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956 May Change The Island’s Economic Development Model Forever, Or Will It Be Déjà Vu All Over Again?

As the Calderon administration pushes its centerpiece job-creation initiative, experts fear an economic development model based on Section 956 will be as vulnerable as the doomed Section 936.


July 12, 2001
Copyright © 2001 CARIBBEAN BUSINESS. All Rights Reserved.

As Gov. Sila Maria Calderon rallies local support to lobby Congress for new federal tax incentives to help Puerto Rico’s economy, Secretary of Economic Development and Commerce Ramon Cantero Frau tells why the proposed amendment to Section 956 of the U.S. Internal Revenue Code may change the island’s economic development model forever.

In a surprise move certain to awaken her beleaguered administration from the doldrums of economic nothing-is-happeningness, Gov. Sila Maria Calderon last week steered clear of the Vieques issue and turned her attention to economic development.

A week ago Monday, freshly returned from Washington, she addressed a television audience to unveil what will undoubtedly be the centerpiece of her job-creation initiative.

The governor has decided to forego her campaign promise to lobby Congress for an extension of the wage credit provisions under Section 30-A of the U.S. Internal Revenue Code (IRC). Instead, she is proposing an amendment to Section 956 of the IRC to provide a new federal tax incentive to help manufacturing companies in Puerto Rico in lieu of Section 936, scheduled by Congress to end in 2006.

On Sunday she convened representatives from just about every sector of Puerto Rico’s society to personally ask for their support in lobbying Congress for the amendment. She got their endorsement.

"Nothing, and I do mean absolutely nothing, is more important for my administration and my government than creating jobs," Calderon told a sizeable crowd made up mostly of administration officials, Popular Democratic Party legislators and mayors.

Business and other private sector representatives were also in attendance. As if following a script, one by one, Puerto Rico Manufacturing Association President Lucy Crespo, Puerto Rico Bankers Association Executive Vice President Arturo Carrion, Puerto Rico Chamber of Commerce President Richard D’Acosta, local AFL-CIO leader Luisa Acevedo, Puerto Rico Products Association President Francisco Martinez and others pledged their personal and institutional support to the governor.

Last week, in an exclusive interview with CARIBBEAN BUSINESS, Economic Development and Commerce Secretary Ramon Cantero Frau explained the significance of the 956 amendment proposal to Puerto Rico’s economic development.

"By definition, this amendment must have a positive effect on Puerto Rico. It will become a determining factor for a corporation to establish a subsidiary on the island. It positions us way beyond any other jurisdiction competitively and will transform Puerto Rico’s industrial base. It will transform not only the manufacturing sector, but also our tourism, service, and construction sectors.

"Section 956’s tax incentive will immediately stop the outflow of companies from Puerto Rico. The entire incremental activity that it brings will make the island an extremely competitive country globally because we have the physical and human infrastructure and a good industrial incentives program," said Cantero.

He points to the fact that since October 1996, when Congress approved the elimination of Section 936 over a 10-year phase-out, manufacturing employment in Puerto Rico has declined by 16,000 jobs, a drop of more than 10%. And while it is common knowledge that the manufacturing industry in the U.S. mainland has shrunk, Cantero points out that no other U.S. jurisdiction has lost manufacturing jobs at such a high rate during the same period.

And more will be lost. In the first four months of this year, a number of Section 936/30-A companies, including Intel, Coach, Sara Lee, Phillips Petroleum, Star Kist, and Playtex have announced that they will close or reduce operations in Puerto Rico. The tally? Another 8,700 additional direct jobs to be lost.

Armed with these statistics, Cantero has been accompanying Gov. Calderon to Washington to deliver a simple message. With the first whack at 936 in 1993, Congress raised $3.7 billion to help balance the U.S. budget. With the 10-year phase-out enacted in 1996, another $10 billion was collected. In effect, the administration seems to be saying: "Puerto Rico has contributed handsomely to the new found federal budget surplus. Now we’re hurting, so we some tax incentives back."

In an nutshell, Gov. Calderon’s 956 proposed amendment would allow subsidiaries of U.S. companies who incorporate in Puerto Rico as controlled foreign corporations (CFCs) under Section 901–something several 936 companies have already done–to lend or invest in the U.S. up to 90% of their profits from Puerto Rico operations free of tax to their U.S. parents or shareholders. Today those profits are fully taxed. The alternative proposal would allow the CFC in Puerto Rico to repatriate dividends and would give the recipient the benefit of an 85%-dividends-received deduction. (See related story for full explanation.)

