Under a local constitution approved by the Congress of the United State (“U.S.”) in 1952, Puerto Rico (“PR”) is a self-governing, unincorporated territory of the United States
with local autonomy and power. Because of this status PR is treated for tax purposes as separate from all the United States.
Starting from 2006, PR has been experiencing a recession for 8 consecutive years. Struggling to emerge from the economic slump on January 2012, Puerto Rican government signed the “Individual Investors Act” (“Act 22”) as well as the “Exportation of Services Act” (“Act 20”).
Act 22 completely eliminated tax on capital gains, interest and dividends for U.S. Citizen that, by living on the island for at least 183 days a year, become PR residents. Section 937 of the U.S. Internal Revenue Code (“US IRC”) provides that in order for an individual to qualify as a Bona Fide Resident of Puerto Rico under US-IRC Section 933 (“Bona Fide PR Resident”), he/she must meet all of the following three tests: Presence Test, Tax Home Test, and Closer Connection.
As a general rule, U.S. Citizen, even if they reside abroad, are taxed by U.S. Internal Revenue Service (“IRS”) on their worldwide income. For example, if a U.S. Citizen resides in a country, which does not impose long-term capital gains taxes, he/she will still have to pay a capital gain tax of 15% or 20% depending on the applicable U.S. tax rate. However, when a U.S. Citizen moves to PR falls under a very peculiar section of the IRS, which trumps Federal Law: US IRC §933 exempts residents of Puerto Rico from federal income tax on that part of their income that has its source in Puerto Rico. Thus, Puerto Rican’s residents pay federal income tax only on income they receive from the United States or other non-Puerto Rican sources.
As per the combination of the U.S. IRS provisions and the dispositions of Act 22, once an American becomes a new resident of PR – where relinquishment of the American Citizenship is not required – he can legally pay zero capital gains tax and no more federal tax on income received from sources within Puerto Rico. Obviously, that’s why Act 22 is also known like the law that turned PR in a tax haven for U.S. Citizens.
Act 22 tax incentives can be summarized as follows:
- PR’s tax rate, during the exemption period, for qualified individual’s income from dividends and interests is 0%, moreover, a qualified individual is also exempt, under U.S. IRS section 933, from U.S. federal income taxes if the revenue generated is considered PR source income. However, interests and dividends deriving from U.S. source are subject to U.S. income taxation;
- After a qualified individual becomes a resident of PR, during the tax exemption period, income from long-term capitals gains is exempt from PR’s income taxes. A qualified individual’s long-term capital gains for investment done, prior to becoming a resident of Puerto Rico, are subject to a 10% tax rate if realized within 10 years of residency or 5% if realized after the 10 years of residency.
Type of Income
Puerto Rico’s Tax rates
Dividend and Interests if not from U.S>
Long-Term capital gains for new Residents
Long-Term capital gains for investments started prior to Residency, realized within 10 years of Residency
Long-Term capital gains for investments started prior to Residency, realized after 10 years of Residency
The tax breaks provided by Act 22 are an evident PR’s attempt to attract new money to regenerate the territory’s economy; accordingly tax breaks apply only to new residents, they are available to individuals who have not been residents of Puerto Rico within the last 15 years and who become residents of Puerto Rico on or before December 31, 2035.
To benefit from the Act 22, the new resident must apply with the Office of Industrial Tax Exemption (OITE) of PR and obtain a tax exemption decree, which will be signed by the Secretary of the Department of Economic Development and Commerce of Puerto Rico and provide full detail of tax rates and conditions mandated by the Act. The Tax Exemption Decree will constitute a contract with the Puerto Rico Government. Once the individual investor obtains the tax exemption decree, the benefits granted will be secured during the term of the decree, irrespective of any change may incur in the applicable PR tax laws. The tax exemption granted under the Individuals Investors Act will expire on December 31, 2035.
The Puerto Rican government also enacted the “Exportation of Services Act”, Act 20, which is focused on encouraging local service providers to expand their businesses by offering their services to clients located outside the Island. Also, it aims to convince foreign services providers to move their businesses to Puerto Rico.
Act 20 provides benefits for services rendered from PR to outside markets and states which activities are eligible to receive the Act benefits. Among the others, eligible activities are: research and development; advertising an public relations; consulting services for any trade or business; professional services as legal, tax and account services.
The eligible activity must not have a nexus with PR – which means that the activity must not be related to the conduct of a trade, business or other services in PR – to qualify for the Act benefits.
