Puerto Rico has a long history of using tax incentives and credits as tools for economic development and recovery after economic crises. Most recently, then Governor of Puerto Rico, Ricardo Rossello, signed Act 60-2019 (“Incentives Act”) into law on July 1, 2019, with an effective date of January 1, 2020. Chapter 2 of the Incentives Act includes measures to attract individual investors to Puerto Rico by providing many incentives to resident individuals, such as full tax exemptions on Puerto Rican-source dividends and on capital gains stemming from the appreciation in value of securities. Further, under Chapter 3 of the Incentives Act, Puerto Rico implemented changes to entice business entities to move their operations to Puerto Rico by reducing Puerto Rican corporate taxes and providing exemptions from property taxes, municipal taxes, and taxes on dividend distributions for income generated and property used in exempt operations.
While it may make sense from a U.S. federal income tax perspective for high income U.S. taxpayers to consider expatriating from the U.S., many people do not want to give up their citizenship or green card simply to reduce their federal income tax liabilities. Additionally, expatriating U.S. citizens are subject to certain immediate tax consequences as a result of the expatriation tax regime. The expatriation rules generally apply to any U.S. citizen who has relinquished his or her citizenship.
Puerto Rico offers a compelling alternative to expatriation. U.S. citizens who become bona fide residents of Puerto Rico can maintain their U.S. citizenship, avoid U.S. federal income tax on capital gains, including U.S.-source capital gains, and avoid paying any income tax on interest and dividends from Puerto Rican sources. The expatriation rules do not apply to U.S. citizens who relocate to Puerto Rico because the relocation by itself does not require any renunciation of U.S. citizenship. Therefore, if an individual relocates to Puerto Rico, the move does not result in an expatriation tax.
Further, U.S. citizens and resident aliens living in Puerto Rico are generally subject to U.S. tax on worldwide income. However, a bona fide resident of Puerto Rico for an entire taxable year may exclude income from sources within Puerto Rico for U.S. federal income tax purposes. An individual is considered to be a bona fide resident of Puerto Rico only if he or she satisfies all of the following three conditions: (1) physical presence test, (2) tax home test, and (3) closer connection test. A special rule applies for the year of the move.
The taxpayer moving to Puerto Rico is required to file Form 8898 with the IRS and file Form 1040 for the year of move. Form 8898 requires the taxpayer to provide information concerning compliance with the above requirements.
Further, Chapter 2 of the Incentives Act offers tax incentives to individuals who relocate to Puerto Rico. For an individual to qualify under Chapter 2 of the Incentives Act, he or she must be considered a resident individual investor (“Resident Individual”). A Resident Individual is defined as a person who is domiciled in Puerto Rico by having a physical presence in Puerto Rico for at least 183 days during the taxable year and has not been a resident of Puerto Rico for the ten years prior to January 1, 2020. Further, Resident Individuals must apply for and obtain a tax exemption decree under Act 60. To obtain access to the approved and signed tax exemption decree, a one-time fee of $5,000 must be satisfied and deposited into a special fund to promote the relocation of Resident Individuals to Puerto Rico. Further, all Resident Individuals that hold a Tax Exemption Decree must comply with an annual contribution of $10,000 to a duly organized and registered nonprofit organization in Puerto Rico. Lastly, a Resident Individual must purchase residential property in Puerto Rico within the first two years after obtaining the decree.
If a Resident Individual qualifies for the tax benefits under Chapter 2 of the Incentives Act, the individual is eligible to receive a 100% tax exemption from Puerto Rican income taxes on all dividends and interest. Further, a Resident Individual would receive Puerto Rico income tax exemptions on capital gains stemming from the sale or exchange of securities that appreciated in value after the individual establishes domicile in Puerto Rico. Thus, gains realized from securities acquired after establishing domicile in Puerto Rico are exempt from Puerto Rico income tax. However, U.S. investors need to appreciate that capital gains derived from securities acquired prior to the individual becoming a Resident Individual are exempt only to the extent that the gain is attributable to the increase in value of the securities after the individual is domiciled in Puerto Rico. The portion of the gain attributable to the increase in value of the securities prior to establishing domicile in Puerto Rico is subject to the applicable Puerto Rico capital gains tax rate, but, if such gain is recognized after ten years from the date that the individual becomes domiciled in Puerto Rico, the Resident Individual benefits from a tax rate reduced to 5%.
Of special note, on January 27, 2021, the Large Business and International Division of the IRS announced that it had opened an audit campaign addressing taxpayers who have claimed Puerto Rico tax benefits without meeting the bona fide resident requirements. For example, according to the IRS, these individuals may be excluding income subject to U.S. tax on a filed U.S. income tax return or failing to file and report income subject to U.S. tax. This campaign will also address those individuals who have met the bona fide resident requirements but may be erroneously reporting U.S.-source income as Puerto Rico-source income in order to avoid U.S. taxation. Thus, taxpayers moving to Puerto Rico will need to maintain the appropriate recordkeeping and obtain appropriate tax advice, in view of anticipated heightened IRS scrutiny.
Chapter 3 of the Incentives Act is meant to act as a facilitator to develop Puerto Rico as an international export service and commerce center. Under Chapter 3, business owners who establish qualifying businesses in Puerto Rico can enjoy significant tax benefits, such as reduced Puerto Rican corporate taxes and exemptions from property taxes, municipal taxes, and taxes on dividend distributions for income generated and property used in the exempt operations
Chapter 3 of the Incentives Act applies to businesses that maintain a bona fide office or establishment in Puerto Rico and conduct eligible services for export or promoter services. An export service provider includes businesses that are engaged in, among other business areas: (1) research and development; (2) advertising and public relations; (3) economic, environmental, technological, scientific, managerial, marketing, human resources, computer, and auditing consulting services; (4) “creative industries” including income related to the broadcasting or the sale of copyrights for a recording intended for audiences outside of Puerto Rico; (5) drafting of construction plans and engineering, architectural, and project management services; (6) professional services; (7) centralized management services including, but not limited to, strategic direction, planning, distribution, logistics, and budgetary services; (8) electronic data processing centers; (9) computer software development; (10) distribution, whether it is physical, online, through the cloud, or related to blockchain technology, and the income earned from the licensing, program subscriptions, or services fees; (11) voice, video, audio, and data telecommunications between persons located outside Puerto Rico; (12) call centers; (13) shared service centers; (14) educational and training services; (15) hospital and laboratory services including medical tourism and telemedicine sites; and (16) investment banking and other financial services.
If a service for export business qualifies for the tax benefits under Chapter 3 of the Incentives Act, the net income stemming from the business is subject to a 4% Puerto Rican corporate tax. Further, distributions from earnings and profits is not subject to Puerto Rican income tax. The real and personal property of businesses used in export of services also enjoys a 75% exemption from municipal and state property taxes. Lastly, a business engaged in export of services benefits from a 50% exemption from the municipal licenses or taxes applicable to the volume of the business.
Both for individuals and businesses, locating in Puerto Rico may provide tax and other opportunities, but in all cases appropriate professional advice is essential.