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The San Juan Star
956 Qualified Income Funnel: Fact Or Fiction?
By RALPH J. Sierra, Jr.
August 9, 2001
In my Aug. 2 column, 1 assert that H.R. 2550, rather than allowing Puerto Rico to compete with Singapore, Malaysia, Ireland and others, would more likely serve as a funnel or laundry for the earnings generated by these to-date more attractive places for CFC operations. Puerto Rico Secretary of Economic Development and Commerce Ramon Cantero-Frau contends in his Aug. 3 letter that this is not so in view of the requirement that only qualified income can reap the benefits of the amendment that would be made.
In summary, H.R. 2550 confers a 90 percent exemption from the dividend imputation consequence of IRC section 956 when a qualifying CFC makes stateside investments otherwise proscribed by that section. If the investment is made through loans to an affiliate, H.R. 2550 would allow the investment to be made free of interest When the CFC pays an actual dividend to its parent company, the full amount of the investment will qualify as previously taxed income, so that the net result is for full federal income tax to fall on only 10 percent of the amount earnings and profits of the CFC invested stateside; that would be an effective tax cost of 3.5 percent under todays rates. In the alternative, the dividend from a CFC subsidiary would qualify for an 85 percent dividends received deduction under IRC section 245 in conjunction with section 243 if the CFC elects this method in lieu of the section 956 approach. H.R. 2550 also allows for the transfer or licensing of intangible property to a qualifying CFC without incremental costs over the amount incurred while the intangible property was used in connection with operations covered by the tax-sparing provisions of IRC sections 30A or 936 to the extent that the intangible is used with respect to the production of qualified income. The corresponding intangible property has to have been developed or purchased by the respective domestic corporation, but that corporation need not be the corporation whose operations were covered by the tax sparing provisions of IRC sections 30A or 936.
A qualifying CFC is one which has been incorporated under the laws of the commonwealth of Puerto Rico or any other possession of the United States, or incorporated under the laws of a foreign country but engaged in the active conduct of a trade or business in the commonwealth of Puerto Rico or possession of the United States. It is this latter entity that opens the funnel.
The funnel starts to function once we look at what constitutes qualified income. Qualified income is defined is income derived from sources outside the United States from:
(1) the active conduct of a trade or business with- in the commonwealth of Puerto Rico or a possession of the United States, or
(2) the sale or exchange of substantially al of the assets used in such a trade or business.
The bill places no limitation on the geographical source of the income that qualifies for this benefit, and leaves open the major issue of economic force of attraction as to when income will be determined to have been derived from the specified active conduct of a trade or business. There is a major difference between income generated by the economic activity carried out in Puerto Rico and income derived from sources outside the United States from the active conduct of a trade or business within the commonwealth of Puerto Rico. The former would be similar to the economic activity credit currently allowed under IRC section 30A, where the profit sheltered is a function of costs incurred in labor and property, plant and equipment; whereas, the latter allows for a much broader base for measuring income. An allocation merely based upon costs directly incurred by the respective branches would not be appropriate.
For example, if the Puerto Rico branch of a Singapore CFC were to operate as a key sales office for the product manufactured in Singapore, the tax attribute of the Puerto Rico branch having provided a material factor could serve to skew the profit split between the Singapore factory branch and the Puerto Rico sales and marketing (with rights to the income attributable to the intangibles) branch. It would do so by having the income element allocatable to the trade or business of the Puerto Rico branch from the sale and marketing (including the corresponding marketing intangibles) of the product to represent a significant portion of the overall income generated by the sale, even though the Singapore branch might have many times more employees than the Puerto Rico branch. Although H.R. 2550 does confer on the U.S. Secretary of the Treasury the authority to prescribe such regulations as are necessary or appropriate to carry out the purposes of the bill once it is enacted into law, unfortunately, the experience awaiting regulations under IRC section 936, and the interpretation and legal disputes concerning those issued, is not encouraging. It should be noted that under the example above, if the product were never to pass through Puerto Rico, virtually al of the income derived from that sale would likewise avoid Puerto Rico income tax jurisdiction.
It is common for the marketing of the reform proposal to insinuate that approval of the proposed IRC section 956 will cause a relocation of factories in Singapore and elsewhere to Puerto Rico. I repeat, the mere opening of a branch in Puerto Rico by these CFCs would be most deceptive for Puerto Rico's ambitions to find a reliable substitute to IRC sections 30A and 936 that would further socio-economic development The proposal will clearly help to retain those companies operating in Puerto Rico under the profit-split and percentage of income provisions of IRC section 936, many of which have already switched to CFC status to avoid the 1998 income cap on section 936 tax-sparing benefits. It may also serve to attract investments to Puerto Rico by stateside small or family businesses. However, to insinuate that the amendment will significantly enhance Puerto Rico's growth, as in the heydays of IRC sections 931 and 936, is an unfair and unfounded conclusion.
The author is a partner in the law firm Sierra Serapion.