June 17, 2022
Potential repeal of Puerto Rico's 4% excise tax on foreign corporations is on the horizon
Puerto Rico's legislature has proposed two bills to replace the 4% excise tax on foreign corporations with an optional election to move to an alternate 10.5% tax on industrial development income from sales of goods and services (Proposals). HB 1345 was presented first in the early days of May, and HB 1367 was filed later in that same month.
Act 154, enacted in October 2010, established a special 4% excise tax on the sale of products that are manufactured in Puerto Rico and acquired by a member of the manufacturer's controlled group. The 4% excise tax also applies to services rendered by a controlled group member. The special excise tax applies when the sum of the gross receipts from sales of personal property manufactured in Puerto Rico or services performed by a group member in Puerto Rico exceeds $75 million for any of the preceding three years.
Generally, US persons may claim a credit against their US income tax liability for certain income taxes paid, as well as taxes paid in lieu of an income tax. Due to certain novel features of the excise tax imposed by Act 154, its status as a creditable tax under US Federal income tax regulations was unclear. In 2011, however, the US Treasury Department and the IRS issued Notice 2011-29, which provided that the IRS would not challenge a taxpayer's position that the excise tax could be claimed as a foreign tax credit against its US tax liability.
Because the final foreign tax credit regulations issued in the United States disallow companies from claiming a credit for the 4% excise tax in tax years beginning on or after January 1, 2023, Puerto Rico's legislative assembly proposed a new statutory framework that would allow companies to elect a new tax regime.
Proposed new tax regime
The Proposals would give companies the option to replace the 4% excise tax on foreign corporations with a 10.5% tax on industrial development income from sales of goods and services. Taxpayers that opt for this alternate tax regime would submit a request to the Department of Economic Development and Commerce (DEDC) to have their tax decree amended to adopt a new tax regime under which the 10.5% tax rate would apply. The Proposals would authorize the DEDC to determine whether granting the election would be in Puerto Rico's best interests. If the DEDC grants the election, the taxpayer may request to have its decree extended for an additional 15 years beginning on the day following the expiration of its existing decree. The election would apply to all controlled group members. Once the decree expires, the taxpayer would have to apply for a new tax decree under the Puerto Rico Incentives Code of 2019, also known as Act 60, to continue to benefit from the alternate, fixed income tax rate.
If before January 1, 2024, however, the taxpayer's industrial development income is subject to a minimum tax of 15% in the United States or any other jurisdiction that adopts global minimum tax initiative of the Organisation for Economic Co-operation and Development, the 15% rate would apply to the taxpayer's industrial development income, instead of the 10.5% rate.
The 10.5% and 15% rates would apply regardless of whether the taxpayer can claim a credit for the tax paid to Puerto Rico in the United States or a foreign country.
Under HB 1367, the excise tax regime would not expire.
Benefits of the new regime
The industrial development income of a business that elects to be subject to the 10.5% rate, or the automatically triggered 15% income tax rate, would qualify for tiered exemption amounts on industrial development income ranging from 20% to 90%. The exact amount of the exemption will depend on certain conditions, such as the level of industrial development income, number of employees, capital investments made and number of municipalities in which the business operates. HB 1345 contains six tiers of available exemptions while HB 1367 proposes four tiers.
HB 1367 would also allow taxpayers to reduce their tax liability by certain tax credits currently available under the corresponding tax incentives legislation, subject to certain new proposed limitations.
Withholding tax on royalties
Taxpayers would be required to do income tax withholding at source if they (1) elect to be subject to the 10.5% rate or the automatically triggered 15% income tax rate, and (2) make royalty payments to corporations, partnerships or nonresident persons that are not engaged in a trade or business in Puerto Rico for the use, or right to use, patents, copyrights, formulas, technical know-how and other similar property in Puerto Rico. HB 1367 would establish a withholding rate of at least 15% on the payments while HB 1345 would fix the rate at 15%. HB 1345 also would incorporate various tax exemption percentages that would apply to royalty payments subject to income tax withholding. Additionally, HB 1345 would establish certain royalty withholding credits that would apply against the tax liability resulting from the 10.5% or 15% income tax rate.
The proposals under HB 1367 would establish a large taxpayers' unit that would keep a registry and profile of large taxpayers, as well as conduct other activities. HB 1367 also would authorize the Secretary of Treasury to create a tax credits management system with the aim to facilitate the administration of tax credits.
The repeal or phasing out of the 4% excise tax has been a topic of contention since its inception in 2010. This tax, which disproportionately impacts a very small number of companies with business activities in Puerto Rico, has become one of the biggest contributors to the government's coffers. Uncertainty about its continued creditability under US federal income tax regulations and its eventual phase out (4% excise tax is slated to expire in 2027) have prompted Puerto Rico to take action.
Puerto Rico's House of Representatives recently held public hearings on these bills. While professional and industrial associations, as well as the executive branch, seem to agree on establishing an available alternate tax framework to the 4% excise tax, positions still differ as to some of the details of the Proposals. HB 1367 is purportedly the result of discussions between the Puerto Rico executive branch of government and local industrial sector. Similarly, the President of the House of Representatives noted in public comments that HB 1345 incorporates discussions he had with companies that are subject to the 4% excise tax. The President also noted that the goal is to approve legislation before the end of the current legislative session, which closes on June 30, 2022.
Taxpayers should monitor the progress of these bills through the legislative process and assess the potential benefits or risks of electing the increased tax rates on industrial development income and royalties, as opposed to remaining subject to the 4% excise tax, which, come January 1, 2023, is expected to no longer be creditable under US federal income tax regulations. Opting for the higher rates could result in a total tax cost that could be lower than paying the excise tax, which would not be creditable. Taxpayers that do not claim a US tax credit, however, might not find the new regime beneficial or may be indifferent to the change.