Postscript Mar. 22, 2016: On Nov. 30, 2015, PR enacted Act 187-2015 amending Acts 22 and 20 to stiffen the requirements. For Act 22 incentives, PR now requires new applicants after Dec. 1, 2015 to purchase residential property in PR within two years and open a deposit account. For Act 20 incentives, PR requires gradually hiring five full-time employees in PR. Read more about the changes on a PR attorney’s blog, Puerto Rico Expands Tax Haven Deal For Americans To Its Own Emigrants, Puerto Rico Act 22 – The Individual Investors Act and Puerto Rico Act 20 – The Export Services Act.
Watch our related Webinar recording “Puerto Rico’s tax haven status is tailor made for investors, traders and investment managers.”
Puerto Rico’s new tax incentive acts are tailor made for traders/investors, investment managers and financial institutions. In the past, Puerto Rico offered tax incentives to manufacturers. Puerto Rican officials now believe investors, investment managers and financial institutions can more easily move virtual businesses there. The officials figure these groups will bring an influx of new money and key investments to the island to help it rise above its current state of financial distress.
“Puerto Rico is one of only a few places in the world where a U.S. citizen or permanent resident can live, without giving up their U.S. citizenship and passport, while legitimately avoiding payment of tax to the IRS on PR source income,” NYC tax attorney William Blum says. “Those who would like to legally reduce their tax burden, and who are ready for an exciting lifestyle change, should seriously consider it.”
Act 22 for traders and investors
Enacted in 2012, PR Act 22 allows investors and traders with bona fide residence in Puerto Rico to exclude 100% of all short-term and long-term capital gains from the sale of personal property accrued after moving to PR. Act 22 does not require investment in Puerto Rican stocks and bonds; trades can be made with a U.S. broker or on any exchange around the world. This applies to day traders. While trader tax status and Section 475 MTM elections are important tax strategies for residents of the U.S., they are irrelevant when applying PR Act 22 exclusions.
U.S. tax law Section 933 “Income from sources within Puerto Rico” is synchronized with PR tax law, including Acts 22 and 20. Americans with residence in PR split their income, reporting “non-PR source” income (income in the U.S. and elsewhere other than in PR) on U.S. Form 1040, and PR-source income on a PR income tax return filed with Hacienda (PR’s tax authority).
IRS Pub 1321 “Special Instructions For Bona Fide Residents Of Puerto Rico Who Must File A U.S. Individual Income Tax Return (Form 1040 or 1040A)” shows how to treat different types of income (see page 2, “Source of Income Rules”). Other than the “sale of personal property” which is sourced in the “seller’s tax home” (presumably in Puerto Rico), other types of income are sourced from: the location of payer for interest and dividend income; where the service is performed for wages and compensation; where services were performed that earned the pension income; where the property is used for royalties paid on patents, copyrights and IP; and the location of property for the sale or real property like residential, rental and commercial real estate.
Can you see the tax loophole? Worldwide capital gains (other than gains on real property) are sourced in PR and they are 100% excluded from both U.S. and PR tax, resulting in a trader’s tax nirvana. There’s one exception: trades made from an office outside of PR do not qualify as PR source capital gains subject to the exclusion.
Pub 1321 includes these instructions: “Caution: There are special rules for gains from dispositions of certain investment property (for example, stocks, bonds, debt instruments, diamonds, and gold) owned by a U.S. citizen or resident alien prior to becoming a bona fide resident of a possession. You are subject to these special rules if you meet both of the following conditions: For the tax year for which the source of gain must be determined, you are a bona fide resident of Puerto Rico; for any of the 10 years preceding that year, you were a citizen or resident alien of the United States (other than a bona fide resident of Puerto Rico); if you meet these conditions, gains from the disposition of this property will not be treated as income from sources within the relevant possession for purposes of the Internal Revenue Code. Accordingly, bona fide residents of American Samoa and Puerto Rico, for example, may not exclude the gain on their U.S. tax return. However, there is a special election that you can make to allocate gain/losses between the U.S. and Puerto Rico from disposition of certain property. For additional details see Publication 570.”
It’s a bit deceptive in marketing materials from PR sites for Act 22. Many promise 100% exclusion on all interest and dividend income, but the U.S. will keep taxing non-PR source interest and dividend income, even if PR does not. Act 22 also provides a 10% PR tax rate on the sale of real property located in PR if held under 10 years since establishing PR residence, and a 5% tax rate if held more than 10 years.
Act 20 for investment managers
Investment managers charge advisory fees, which are service business revenues. They export their services to investors outside of Puerto Rico and hence they can qualify for Act 20 tax incentives for “export service businesses.”
