Everyone There Will Have Moved Here! An Overview Of The US Federal And Puerto Rican Tax Incentives For Bona Fide Residents Of Puerto Rico

Keywords: Puerto Rican tax incentives, DEDC, income tax

The play West Side Story focuses on the challenges occasioned by the mid-twentieth century migration of significant numbers of Puerto Rican families to New York City. The plight depicted in the theater was real; the economic situation at the time in Puerto Rico was dire. The government of Puerto Rico, seeking to stem mass emigration, responded with a mix of tax and economic incentives.1 The response to these tax incentives over the next three decades was spectacular. Puerto Rico was transformed from an impoverished agrarian economy to a technologically advanced industrial country.2

The Federal income subsidies supporting Puerto Rico were repealed in 1994. The impact on the economy of Puerto Rico was substantial.3 These changes, coupled with a rise in inexpensive labor elsewhere in the world, caused a prolonged recession in Puerto Rico and the emigration of some of Puerto Rico's best and brightest young people began again. Today, La Isla del Encanto is making bold moves to attempt to reverse its negative economic trends and bring individuals (including Puerto Rican nationals who may have left many years before), families, and businesses back to its economy.4 The Puerto Rican Department of Economic Development and Commerce (the "DEDC") has been actively engaged in an information campaign extolling the benefits of relocating one's business and residence to Puerto Rico.5 This article explores certain US Federal and Puerto Rican income tax considerations for individuals who may wish to consider relocating to Puerto Rico.

At the current time, the success of Puerto Rico's new laws remains uncertain, but reports suggest that the opportunity is attracting attention.6 As analyzed below, however, the Puerto Rican tax incentives must be understood in light of existing US rules, which are very effective in ensuring the integrity of the US tax system on built-in gains and investment income. Concomitantly, Congress has recognized the need for special tax incentives to assist US possessions, including Puerto Rico, in obtaining jobs.7 The need for special tax incentives has been attributed to the additional costs imposedby possession status, such as the requirement to use US flagships and the minimum wage standards. These policy statements were reaffirmed by Congress in May 2012.8

Overview of 2013 and Future Tax Burdens on US Individuals

At the end of 2012, the House of Representatives followed the Senate in passing H.R. 8, the American Taxpayer Relief Act of 2012 (the "Act"). President Obama signed this legislation into law on January 2, 2013. Succinctly stated, the Act imposed an income tax increase on topearning US taxpayers, nudged up the estate tax rate to a maximum of 40% (from 35%), and extended a variety of tax incentives that either had already expired or were set to expire. Tax rates on top-earning individual US taxpayers went up by a significant amount, but triggered beginning at $400,000. Specifically, for individuals with incomes over $400,000, beginning in 2013, the highest marginal rate was permanently increased to 39.6%. In addition, the Act imposed a stiff marriage penalty— married couples filing jointly with combined incomes of $450,000 are subject to the 39.6% rate. For low and moderate income taxpayers, the Act retained the existing rate structure.

The Act, however, does not use the $400,000 ($450,000 for married taxpayers filing jointly) thresholds for all purposes. Specifically, the phase-outs for itemized deductions and personal exemptions apply at adjusted gross incomes of $250,000 for individuals and $300,000 for joint returns. Also, the Pease limitation on itemized deductions has been reinstated. The Pease limitation reduces most itemized deductions by 3% of the amount by which adjusted gross income exceeds a specified threshold, up to a maximum reduction of 80% of itemized deductions. The thresholds are also going to be adjusted for inflation beginning in 2014. The federal income tax rate on long-term capital gains was increased from 15% to 20% for individuals with incomes of $400,000 or more ($450,000 for married couples filing jointly) beginning in 2013. Qualified dividend income remains taxable at the rates applicable to longterm capital gains, and thus at the 20% rate applicable to taxpayers with income of at least $400,000 ($450,000 for married couples). Capital gains and other items of net investment income can also be subject to a 3.8% Medicare Tax beginning in 2013.