Act 20 seeks to attract business trough the following profitable tax incentives, which apply to all new Puerto Rican businesses under a Tax Exemption Decree:
– a 4% flat income tax rate on income generated from export services;
– a 100% tax exemption of earning and profit distributions on income generated from export services;
– Exemption from US Federal tax on Puerto Rico source income, considering that under the US Internal Revenue Code, the country source of service income is the jurisdiction where the service is performed, income earned by performing a service entirely in Puerto Rico is Puerto Rico-sourced income. Under US Internal Revenue Code Sections 933 and 861, if the person performing the service (whether an individual or an entity) is a Puerto Rican resident working in Puerto Rico, the income is exempt from US tax. Puerto Rican entities are considered foreign corporations for US tax purposes. Therefore in order to benefit from Act 20, the PR’s business must avoid doing anything in the USA that contributes to producing the service.
Other important benefits of Act 20:
– The flat income tax rate may drop from 4% to 3% if more than 90% of a company’s gross income is derived from exporting services and the Puerto Rican government deems such services “strategic,” which generally means that rendering such services from Puerto Rico is in “the Island’s best economic and social interest”;
– Some entities may receive a 100% property tax exemption for the initial five years of operation. After the five-year period, a 90% tax exemption will apply for the remainder of the Act 20 decree. This benefit is mostly granted only to call centers, shared service centers, or companies that move their headquarters to Puerto Rico;
– 60% tax exemption on Municipality taxes.
The PR government has the sole discretion to grant or withhold Act 20 status; the OITE will perform a due diligence on the company and its management. Considering the above, is very important that the application satisfies all written and unwritten requirements, which can be summarized as follows:
– Explaining in details the nature of the business,
– Providing basic revenue and profit growth projections for three years;
– Generating at least three payroll jobs in PR with plan of growth.
Considering the above, if you think about moving to PR, you also have to know that the maximum income tax rate, on the salary you receive for services rendered in PR, is 33% – which applies on the net taxable income over $61,500 – plus Federal Insurance Contributions tax (FICA) and other payroll taxes.
To qualify for these business tax incentives, you need to form a Puerto Rican entity. You will be required to have a salary of 1/3 of the entity’s net profits, up to a maximum salary of $250,000. Thus, new services providers will have to pay income tax on the $250,000 salary (using a graduated rate of up to 33%) and 4% tax on income over $250,000. For example, on a 1 million of business profits, you will have a tax bill of around $105,000 – $75,000 (assuming that the graduate rate to be applied at the 250,000 salary is 30%) plus $30,000 (which represents the 4% of 750,000)= $105,000.00 – or about 10%. Considering the above, you will really benefit of the tax incentive if your business generates at least $250,000 in annual profits, as income above this threshold is subject to only a 4% income tax.
If you receive a salary from a U.S. Company for services rendered outside of Puerto Rico, as a US citizen, you will be subject to federal income taxes as well as Puerto Rico income taxes. However, as a Puerto Rico resident, you are entitled to a tax credit for the federal taxes. PR tax on dividends and interests income is 0% but, if interest and dividend are coming from a US company, such incomes are still subject US income taxation.
As well as for Act 22, to benefit from Act 20 the service provider needs to submit an application with OITE and obtain a tax exemption decree, which will be considered a contract between the Puerto Rican Government and the service provider. The Act’s benefits will be secured during the term of the decree, irrespective of any change may incur in the applicable PR tax laws. The decree shall have a term of 20 years; whit a possible 10-year extension provided certain conditions are satisfied.
The tax incentives of Acts 20 and 22 represent a unique opportunity for U.S. taxpayers to conduct business with a substantial lower tax burden than in the U.S. mainland. However, in order to avoid losing the tax benefits and paying substantial penalties, we strongly recommend to understand and follow not only tax rules governing the PR’s tax program but also those rules contained in the US IRC which are designed to ensure that individuals relocating to PR do so within the Congressional approved standards applicable to territorial and international taxation.
Cav. Piero Salussolia, Esq.
Avv. Gemma A. Caterini (admitted only in Italy).
This article was written with effort and dedication in order to provide valuable information on diverse topics. Please feel free to share this information with your colleagues and friend so long as you do not modify or alter its contents and our contact information.
With the cooperation of Orlando J. Rodriguez Esq.
 26 U.S. Code § 937 – Bona fide resident
For purposes of this subpart, section 865 (g)(3), section 876, section 881 (b), paragraphs (2) and (3) of section 901 (b), section 957(c), section 3401 (a)(8)(C), and section 7654 (a), except as provided in regulations, the term “bona fide resident” means a person—
(1) who is present for at least 183 days during the taxable year in Guam, American Samoa, the Northern Mariana Islands, Puerto Rico, or the Virgin Islands, as the case may be, and
(2) who does not have a tax home (determined under the principles of section 911 (d)(3) without regard to the second sentence thereof) outside such specified possession during the taxable year and does not have a closer connection (determined under the principles of section 7701 (b)(3)(B)(ii)) to the United States or a foreign country than to such specified possession.