taxpayers who are bona fide residents of Puerto Rico are subject to a favorable tax regime. Section 933(1) excludes from U.S. federal income tax income derived from sources within Puerto Rico.1 In addition, under Puerto Rico’s Individual Investors Act (Act 22), these taxpayers are provided with a 100 percent exclusion from Puerto Rican income tax for all interest, dividends, and capital gains (to the extent such gains accrue after the person becomes a resident of Puerto Rico). These benefits are available to bona fide residents of Puerto Rico even though they remain U.S. taxpayers for all other purposes. Furthermore, Puerto Rican corporations are only subject to a 4 percent corporate income tax on both export services income under the Export Services Act (Act 20) and financial services income (such as interest and royalties) under the International Financial Center Regulatory Act (Act 273).
Additional benefits are available to bona fide residents of Puerto Rico who own shares of corporations organized in Puerto Rico. These benefits include a complete exemption from the U.S.-controlled foreign corporation (CFC) rules and the passive foreign investment company (PFIC) rules with respect to their ownership of Puerto Rican corporations. As a result of the “check the box” rules, these exemptions may be extended to income derived in foreign jurisdictions other than Puerto Rico (including U.S.-source, treaty-benefitted income) without that income being subject to tax in the U.S. Finally, with proper planning, it may be possible for bona fide residents of Puerto Rico to repatriate profits in the form of tax-free dividends even if only a de minimis portion of those profits are attributable to earnings that have accrued in Puerto Rico.
Bona Fide Residents of Puerto Rico
A U.S. taxpayer who is a bona fide resident of Puerto Rico for an entire taxable year is able to exclude from U.S. federal income tax under §933(1) Puerto Rican-source interest and dividends, and (possibly) worldwide capital gains.2 This income also would be excluded from Puerto Rican income tax. A person will be considered a bona fide resident of Puerto Rico for a particular taxable year only if such a person 1) satisfies the presence test; 2) does not have a tax home outside Puerto Rico during the year; and 3) does not have a closer connection to the United States or a foreign country than to Puerto Rico for that tax year.3
An individual will be considered to meet the presence test if one of five tests is met: 1) The individual is present in Puerto Rico for at least 183 days during the taxable year; 2) the individual is present in Puerto Rico for at least 549 days during the three-year period consisting of the current taxable year and two immediately preceding taxable years, provided that the individual is present in Puerto Rico for at least 60 days during each of those years; 3) the individual is present in the U.S. for no more than 90 days during the taxable year; 4) during the taxable year, the individual had earned income (meaning wages, salary, professional fees, and compensation for personal services actually rendered) of less than $3,000 and was present for more days in Puerto Rico than the U.S.; or 5) the individual had no significant connection to the U.S. during the taxable year.4
A person’s tax home is considered to be located at his or her “regular or principal place of business.” If, due to the nature of an individual’s occupation (or because the individual does not carry on a trade or business), the individual does not have a regular or principal place of business, then the person’s tax home is his or her regular place of residence.5
The closer connection test is a facts and circumstance test. An individual is considered to have a closer connection to Puerto Rico than the U.S. if such individual maintains more significant contacts with Puerto Rico than the U.S. Nine nonexclusive factors are listed as relevant to the determination as to whether an individual maintains a closer connection to Puerto Rico: 1) the location of the individual’s permanent home (determined in the same manner as under the presence test); 2) the location of the individual’s family; 3) the location of personal belongings, such as automobiles, furniture, clothing, and jewelry owned by the individual and his or her family; 4) the location of social, political, cultural, or religious organizations with which the individual has a current relationship; 5) the location where the individual conducts his or her routine personal banking activities; 6) the location where the individual conducts business activities (other than those that constitute the individual’s tax home); 7) the location of the jurisdiction in which the individual holds a driver’s license; 8) the location of the jurisdiction in which the individual votes; and 9) the country of residence designated by the individual on forms and documents.6
As noted above, the §933 exclusion applies only if the taxpayer is a bona fide resident of Puerto Rico for the entire taxable year. In other words, the exclusion applies only if residence is established on the first day of the year.7 If the individual relocates to Puerto Rico during the taxable year, the individual will be treated as a bona fide resident for that entire taxable year only if 1) for each of the three taxable years immediately preceding the taxable year of the change of residence, the individual is not a bona fide resident of Puerto Rico; 2) for each of the last 183 days of the taxable year of the change of residence, the individual does not have a tax home outside of Puerto Rico or a closer connection to the U.S. or a foreign country than to Puerto Rico; and 3) for each of the three taxable years immediately following the taxable year of the change of residence, the individual is a bona fide resident of Puerto Rico.8
