Puerto Rico enacted two laws in 2012, generally known as the Export Services Act (“Act 20”) and the Individual Investors Act (“Act 22”). Under Act 20, income from certain eligible services provided by Puerto Rican entities to non-Puerto Rican residents (both individuals and entities) is taxed at a reduced rate of 4 percent. Under Act 22, individuals who are bona fide Puerto Rican residents are entitled to a 100% tax exemption on certain interest, dividends, and capital gains.
In addition, U.S. federal tax laws provide a special tax regime pursuant to which income derived from sources within Puerto Rico, including certain dividends and interests from Puerto Rican corporations and gain from the sale of stock of such corporations, is excluded from a U.S. citizen’s gross income if that individual is a bona fide resident of Puerto Rico for the entire tax year (the “Section 933 Exclusion”). Such income can thus be taxed at an effective rate of 4% (or less) rather than the 39.6% (20% for capital gains) that generally would be imposed on U.S. citizens who are not Puerto Rican residents.
In order to become a bona fide resident of Puerto Rico, U.S. citizens generally must (i) be physically present in Puerto Rico for at least 183 days during the taxable year; (ii) not have a tax home outside of Puerto Rico during any part of the taxable year; and (iii) have a closer connection to Puerto Rico than to the U.S. or a foreign country. Each of these tests is fact sensitive and requires careful scrutiny. Act 20 and Act 22, coupled with the Section 933 Exclusion, have attracted many U.S. citizens to Puerto Rico, who set up Puerto Rican corporations to provide services, such as research and development, marketing, technological, managerial, back office, consulting, financial etc., to U.S. customers. These companies often have U.S. citizens as owners, investors or managers, only some of whom are bona fide Puerto Rican Residents, and may have some management, technology or support staff in the U.S., resulting in at least some of the operating income being attributable to the U.S.
The rules relating to the Section 933 Exclusion are neither simple nor clear, and raise a number of U.S. federal income tax issues regarding the source of income earned by the Puerto Rican corporation, the source of dividends paid by the corporation, the application of the controlled foreign corporation and passive foreign investment company rules, and the taxation of gain from the sale of the stock of the Puerto Rican corporation. In addition, moving an existing business to Puerto Rico generally gives rise to U.S. taxation. In order to claim tax incentives under the two Puerto Rican Acts and the Section 933 Exclusion, and to avoid any unintended U.S. tax consequences, tax planning is critical before a U.S. citizen moves to Puerto Rico and sets up a business and before such individual moves back to the U.S.
Mary F. Voce is a shareholder and Pallav Raghuvanshi is an associate in the international law firm of Greenberg Traurig, concentrating their practices on corporate and international tax. They handle both in-bound and out-bound international tax planning for U.S. and foreign entities and individuals.