If it sounds awfully like Section 936, that’s because it is. The basic difference is that Sections 936 and 30-A were available to domestic (i.e. U.S.) corporations, whereas, Section 956 governs–and its proposed amendment would benefit–U.S. subsidiaries incorporated in foreign countries under Section 901. Subsidiaries of U.S. companies in Puerto Rico can incorporate either as a domestic corporation or a controlled foreign corporation.

Calderon and Cantero are touting the 956 proposal as an incentive for companies to establish CFCs in Puerto Rico instead of in competing foreign countries. "With the proposed tax provision, an American company will have an incentive to remain in Puerto Rico as a CFC, instead of leaving for competing foreign countries, as they are now doing in increasing numbers. I believe this proposal is a win-win situation for Puerto Rico and the U.S.," Gov. Calderon told a group of members of the House Ways and Means Committee in Washington.

"For the first time, Puerto Rico is not asking for giveaways," said Cantero. "This will be much simpler to accomplish than it was to come up with Section 30-A because here we will be using the existing tax structure under Sections 901 and 956, and amend it to provide an incentive that will spur economic activity in the way of jobs and industrial development in Puerto Rico and fresh capital to the U.S."

Not everybody shares his enthusiasm. Tax experts told CARIBBEAN BUSINESS that from a strictly technical–not political–point of view, the proposed amendment to 956 will be a hard sell indeed.

"What the administration is proposing would effectively turn the purpose of 956 upside down, at least with respect to CFCs in Puerto Rico. It remains to be seen whether they’ll go for it in Washington," a tax partner at a Big Six accounting firm told CARIBBEAN BUSINESS.

"Historically, the purpose behind Section 956 has been to dissuade U.S. companies from leaving the U.S. and setting themselves up in a foreign jurisdiction as Section 901 companies to avoid taxation. That’s why currently, under section 956, their earnings are taxed as soon as they are repatriated, either for investment or to pay out as dividends," the source said.

"It’s true that, other things being equal, the proposed amendment would make setting up as a CFC in Puerto Rico more attractive than in a foreign country. The problem is that it would also be more attractive than remaining in North Carolina or New Jersey. There’s no way they will not attack this proposal as a ‘runaway plant’ gimmick," the tax expert said.

Others agree. Shortly after conclusion of the pledge-of-support event hosted by Gov. Calderon Sunday, Puerto Rico Chamber of Commerce immediate past president Luis Torres Llompart, himself a Certified Public Accountant, warned the runaway plant label could be the death knell for the proposal.

"We are recommending to the governor that the proposal be amended to make it available only for CFCs now established in foreign countries, but not for U.S. companies that may want to come to Puerto Rico to avoid taxes," said Torres Llompart.

What about 30-A?

According to the tax expert, the 956 proposal is not equally attractive to all companies that formerly operated under Section 936. "You must understand that the option of converting to a CFC under Section 901 is attractive only to companies that do not need to repatriate profits for whatever reasons. To others, who need the cash back home to pay down debt or for whatever, Section 901 is simply not an option. Locally, those tend to be the labor intensive companies who have been filing under 30-A."

Section 30-A provides former Section 936 companies a tax credit based on wages paid instead of profits earned. Congress’ rationale in adopting the provision was to try to link the federal tax incentive more directly to job creation. As 936 companies’ profits grew over time, the amount of tax exemption per worker hired became so huge that Section 936 came under attack as corporate welfare. Like Section 936, Section 30-A is scheduled to disappear in 2006.

Against that historical background, the question of which type of company is more likely to reap the greater benefit of the Section 956 tax exemption might very much affect its chances of being adopted. "We will have to wait for the numbers, but my guess is that it would be more attractive to pharmaceutical companies and, perhaps, the high tech guys," said Jon Sheiner, tax counsel in Congressman Charles Rangel’s (D-NY) office. Rangel, ranking minority member on the important House Ways and Means Committee, supports the proposed amendment.

Regardless of the chances of success in lobbying Congress for the proposed Section 956 amendment, the administration ought not to drop the ball on 30-A, said the local accounting firm partner who preferred to remain anonymous. "I have many clients who are labor intensive and who would rather have an extension of 30-A than the amended Section 956."