U.S. Anti-Deferral Rules
Assuming the individual becomes a bona fide resident of Puerto Rico pursuant to the tests above, that person may be eligible for U.S. income tax benefits relating to Puerto Rican corporations that would not otherwise be available to foreign corporations organized in other jurisdictions. “United States shareholders” who own more than 50 percent of the stock of a foreign corporation (which, for this purpose, includes Puerto Rican corporations) generally are subject to current U.S. federal income tax on any “subpart F” income earned by such CFC, even if the income is not distributed to the shareholder in the form of a dividend.9 Similarly, U.S. shareholders are also subject to current U.S. federal income tax on their pro rata share of the average of the amounts of “United States property” held by a CFC at the close of each quarter of a taxable year.10
A U.S. taxpayer who is a bona fide resident of Puerto Rico, however, will not be treated as a “U.S. shareholder” for purposes of determining whether a Puerto Rican corporation is a CFC, if a dividend received by such individual from the Puerto Rican corporation would be treated, for purposes of §933(1), as Puerto Rican-source income.11 Generally, for purposes of §933(1), the source of a dividend paid by a corporation organized in a U.S. possession will be treated as derived from sources within that possession based on the “possession source ratio” of such dividend.12 A different rule applies with respect to a possession corporation that is engaged in the active conduct of a trade or business in such possession. In that case, the entire dividend will be treated as income derived from that possession if 1) 80 percent or more of the gross income of the corporation during the prior three years was derived from sources within such possession; and 2) 50 percent or more of the gross income during the prior three years was derived from the active conduct of a trade or business within such possession.13
These sourcing rules do not apply, however, to dividends paid by Puerto Rican corporations for purposes of determining whether the corporation is a CFC.14 Instead, dividends paid by a Puerto Rican corporation typically are treated as Puerto Rican source income for purposes of §§957(c) and 933(1), so long as less than 25 percent of the Puerto Rican corporation’s gross income is comprised of income effectively connected to a U.S. trade or business.15 Accordingly, unless a Puerto Rican corporation derives at least 25 percent of its income from income effectively connected to a U.S. trade or business, that corporation will not be treated as a CFC with respect to a U.S. taxpayer who is a bona fide resident of Puerto Rico.
Similar favorable provisions also apply to bona fide residents of Puerto Rico who are shareholders of PFICs. Typically, a U.S. taxpayer that owns shares of a PFIC will be subject to adverse U.S. federal income tax consequences when they receive certain distributions from a PFIC, as well as when they sell their PFIC shares. Proposed regulations, however, provide an exception to the PFIC rules for a bona fide resident of Puerto Rico for the year in question.16
Structuring to Take Advantage of Puerto Rican Tax Incentives
• Treaty Planning — A U.S. taxpayer who owns shares in a Puerto Rican corporation that qualifies for benefits under Act 20 of the Export Services Act generally would not be concerned about the CFC or PFIC rules because income derived from the performance of services in Puerto Rico should not be treated as subpart F income under the CFC rules or passive income under the PFIC rules. Where a bona fide resident of Puerto Rico would benefit significantly from the lack of application of the CFC and PFIC rules would be with respect to income (including passive income) earned outside of Puerto Rico through foreign disregarded entities owned by a Puerto Rican corporation. having the Puerto Rican corporation own foreign subsidiaries that, for U.S. federal income tax purposes, are treated as branches of the Puerto Rican entity, the CFC and PFIC exceptions noted above continue to apply to income (including U.S.-source, treaty-benefitted income) earned by those foreign subsidiaries, regardless of whether it is connected to Puerto Rico.17
For example, assume a U.S. citizen taxpayer (T) owns an operating business in the United States. T wishes to relocate to Puerto Rico and form a Puerto Rican corporation to perform R&D services and develop intellectual property (IP), which will be licensed back to the U.S. business. T forms a Puerto Rican company and applies for Act 273 benefits in Puerto Rico. Act 273 provides for a 4 percent corporate income tax on income derived by “international financial entities,” which includes royalties. T then causes the Puerto Rican corporation in turn to form an Irish limited liability company (Irish Co) to own the IP.18 T causes Irish Co to elect to be treated as a disregarded entity for U.S. tax purposes. Irish Co then licenses the IP, on a royalty-free basis, to a Hungarian limited liability company (Hungarian Co), also owned by the Puerto Rican corporation and also a disregarded entity for U.S. tax purposes. Hungarian Co in turn sub-licenses the IP to the U.S. company, in exchange for royalty payments. Because Puerto Rico treats foreign LLCs that are disregarded for U.S. tax purposes as flow-through entities in Puerto Rico, any royalties earned by Hungarian Co and Irish Co will be taxable in Puerto Rico at a 4 percent corporate tax rate under Act 273.