Notwithstanding these substantial tax increases on individuals with incomes over $400,000, President Obama has been pressing Congress to consider additional "revenue options."9 The 2013 federal income tax increases, coupled with the prospects for additional tax increases in the near term, has increased the attractiveness of jurisdictions with more moderate tax burdens. As discussed below, Puerto Rico is such a place— at least for the time being. Puerto Rico offers the additional advantage of US citizens not being required to give up their US citizenship.10

The Puerto Rican Tax Rules for US IndividualsWho Become Residents of Puerto Rico

In January 2012, Puerto Rico passed Act No. 22 of 2012 ("Act No. 22"). Act No. 22 contains numerous incentives to encourage individuals to relocate to Puerto Rico. The law provides the following benefits to new Puerto Rico bona fide residents on qualified investments (more on who qualifies as a new bona fide resident below): (i) 100% tax exemption from Puerto Rico income taxes on all dividends; (ii) 100% tax exemption from Puerto Rico income taxes on all interest; and (iii) 100% tax exemption from Puerto Rico income taxes on all long-term capital gainsaccrued after the individual becomes a bona fide resident of Puerto Rico. The new resident must not have been a resident of Puerto Rico at any time during the 15-year period preceding the effective date of Act No. 22, which period would be from January 16, 1997 through January 16, 2012.

Other complementary laws were enacted in 2012, mainly:

The Export Services Act (Act 20 of 2012), which provides for 4% maximum tax rate on income related to services for exportation provided by new Export Services businesses in Puerto Rico. The International Financial Center Regulatory Act (Act 273 of 2012), with the objective of making Puerto Rico an international banking and financial center by providing tax incentives (mainly, a 4% income tax rate) for new banking and financial activity in Puerto Rico that is done for clients outside of Puerto Rico. There is a process in place whereby an individual files an application for a Puerto Rico tax decree prior to relocation which would serve as a contract guaranteeing the incentives through 2035 from any subsequent changes in local legislation. It should be noted that these efforts are not dissimilar to the Federal government allocating tax credits to stimulate certain types of economic activity (recent examples being renewable energy initiatives), or what states have often done: providing tax holidays to companies to move their factories.

US Individuals Who Become Bona Fide Residents of Puerto Rico

In general, a US individual remains subject to full Federal income tax regardless of where (s)he is domiciled.11 The US Internal Revenue Code of 1986, as amended (the "Code"), however, provides special rules for an "individual who is a bona fide resident" of Puerto Rico.12 Under these special rules, income from sources within Puerto Rico is not included in gross income and is not subject to US federal income tax.13 Thus, there are two levels of inquiries for US individuals who relocate to Puerto Rico. First, is the individual a bona fide resident of Puerto Rico? If so, what items of income can be included in his or her Puerto Rican income and thereby excluded from US income?

BONA FIDE RESIDENTS OF PUERTO RICO

An individual is considered to be a bona fide resident of Puerto Rico if three tests are met. The first test is mostly mechanical. The individual must be present for at least 183 days during the taxable year in Puerto Rico (the "presence test").14 Second, the individual must not have a tax home outside of Puerto Rico during the taxable year.15 Third, the individual must not have a "closer connection" to the United States or a foreign country than to Puerto Rico during the taxable year.16 Special rules are provided for the year of the move from the United States to Puerto Rico.

The Presence Test

The mechanical 183-day presence test is loosened by Treasury Regulations. Under these regulations, an individual will be considered to meet the presence test if one of five tests is met:17

The individual was present in Puerto Rico for at least 183 days during the taxable year; The individual was present in Puerto Rico for at least 549 days during the 3-year period consisting of the current taxableyear and two immediately preceding taxable years, provided that the individual was present in Puerto Rico for at least 60 days during each of those years;18 The individual was present in the United States for no more than 90 days during the taxable year; 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...