Cantero shrugs off any suggestion that dropping the ball on 30-A is reneging on a campaign promise. The Popular Democratic Party administration’s political platform promised that it would fight in Congress to extend Section 30A. Cantero now admits that while he authored that commitment in his party’s platform, at the time he didn’t realize the negative connotation Section 30-A had acquired because of its close relationship to Section 936.

"Sections 30-A and 936 have been prostituted in Congress. We spoke to four or five key people when we began this effort and they assured us that no one could revive either of the measures. They can’t be revived because of the bad name and ill will they have gathered and bad taste they left behind."

He also offers other reasons. Among them, that Section 30-A is a "backward looking" incentive in the sense that it is attractive only to labor-intensive companies that even with the Section 30-A credit, cannot compete with low-cost countries overseas.

There seems to be either some confusion or some duplicity in the argument. Most of the manufacturing plants that have announced closings this year–such as Coach, Sara Lee, Star Kist, and Playtex, which the administration used in its briefings to Congress–are precisely examples of labor-intensive operations that could benefit from an extension of 30-A and that according to experts would not have much use for the proposed amended Section 956 incentive.

The fact has not escaped the attention of the New Progressive Party opposition, under whose earlier stint in office, Section 30-A was adopted. Senate minority leader Kenneth McClintock was quick to criticize the Calderon administration for not pursuing Section 30-A which, according to him, is a better tool for job creation because the tax break is tied to wages paid, not profits earned.

Cantero dismisses the criticism. "The future of job creation and economic growth in Puerto Rico is in the high technology sectors. Companies in these sectors find that a CFC status–even without the Section 956 exemption–provides greater flexibility for structuring international operations because the advantages of indefinite tax deferrals conferred by such status is generally more attractive. The Section 956 exemption would give Puerto Rico a significant advantage over other countries," he said.

The tab, please

While Cantero and the Puerto Rico government’s lobbyists and consultants have met with more than 100 congressional staffers to explain their Section 956 proposal, its chances of success will depend largely on a different number. At press time it was still being worked out by the U.S. Congress Joint Committee on Taxation. "Scoring," as it’s called, means how much will it cost Uncle Sam, mostly in terms of foregone tax revenue, to implement the proposal.

"I don’t know whether they’ve even gotten to it yet; and even when they do it will take them a while," said Sheiner referring to the Joint Committee’s staff. "A measure like this requires much work, including creating economic models. It might take a while," he said.

Cantero believes it will be substantially less than an extension of Section 30-A because companies doing business outside the U.S. through CFCs often have the ability to defer the payment of federal taxes on the active income of these CFCs indefinitely. But he still doesn’t know.

Neither do the scores of Senators and Representatives who have "positively received" Gov. Calderon’s proposal.

"The reaction to the proposed Section 956 tax exemption has been very positive in Washington, D.C.," Cantero said.

According to him, critical bipartisan support has been forthcoming from Congressmen Rangel, and Phillip Crane (R-IL), ranking majority member in House Ways & Means Committee; and Senators Max Baucus (D-MT), chairman, and Chuck Grassley (R-IA), ranking minority member, of the Senate’s Finance Committee.

Still at press time there was no word on Ways & Means Committee Chairman Bill Thomas’ position on the proposal. Despite the fact that Crane had more seniority on the committee, the leadership selected Thomas (R-CA) to replace former chairman and 936- nemesis Bill Archer (R-TX) who retired last year.

"There’s nothing to report because the chairman has not taken a position on the proposal," committee staff member Mark Gunderson told CARIBBEAN BUSINESS. Gunderson, who is familiar with the issue, could not even confirm whether Thomas had even been briefed on it nor when he might take a position on it. As a general rule, committee chairmen determine legislative priorities in their committee. Without their support, legislation rarely gets acted upon. The House Ways and Means committee must act on all tax legislation.

"Congressional staffers recognize that Puerto Rico is going through a serious situation with the gradual slowdown of economic growth rates and unprecedented decrease in manufacturing jobs due to the inability of Section 936 to generate the anticipated revenue. The successful turnover of companies that had previously filed as 936 corporations to CFCs--up to 67 companies by now in Puerto Rico--also indicates that others will soon follow because they prefer the CFC status," said Cantero.

And yet, Washington observers tend to agree, chances of action this year are slim. "The White House has finished with tax legislation this year. Its focus was a tax cut for individuals. It got it and it is unlikely to move on tax breaks for companies before next year," a Washington insider said.

This Caribbean Business article appears courtesy of Casiano Communications.
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