The royalties should be exempt from U.S. withholding tax under the U.S.-Hungary income tax treaty (both the existing treaty currently in effect and the new treaty still pending in Congress). Hungarian Co should qualify for treaty benefits in this case. The existing treaty has no limitation of benefits (LOB) provision. The pending U.S-Hungary treaty contains an LOB provision that allows U.S. citizens (regardless of where they are resident) who are the ultimate beneficial owners of a Hungarian company to qualify the company for treaty benefits.19
When Hungarian Co receives the royalty payment, it should be entitled to a deemed deduction for Hungarian tax purposes due to the royalty-free license with Irish Co.20 Therefore, Hungarian Co only will be taxable on a minimal spread. Furthermore, while Ireland does have transfer pricing rules, these rules only apply to income derived from a trading activity, which would not include a single license. Therefore, no income will accrue in Ireland. Consequently, this structure allows for the payment of deductible U.S.-source royalties that are exempt from U.S. withholding tax, and are only subject to minimal foreign income tax in Hungary and Puerto Rico. In addition, despite the passive nature of the income, neither the CFC nor the PFIC rules should apply because the foreign subsidiaries are treated as branches of a Puerto Rican corporation.
The profits of the Puerto Rican corporation ultimately can be repatriated to the shareholder in the form of a liquidating distribution.21 Any gain realized from such liquidating distribution will be completely exempt from U.S. federal income tax under §933(1), so long as the shares were not owned at any time during the 10-year period prior to the U.S. taxpayer becoming a bona fide resident of Puerto Rico.22
• Reorganization of Non-Puerto Rican Corporations into Puerto Rico — Another significant advantage offered to bona fide residents of Puerto Rico is the potential ability to repatriate profits in the form of tax-free dividends under §933(1), even if those dividends are attributable to earnings that have accrued outside of Puerto Rico. As discussed above, §933(1) excludes from U.S. federal income tax Puerto Rican-source dividends. Generally, the source of a dividend paid by a Puerto Rican corporation is based on the “possession source ratio” of such dividend. For this purpose, the “possessions source ratio” is a fraction, the numerator of which is the gross income of the corporation from sources within Puerto Rico for the “testing period” and the denominator of which is the total gross income of the corporation for the testing period.23
A different rule applies with respect to a corporation that is engaged in the active conduct of a trade or business in Puerto Rico. In that case, the entire dividend will be treated as Puerto Rico-source income if 1) 80 percent or more of the gross income of the corporation for the “testing period” is derived from sources within Puerto Rico; and 2) 50 percent or more of the gross income for the testing period is derived from the active conduct of a trade or business within Puerto Rico.24
An interesting tax planning opportunity exists as a result of the manner in which the regulations define the term “testing period.” For this purpose, the term means “the 3-year period ending with the close of the taxable year of the payment of the dividend (or for such part of such period as the corporation has been in existence).”25 Therefore, for a Puerto Rican corporation that has been in existence for less than three years, the testing period is simply the period the corporation has been in existence. This language seems to indicate that a bona fide resident of Puerto Rico that owns foreign corporations organized outside of Puerto Rico that have untaxed earnings can cause those corporations to merge into a newly formed Puerto Rican corporation and subsequently repatriate those earnings as a tax-free dividend under §933(1).26 Apparently, all that is required is for the surviving Puerto Rican corporation to earn at least $1 dollar of Puerto Rican-source income. This result stems from the fact that the source rules described above simply look to the ratio of the gross income derived in Puerto Rico for the period the Puerto Rican corporation has been in existence compared to the total gross income derived by such corporation during such period.