To receive these incentives, they need to move their operations to PR and they should have a minimum of three employees there who are paid reasonable wages. The employees are bona fide residents and they pay PR taxes on their individual tax returns on this compensation. PR is part of FICA and Medicare, so the employer needs to charge payroll taxes in a similar manner to the U.S.
The Act 20 tax incentive is a 4% flat tax rate on net business income. The owner receives Act 22 100% exclusion on dividends received from the PR business entity. PR-sourced dividends are excluded from U.S. taxes under Section 933.
Companies retaining some operations in the U.S. will have “effectively connected” trade or business income subject to U.S. tax.
Many owners and employees of investment management operations have significant capital gains income generated from their own investment portfolios, including investments in their own funds and profit allocations of capital gains in their managed hedge funds. These capital gains can be excluded under Act 22, except for the trades that originate from an office outside of PR. A CEO of an investment management firm can not be the only one that moves to PR, he also needs to bring along much of his investment management operations and employees, too.
Bona fide residence has stringent tests
You must pass all three different tests — the presence test, tax home test and closer connection test – for individual bona fide residence and all three are not easy to pass. Many taxpayers and advisors are aggressive about state residency tests for domicile and they lose when audited by tough tax examiners. PR’s Act 22 and 20 are new and only 2012 and 2013 tax returns have been filed, not giving state and PR auditors much time to check yet.
It’s difficult to move an investment management business to PR. You have to change documents with investors, hedge funds and counterparties to reflect the PR company name and address and carry on your business from Puerto Rico.
“Everyone There Will Have Moved Here! An Overview of the US Federal and Puerto Rican Tax Incentives for Bona Fide Residents of Puerto Rico” is an excellent article by NYC tax attorney Mark Leeds and PR tax accountant Gabriel Hernandez. (The article includes in-depth information about the three residency tests and an example of an investment manager.)
When someone calls with questions about Puerto Rican tax benefits, Leeds says offspring are an important factor. “The first thing I ask is do you have kids and what are their ages? The sweet spot of the PR tax strategy is for people in their 20s without kids and older people whose children have moved on,” he says. “If children are embedded in communities, it’s hard to make the change of residence work because it’s hard to meet the bona fide residence tests. If kids and spouses will stay in the U.S., it’s unlikely that the trader will satisfy the closer connection test. The strategy works well for young traders and older guys in private equity and hedge funds.”
The article says “(Act 22) has a 100% tax exemption from Puerto Rico income taxes on all long-term capital gains accrued after the individual becomes a bona fide resident of Puerto Rico.” I asked Mr. Hernandez if this should say all capital gains (including short term). Hernandez confirmed all capital gains now receive the exemption.
“Originally, PR Act 22 had only the long-term capital gains exclusion and after a short while they corrected it to include all capital gains (on the sale of personal property),” he says. Afterwards, I asked Mr. Hernandez for a legal citation on this correction and he emailed me Law 138 in Spanish and wrote “Article 3 of Law 138 amends Article 5 of Act 22 to provide exemption to the “totalidad” (which means 100%) of the capital gains.”
Some tax professionals feel the Hacienda might consider a day trader, scalper or high-frequency trading market-maker to be a business, and disqualify their trading gains from Act 22 exclusions. But Hernandez and Leeds disagree.
“Puerto Rico follows federal precedents on trade or business, and trading is a capital gains activity in the U.S.,” Hernandez says.
Moving to a foreign country instead
If an American citizen or legal resident (greencard holder) becomes a bona fide resident of a foreign country, as opposed to a U.S. territory or possession like Puerto Rico, their taxes are handled as follows: If they retain U.S. citizenship or legal residence status, they may use Section 911’s Foreign Earned Income Exclusion ($99,200 for 2014). If they surrender U.S. citizenship or legal residence status, they are subject to Section 877’s Expatriation Tax rules. (Both are beyond the scope of this article.)
For traders and investment managers who are ready, willing and able to meet the stringent bona fide residency tests, PR Act 22 and Act 20 tax incentives are probably a great deal.
For such a drastic move and change of lifestyle, you will want to be conservative in assessing your passing of the residency tests. It’s wise to discuss the ins and outs of these tax programs with experts in these matters, and run pro-forma U.S. and PR tax returns based on your facts and circumstances over a few years of projected stay. Carefully assess the pros and cons. One con is there’s no Section 475 NOL tax loss insurance for business traders.
If you’re young and single or an empty nester, this type of move may work well for you. Saving up to 50% or more on federal and state income tax rates on your trading gains can beef up your retirement income in a significant way. Plus, in PR you already found your retirement home in the sun!