Do U.S. Citizens Head to Puerto Rico for Income Tax Breaks?
Puerto Rico is commonly referred to as the “Island of Enchantment” and attracts many Americans each year for both business and pleasure. Recent trends have shown more and more U.S. citizens flocking to the island for another reason – income tax breaks.
Generally, U.S. persons are taxed on the income they earn worldwide, regardless of their place of domicile. This means that a U.S. citizen living and/or working in a foreign country may be taxed on that foreign income in the respective foreign country and again in the U.S. There are favorable U.S. tax laws in place to avoid double taxation on the same income, such as the foreign earned income exclusion and foreign tax credits, where the income might still need to be reported, but not fully taxed, in the U.S.
Pros and Cons of Expatriating for Tax Reasons
As a result of the high U.S. taxes and worldwide taxation, many high-income U.S. taxpayers consider expatriating from the U.S. Ultimately, they may not want to give up their citizenship or green card simply to lower their federal income taxes. In addition, expatriating citizens may also be subject to immediate expatriation tax consequences.
Puerto Rico, however, offers a persuasive alternative to expatriation. Governor Ricardo Rossello of Puerto Rico 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 aims to attract individual investors to Puerto Rico by providing many incentives to resident individuals. Chapter 3 implemented changes to entice business entities to move their operations to Puerto Rico. Act 60 replaced Acts 20 and 22 that were similar and previously in place.
Being a U.S. territory, Puerto Rico is treated a bit differently by the IRS. If a U.S. citizen becomes a bona fide resident of Puerto Rico, they can still maintain their U.S.. citizenship and avoid possible worldwide taxation on income earned in Puerto Rico. The expatriation rules do not apply to U.S. citizens who relocate to Puerto Rico because the relocation by itself does not require any renouncement of U.S. citizenship. Thus, no expatriation tax is required and the individual can move back to the mainland U.S. in the future.
Incentives Act Chapter 2 – Individuals
Chapter 2 of the Incentives Act aims to attract U.S. individuals to relocate to Puerto Rico. There are many hurdles and other financial obligations to overcome. To qualify under Chapter 2 the individual must be considered a resident individual investor (Resident Individual). A Resident Individual satisfies all of the following three conditions:
- Physical Presence Test – an individual is domiciled 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;
- Tax Home Test – Puerto Rico is considered to be his or her “regular or principal place of business”; and
- Closer Connection Test – a facts and circumstances test proving the individual has an aggregate closer connection to Puerto Rico than to the U.S. or any other foreign country. This test includes, but is not limited to:
- personal belongings located in Puerto Rico, such as automobiles, furniture, clothing, and jewelry owned by the individual;
- social, political, cultural, or religious organizations with which the individual has a current relationship;
- personal banking activities;
- business activities;
- jurisdiction in which the individual holds a driver’s license;
- jurisdiction in which the individual votes; and
- country of residence designated by the individual on forms and documents.
Resident Individuals must apply for and obtain a tax exemption decree under the Incentives Act. To obtain access to and maintain the approved and signed tax exemption decree, three conditions must be satisfied:
- A one-time fee of $5,000 must be paid and deposited into a special fund to promote the relocation of Resident Individuals to Puerto Rico;
- All Resident Individuals that hold a tax exemption decree must comply with an annual contribution of $10,000 to an organized and registered nonprofit organization in Puerto Rico; and
- A Resident Individual must purchase residential property in Puerto Rico within the first two years after obtaining the decree.
If a Resident Individual meets these requirements and qualifies for the tax benefits under Chapter 2, the individual is eligible to receive a 100 percent tax exemption from Puerto Rican income taxes on all dividends and interest. A Resident Individual would also receive Puerto Rico income tax exemptions on capital gains stemming from the sale or exchange of securities that appreciated in value after the individual established domicile in Puerto Rico. However, US citizen investors may still be taxed in the US on capital gains generated from securities acquired prior to the individual becoming a Resident Individual, but only the increase in value up to the time of relocation. 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 percent.
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 in the US for the year of move. Form 8898 requires the taxpayer to provide information concerning compliance with the above requirements.
Incentives Act Chapter 3 – Businesses
Chapter 3 of the Incentives Act is meant to act as a path to develop Puerto Rico as an international export service and commerce center. Under Chapter 3, business owners who establish certain qualifying businesses in Puerto Rico may be able to take advantage of significant tax benefits.
To qualify under Chapter 3, businesses must maintain a bona fide office or establishment in Puerto Rico and conduct eligible services for export or promoter services. Export or promotor services may include research and development, advertising and public relations, creative industries, engineering, architectural, project management services, or other professional services delivered to customers outside the island. The key is that the services be performed in Puerto Rico for customers outside of Puerto Rico. The list of qualified services is extensive, however, there are also many services that are not qualified, such as many digital and e-commerce businesses. Before making the decision to relocate a business to Puerto Rico, double-check that it will meet the Incentives Act requirements.
If an export service business does qualify for the tax benefits under Chapter 3, the net income generated by the business is subject to a four percent Puerto Rican corporate tax. In addition, distributions from earnings and profits to the owners are not subject to Puerto Rican income tax. The real and personal property of businesses used in the export of services may also benefit from a 75 percent exemption from municipal and state property taxes and a 50 percent exemption from the municipal licenses or taxes applicable to sales volume. As long as both the export entity and owners are Puerto Rico domiciled, there is no taxation on this income in the U.S.
Taking Advantage of Chapters 2 and 3
If a U.S. individual is ready to commit to island life and willing to relinquish U.S. residency, a move to Puerto Rico may be beneficial for income tax purposes. The relocation may be the result of retiring and taking advantage of Chapter 2 benefits on interest, dividends and capital gains. Or the move may be motivated by the corporate tax savings available to export service companies. It is possible to form a new export company in Puerto Rico and still retain an existing related business in the U.S. The Puerto Rico company may provide management or other services to the U.S. company. The service fees paid to Puerto Rico would be a tax deduction in the U.S., and income-eligible for the four percent reduced corporate tax rate in Puerto Rico. Be mindful that any transactions between the two entities would still be subject to transfer pricing regulations in both Puerto Rico and the U.S., and proper management services or other agreements must be put into place. Consulting the appropriate tax advisors in both the U.S. and Puerto Rico is critical before engaging in such transactions.
What’s the Catch?
Moving to Puerto Rico may not exempt U.S. citizens from all U.S. income taxes. Any income generated from U.S. sources, or other non-Puerto Rican sources, will still be subject to U.S. income tax. A U.S. citizen becoming a bona fide resident of Puerto Rico may still be required to file and pay U.S. income taxes.
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. 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 at all. This campaign also addresses 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 light of this anticipated heightened IRS scrutiny.
There is also mention of Puerto Rico potentially become a U.S. state. If this occurs are these taxpayers back in the same U.S. taxpaying position they began? In addition, tax laws can turn unfavorable just as quickly, and with a mounting debt that has tripled in the last 15 years, raising taxes might be a potential solution.
The move to Puerto Rico may be beneficial but also difficult. With recent hurricanes, earthquakes and a U.S. equivalent housing shortage, the move may not be as simple as just packing your bags and moving.
For more information on international taxation, please reach out to Nicole Suk, or your Windham Brannon advisor.