For example, assume a U.S. citizen owns operating businesses in both the Cayman Islands and the Bahamas that have been in existence for more than 10 years. Each company has several million dollars of untaxed earnings and profits. Both companies are CFCs but no part of their income is characterized as subpart F income. Assume that on June 1, 2016, both operating companies merge into a newly formed Puerto Rican corporation with the Puerto Rican corporation surviving the merger. The earnings and profits of both corporations carry over to the Puerto Rican corporation under §381(a).
On January 1, 2017, the shareholder becomes a bona fide resident of Puerto Rico and remains a bona fide resident for the entire taxable year. On December 31, 2017, the Puerto Rican corporation declares a $10 million dividend, which equals the total earnings and profits carried over from the prior operating businesses in the merger. If the Puerto Rican corporation earns $100 of gross income from Puerto Rican sources during the 2017 taxable year, it appears that the entire $10 million dividend would be excludible by the shareholder under §933(1). This is because the only income earned during the testing period (i.e., June 1, 2016, through December 31, 2017) is Puerto Rican-source income. Therefore, the $10 million distribution is multiplied by a ratio of $100/$100 (or 100 percent) to determine the Puerto Rican source portion of such amount. This clearly would be a taxpayer-friendly result.27
As noted above, significant tax savings can be realized for U.S. taxpayers who become bona fide residents of Puerto Rico. It is the only statutory means of obtaining unlimited tax-free income while also avoiding the exit tax rules of §877A.
1 All references to section refers to those of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder.
2 Gains that have accrued prior to relocating to Puerto Rico will be subject to U.S. federal income tax for up to 10 years. See Treas. Reg. §1.937-2(f). Puerto Rico also will tax such gains.
3 I.R.C. §937(a).
4 Treas. Reg. §1.937-1(c). An individual is considered to have a significant connection to the U.S. if one of three tests are met: 1) the individual has a permanent home in the U.S.; 2) the individual has a current voter registration in any political subdivision of the U.S.; or 3) the individual has a spouse or child under the age of 18 whose principal place of residence is in the U.S. unless the child is living in the U.S. with a custodial parent under a custodial decree or the child is in the U.S. as a student. A permanent home includes a furnished room or an apartment that may be either owned or rented. If the place is not occupied for long durations, it is considered a permanent home. Under these rules, the rental property can be treated as a non-permanent home if the taxpayer does not use any portion of it as a residence during the taxable year. Treas. Reg. §1.937-1(c)(5).
5 Treas. Reg. §1.937-1(d)(1).
6 Treas. Reg. §1.937-1(e) and Treas. Reg. §301.7701(b)-2.
7 Treas. Reg. §1.933-1(a).
8 Treas. Reg. §1.937-1(f).
9 I.R.C. §951(a)(1)(A)(i).
10 I.R.C. §§951(a)(1)(B) and 956.
11 I.R.C. §957(c).
12 Treas. Reg. §1.937-2(g)(1)(i).
13 Treas. Reg. §1.937-2(g)(1)(ii). It should be noted that U.S.-source income cannot be treated as possessions source income. Treas. Reg. §1.937-2(c)(1).
14 Treas. Reg. §1.957-3(b)(2).
15 I.R.C. §861(a)(2)(B).These sourcing rules still apply to determine whether the dividend is excludable from U.S. federal income tax under §933(1). To the extent the dividend is excludable only in part, the portion of the dividend that is attributable to non-Puerto Rican source income will be subject to U.S. federal income tax at qualified dividend rates (i.e., 23.8 percent). Section 1(h)(11)(C)(i)(I).
16 Prop. Treas. Reg. §1.1291-1(f).
17 It should be noted that Puerto Rico treats foreign LLCs that are disregarded for U.S. tax purposes as flow-through entities for Puerto Rican tax purposes.
