March 14 (Bloomberg) -- Puerto Rico occupies a space between foreign and domestic status with U.S. citizenship for residents, its own Olympic team and a tax system that allows individuals and companies the chance to elude the IRS.
The U.S. territory’s leaders are seeking to lure mainland residents such as hedge-fund billionaire John Paulson. Moving to Puerto Rico could allow Paulson and other top-earning taxpayers to shield future income from the Internal Revenue Service without giving up their passports.
Puerto Rico, eager for economic growth, is making an unusually direct pitch to wealthy Americans that risks a political backlash from Congress, said John Buckley, a former tax counsel for Democrats on the House Ways and Means Committee.
“They’re walking a fine line,” Buckley said. “This would be the first time that Puerto Rico would kind of deliberately erode the U.S. tax base for individuals.”
Already, 10 Americans have taken advantage of a year-old Puerto Rico law that lets them avoid local and U.S. capital gains taxes by signing agreements with the territory’s government. Paulson, a 57-year-old New Yorker, is considering such a move, according to four people who have spoken with him about it, Bloomberg News reported March 11.
The law was designed to promote investment in the island territory. The unemployment rate there was 14 percent in December 2012, compared with 10.2 percent in Nevada and Rhode Island, the states with the highest unemployment, according to the U.S. Bureau of Labor Statistics.
Puerto Rico’s gross domestic product per capita in 2010 was $16,300, about the same as Botswana or Belarus, according to the CIA World Factbook.
Puerto Rico wants to diversify its economy, which has lost some of its manufacturing base to low-wage countries such as the Dominican Republic and China, said Gabriel Hernandez, one of the framers of the Puerto Rican tax law and head of the tax division of BDO Puerto Rico PSC.
“It’s our reaction to what happened, that the world got more connected,” said Hernandez, who likened the effort to tax incentives used by states to lure businesses.
The U.S., he said, should embrace “the whole concept of trying to make our economy more independent or more stable or more self-reliant.”
The law takes advantage of the longstanding interaction between the tax codes of the U.S. and Puerto Rico. Under laws previously passed by Congress, all income earned in Puerto Rico by island residents is exempt from U.S. taxation. Residents still owe the IRS taxes on any U.S. income.
By moving to Puerto Rico, wealthy Americans can transform potential U.S. capital gains income taxed at up to 23.8 percent into untaxed Puerto Rican income. They must meet residency tests, including spending 183 days a year in Puerto Rico and having social and personal connections on the island.
By contrast, renouncing U.S. citizenship by moving to another country is much more punitive for wealthy taxpayers. They must surrender their U.S. passports and pay an exit tax on the value of unrealized capital gains. As a simplified example, someone giving up citizenship who has $100 million in untaxed stock gains could pay $23.8 million upon departure.
Even with potential tax advantages, Paulson and others considering a move to Puerto Rico should be wary, said Argeo Quinones Perez, a professor of economics at the University of Puerto Rico’s Rio Piedras campus.
“For people as wealthy as Mr. Paulson and the like, spending half a year in this provincial, third-world environment would be like spending half a year in minimum-security prison,” he said in an e-mail. “The tax breaks Mr. Paulson and other people and entities enjoy in this fiscal paradise are at the heart of the long-term fiscal crisis and economic stagnation we suffer.”
Puerto Rico, which has a population of about 4 million and is smaller geographically than Connecticut, has been a part of the U.S. since the Spanish-American War in 1898. The commonwealth has a non-voting resident commissioner, Pedro Pierluisi, who represents residents in Congress and caucuses with House Democrats.
In an interview yesterday, Pierluisi blamed Puerto Rico’s unresolved status between statehood and independence. As a state, he said, Puerto Rico would get more federal funding, which would be an acceptable tradeoff for bringing residents’ income under the federal income tax. Residents and employers do pay federal payroll taxes.
“Short of statehood, this is what you do,” he said, adding that a struggling Puerto Rico economy just encourages migration in the opposite direction, to Florida, Texas and North and South Carolina.
Puerto Rico’s separate tax system makes it different from several other U.S. territories. Guam, the U.S. Virgin Islands and the Northern Mariana Islands all use what is called a “mirror code,” in which they use the U.S. tax code and substitute the name of the territory each time the law says United States. The District of Columbia is treated generally like a state for tax purposes.
The Virgin Islands attempted to lure hedge-fund managers more than a decade ago, using authority Congress granted the territory to encourage economic development.
That effort fizzled after Congress changed the law in 2004 to make it more difficult to recharacterize U.S. income as island-based, and the IRS began auditing more aggressively.
Puerto Rico’s attempts to lure U.S. taxpayers could draw more scrutiny of taxation in the territories, which hasn’t received much attention lately, said Senator Charles Grassley, former chairman of the Finance Committee, who led the effort against the Virgin Islands maneuvers.
“Harmonizing the tax rules of the territories could be something to look at if Congress and the president undertake comprehensive tax reform,” the Iowa Republican said in an e-mailed statement this week. “Or if Puerto Rico maintains a separate tax system, that could be conditioned on accepting certain rules to prevent tax evasion.”
The hybrid system of Puerto Rican taxation has implications for companies, too. Until 2006, the U.S. offered companies a credit against U.S. income taxes for investments in the territories. Companies also have access to the U.S. market, patent protection and the U.S. legal system, Hernandez said.
After that break expired, companies restructured their Puerto Rican operations to take advantage of the fact that it’s considered a foreign jurisdiction for tax purposes.
Companies such as Amgen Inc., Pfizer Inc. and Microsoft Corp. receive local tax benefits from their operations on the island, according to regulatory filings. As with profits in another country, the companies can earn and leave money in Puerto Rico without paying U.S. corporate income taxes.
“The same thing that Paulson is getting, corporations are getting in the manufacturing sector,” Pierluisi said.
At a hearing last year, Senator Carl Levin, a Michigan Democrat, said Microsoft’s method of routing profits through Puerto Rico saved the company $4.5 billion over three years.
Bill Sample, the company’s corporate vice president for worldwide tax, testified at the hearing that Microsoft follows all tax laws.
For U.S. lawmakers concerned about the budget deficit, the Puerto Rico law could be a boon, said Buckley, who now teaches tax law at Georgetown University in Washington. A legislative attempt to prevent Paulson and others from tax-free moves to Puerto Rico could generate revenue for the U.S. Treasury.
“You could get a score here,” Buckley said, “And I doubt a lot of people are going to stand up and defend him.”
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