In Wal-Mart Puerto Rico, Inc. v. Juan C. Zaragoza-Gomez, the First Circuit Court of Appeals, affirming the district court decision, has ruled that a portion of Puerto Rico's corporate alternative minimum tax (AMT), as amended in 2015, violates the dormant Commerce Clause of the US Constitution. As a result, the Court continues the injunction against the collection of the AMT.

Facts

Generally, the structure of the AMT regime includes two measures to calculate the obligation. The Court decision relates to the second measure, which covers the calculation of a minimum tax based on the value of goods acquired or services provided by affiliates of the taxpayer in Puerto Rico. In particular, the AMT's tangible property tax, which is a component of that second measure, was a fixed rate of 2% before the amendments made by Act 72 of 2015. The amendments created graduated rates for the tangible property tax with a top rate of 6.5% for affiliated corporate taxpayers with $2.75 billion or more in gross sales in Puerto Rico. The amendments also eliminated the provision that allowed Puerto Rico's Treasury Secretary (the Secretary) to tax a related-party transaction at a lower tax rate if the Secretary found the transfer price paid by the corporate taxpayer to the related party was the same price or substantially similar to the price for which the related party would sell the property to an unrelated party.

Fiscal year 2016, which ran from February 1, 2015 to January 31, 2016, was the first year for which Wal-Mart PR was subject to the graduated tangible property tax rates. In FY 2016, Wal-Mart PR's total tax liability was $46.5 million with approximately $32.9 million of that amount attributable to the AMT.

Wal-Mart PR filed suit against the Secretary, Juan Zaragoza-Gómez, on December 4, 2015, seeking an injunction against the enforcement of the AMT and a ruling that the AMT violates the dormant Commerce clause, Equal Protection Clause, Bill of Attainder Clauses and Federal Relations Act. The district court ruled that the AMT violates: (1) the dormant Commerce Clause; (2) the Equal Protection Clause; and (3) the Federal Relations Act. The district court found that the AMT did not violate the Bill of Attainder Clauses.

Accordingly, the district court granted the injunction barring the enforcement of the AMT and the Secretary appealed.

Holding

Jurisdiction

Before determining whether the AMT was unconstitutional, the First Circuit had to determine whether the federal district court had jurisdiction. The First Circuit found the district court had jurisdiction under the Butler Act of 1927 because Puerto Rico does not have a "plain, speedy and efficient" remedy available in its courts. Because of Puerto Rico's current financial status and the Special Fiscal and Operational Sustainability Act of 2014, which caps the payment of any judgments over $20 million against Puerto Rico to $3 million per year, among certain other factors, the Court found Puerto Rico's tax refund process is not a "plain, speedy and efficient" remedy.

The First Circuit also took judicial notice of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), a statute passed after the district court's March decision, which attempts to address Puerto Rico's fiscal crisis by establishing a fiscal board and a process to restructure its public debt (see Tax Alert 2016-1442). Because PROMESA does not contain provisions to prioritize the payment of a tax refund, the Court held that Wal-Mart PR would still be unlikely to obtain its tax refund. Per the Court decision, PROMESA does not change the fact that the local remedy is inadequate and continues to justify the exercise of federal court jurisdiction to the issue of injunctive relief.

Dormant Commerce Clause

The dormant Commerce Clause prohibits states from taxing transactions differently based on whether the transactions are interstate or intrastate. Citing United Haulers Ass'n, Inc. v. Oneida-Herkimer Solid Waste Mgmt. Auth., 550 U.S. 330, 338 (2007), the First Circuit observed that, in applying the dormant Commerce Clause, it must determine whether the AMT "discriminates on its face against interstate commerce."

The Secretary argued that the AMT is not facially discriminatory against interstate commerce because it does not apply to specific "interjurisdictional transfers but is instead merely a component in calculating an annual tax formula." Rejecting that argument, the Court ruled that the amended AMT discriminates because "it taxes only cross-border transactions between a Puerto Rico corporate taxpayer and a home office or related entity outside of Puerto Rico."

Citing Comptroller of Treasury of Md. v. Wynne, 135 S. Ct. 1787, 1802 (2015), the Court also applied the internal consistency test to the AMT. The internal consistency test considers the structure of the tax to determine whether its application by every state would place interstate commerce at a disadvantage as compared to intrastate commerce. The Court found the AMT fails the internal consistency test; if every state were to apply the AMT, "multistate corporations doing business across state lines would be disadvantaged relative to corporations whose operations are consolidated in one state."

Additionally, the Court observed that, while Puerto Rico has a legitimate local purpose (e.g., combatting profit-shifting abuse) in applying the AMT, there are a number of less restrictive alternatives to advance that purpose. It found "it would be a perverse outcome if the resource and administrative limitations of the Puerto Rico Treasury required us to hold that the otherwise unconstitutional AMT passes constitutional muster." Therefore, the Court ruled that the AMT "is a facially discriminatory law that does not survive heightened scrutiny under the dormant Commerce Clause."

Implications

Since this ruling, the Secretary has indicated in public statements that the Government does not intend to appeal the First Circuit's decision. Instead, the Government will implement new transfer pricing regulations. The Secretary has said that a draft of the transfer pricing regulations could be ready as early as October 2016.

Because a portion of the AMT has been declared unconstitutional, local taxpayers might have overpaid taxes and should evaluate pertinent actions to recover those taxes. We expect the Puerto Rico Treasury Department to issue administrative pronouncements with guidelines for taxpayers that have been subject to the unconstitutional portion of the AMT. Moreover, the Puerto Rico legislative assembly may consider amending the AMT the next time it is in session.

The Court ruling could also affect the tax accounting aspects of the income tax provision of companies for affected periods.

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