18 Proper planning is needed for any IP that will be sold by T to Irish Co. While capital gain derived by a bona fide resident of Puerto Rico generally would be exempt from U.S. federal income tax under §933(1), an exception applies for gain triggered on the sale of property within 10 years of the U.S. taxpayer becoming a bona fide resident of Puerto Rico if such property were owned prior to relocating to Puerto Rico. Treas. Reg. §1.937-2(f)(1).
19Despite the fact that Hungarian Co and Ireland Co are disregarded for U.S. tax purposes, §894(c) will not deny treaty benefits because the income is treated as “derived” in Hungary for Hungarian tax purposes. Finally, the conduit financing regulations should not apply because if the royalties were paid directly to Irish Co, they would be eligible for 0 percent withholding under the U.S.-Ireland income tax treaty. See Treas. Reg. §1.881-3(b)(2)(i).
20 The base erosion provision of the LOB article in the pending U.S.-Hungary treaty should be satisfied because the deductible amounts accrued in Hungary are owed to another EU-country member. See Art. 22, §4(b) of the 2010 U.S.-Hungary income tax treaty.
21 Hungarian Co also will be required to pay a dividend to the Puerto Rican corporation. Such dividend should be exempt from Hungarian withholding tax under local law. The Puerto Rican corporation will not be subject to tax on such dividend because Hungarian Co will be treated as a partnership for Puerto Rican tax purposes. Therefore, the royalties already will have been subject to tax in Puerto Rico at the four percent rate.
22 The gain will be treated as Puerto Rican-source income and thus exempt under §933(1), so long as more than 50 percent of the Puerto Rican corporation’s income is attributable to an active trade or business in Puerto Rico. Treas. Reg. §1.937-2(f)(2)(i)(B) and §865(g)(3). See also Notice 89-40, 1989-1 C.B. 681, which eliminates the 10 percent foreign tax requirement otherwise required by §865(g)(2) for bona fide residents of Puerto Rico who sell personal property. Section 1248 should not apply if the Puerto Rican corporation was never a CFC for U.S. federal income tax purposes.
23 Treas. Reg. §1.937-2(g)(1)(i)(A).
24 Treas. Reg. §1.937-2(g)(1)(ii).
25 Emphasis added; Treas. Reg. §1.937-2(g)(1)(iii).
26 The merger would need to be structured as a tax-free reorganization under §368(a), other than a reorganization under §368(a)(1)(F) (i.e., an F reorganization). An F reorganization is treated as a continuation of the prior corporation, and, therefore, the three-year testing period would apply. Treas. Reg. §1.381(b)-1(a)(2).
27 It should be noted that Treas. Reg. §1.367(b)-4 should not apply to cause the previously untaxed earnings to be taxable under §1248 at the time of the merger in June 2016. This is because the exchanging shareholder is not losing his or her status as a §1248 shareholder. See Treas. Reg. §1.367(b)-4(b)(1)(i). Moreover, because relocating to Puerto Rico is not a taxable event under §877A (or any other provision), there would be no deemed sale of the shares of the non-Puerto Rican corporations that would trigger a §1248 inclusion. Finally, even if the merger and the shareholder relocating to Puerto Rico occurs at the same time, it is questionable whether the previously untaxed earnings would be taxable as a §1248 dividend under Treas. Reg. §1.367(b)-4. This is because §957(c) only applies for purposes of §§951 through 965, and not for purposes of §1248. Therefore, it appears that under Treas. Reg. §§1.367(b)-4(b)(1)(i) and 1.367(b)-2(b) the bona fide resident of Puerto Rico continues to be a §1248 shareholder (i.e., a U.S. person that satisfies the ownership requirement of §1248(a)(2) with respect to a foreign corporation.
Summer Ayers LePree is a tax partner at Bilzin Sumberg in Miami. She received her J.D. and her LL.M. in taxation from the University of Florida Levin College of Law. She is a member of The Florida Bar.
Jeffrey L. Rubinger is a tax partner at Bilzin Sumberg in Miami and heads its international tax practice. He received his J.D. from the University of Florida Levin College of Law and an LL.M. in taxation from New York University School of Law. He is admitted to the Florida and New York bars.
This column is submitted on behalf of the Tax Law Section, William Roy Lane, Jr., chair, and Christine Concepcion, Michael Miller, and Benjamin Jablow, editors.