September 23, 2022
IRS and Treasury intend to issue proposed regulations on application of the noncompulsory payment regulations to certain amended Puerto Rico tax decrees
In Notice 2022-42, the IRS and Department of Treasury have announced that they plan to issue proposed regulations amending the IRC Section 901 regulations on the application of the noncompulsory payment regulations to certain amended Puerto Rico tax decrees. Taxpayers can rely on the notice pending the issuance of the regulations.
Taxpayers doing business in Puerto Rico may negotiate reduced tax rates by entering into long-term tax agreements (i.e., tax decrees). While the taxpayers may benefit from reduced tax rates, the tax decrees do not change the application of the modified effectively connected income rules under Section 1123(f)(3)(B) of the Puerto Rico Internal Revenue Code of 1994, as amended (1994 PRI IRC) and incorporated by reference into the Puerto Rico Internal Revenue Code of 2011, as amended (2011 PR IRC) by Section 1035.05 of the 2011 PR IRC. The modified effectively connected income rules subject to tax income deemed to be earned in connection with a Puerto Rico trade or business. The tax decrees also do not modify the application of the 4% excise tax on (1) the acquisition of certain personal property manufactured or produced in Puerto Rico and (2) amounts paid for certain services performed in Puerto Rico.
The IRS stated in Notice 2011-29that it would not challenge a taxpayer that took the position that the 4% excise tax was creditable, pending further study by the IRS and Treasury.
The final foreign tax credit regulations (see Tax Alert 2022-0040) allow a credit for foreign tax imposed on a nonresident if the tax is based on:
The final regulations appear to result in the modified effectively connected income tax and the excise tax no longer qualifying as foreign income taxes. Accordingly, pursuant to this position, a taxpayer would not be able to claim a credit for those taxes under IRC Section 901. However, the regulations delayed their applicability to the Puerto Rico modified effectively connected income tax rules and 4% excise tax until tax years beginning on or after January 1, 2023, and stated that Notice 2011-29 would be withdrawn at that time.
On June 30, 2022, Puerto Rico enacted Act 52-2022, which allows taxpayers to amend existing tax decrees to replace the existing income tax and royalty withholding tax framework with a new framework which, among other provisions, includes a 10.5% income tax rate on industrial development income. If a taxpayer has an existing tax decree amended, 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. Taxpayers that elect to amend their existing tax decrees also are no longer subject to the modified effectively connected income tax rules and 4% excise tax.
Under Treas. Reg. Section 1.901-2(e)(5)(i), an amount paid to a foreign country is not a compulsory payment, and therefore not a foreign tax paid, to the extent the amount paid exceeds the taxpayer's liability for foreign income tax under the foreign tax law (noncompulsory payment regulations).
The IRS and Treasury state in Notice 2022-42 that they have received questions regarding whether the election to amend an existing tax decree in Puerto Rico will cause an amount paid to Puerto Rico in excess of the tax that would have been owed but for the election to amend the tax decree to be treated as a noncompulsory payment under Treas. Reg. Section 1.901-2(e)(5) and, therefore, not eligible for a foreign tax credit.
Forthcoming proposed regulations
The forthcoming proposed regulations would provide that foreign income tax paid or accrued to Puerto Rico under an existing tax decree amended on or before December 31, 2022, would not be treated as noncompulsory amounts under Treas. Reg. Section 1.901-2(e)(5). In particular, the forthcoming proposed regulations would not consider amending an existing tax decree under Act 52-2022 as increasing a taxpayer's Puerto Rico income tax liability over time for purposes of Treas. Reg. Section 1.901-2(e)(5), solely because of any difference in the Puerto Rico income tax liability under the existing tax decree and the amended tax decree. The taxpayer, however, must have its existing tax decree amended on or before December 31, 2022, and "the taxpayer's Puerto Rico income tax liability under the amended tax decree in each [tax] year [must be] less than the amount of income tax the taxpayer would have owed to Puerto Rico under Puerto Rico's generally applicable income tax laws in the absence of any tax decree in the [tax] year."
Notice 2022-42 provides that no inference as to the application of the noncompulsory payment regulations in any other context should be drawn from the notice.
The forthcoming proposed regulations would apply to tax years ending on or after October 11, 2022, which is the date the notice will be published in the Internal Revenue Bulletin. Until those regulations are issued, taxpayers may rely on the guidance in Notice 2022-42.
Notice 2022-42 revokes Notice 2011-29 for excise tax paid or accrued in tax years beginning on or after January 1, 2023.
Notice 2022-42 gives taxpayers more certainty as to the US tax implications of an amendment made to their tax grants and eliminates one potential concern with making such amendment. However, although the provisions under Act 52-2022 that allow taxpayers to elect out from the 4% excise tax to a new tax framework do not impose a certain due date, the relief under Notice 2022-42 is conditioned on having the existing tax grants amended on or before December 31, 2022.
In addition, Notice 2022-42 does not completely eliminate the need to undertake an analysis of the noncompulsory payment rules under Treas. Reg. Section 1.901-2(e)(5). Taxpayers must still analyze whether entering into a new agreement would cause their tax liability to exceed their tax liability as determined under Puerto Rico's generally applicable tax laws. Furthermore, under Treas. Reg. Section 1.901-2(e)(5), the analysis must be on a separate entity by separate entity basis, which means that in the case of a US-based company with a controlled foreign corporation (CFC) in Puerto Rico, the noncompulsory payment rules must be applied to the US entity and the CFC separately.