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Manufacturers Association Considers Promoting Two Tax Bills Before Congress

Local And Federal Tax Exemption On Dividends, Recognition Of Local CFCs As Domestic Instead Of Foreign Corporations Under Discussion


March 11, 2004
Copyright © 2004 CARIBBEAN BUSINESS. All Rights Reserved.

Faced with the final phaseout of Internal Revenue Code (IRC) Section 936 in 2005, the fact that an extension to Section 30A wasn’t pursued, and that the effort to amend Section 956 got nowhere in the U.S. Congress, Puerto Rico’s manufacturing industry is desperately seeking alternatives to new federal tax breaks that could help it remain competitive.

Ironically, some of the alternatives being considered seek to have Puerto Rico operations qualify as domestic instead of foreign companies for federal tax purposes.

The Puerto Rico Manufacturers Association’s (PRMA) Tax Committee recently presented two proposals for tax incentives in hopes of countering proposals currently being discussed in Congress that could draw local manufacturing operations to the U.S. mainland.

Last month, two separate U.S. Senate and House bills were pitched to encourage companies operating in Puerto Rico as controlled foreign corporations (CFCs) to repatriate their income to the U.S. According to the bills, a 5.25% tax rate, compared with 35%, would be applied on repatriated funds during a six-month to one-year window.

A CFC, as defined by IRC Subpart F, is a foreign corporation in which U.S. shareholders own more than 50% of the total voting power or the value of the stock, but whose income isn’t taxable until repatriated to the U.S. Following legislation in the past decade to phase out Section 936, many, if not most, Puerto Rico subsidiaries of U.S. manufacturing companies became CFCs.

During the recent PRMA Summit, the Tax Committee introduced several proposals to counteract this U.S. legislation and to improve local tax incentives to attract new industries to the island.

Recognizing local corporations as domestic entities under IRC 243

The first proposal was to amend IRC Section 243, which deals with dividends-received deductions (DRD), so that Puerto Rico corporations are recognized as domestic corporations for purposes of distributing dividends to the parent and thus remain exempt from both local and federal taxes.

"Under Section 243, corporations are allowed a deduction equal to the dividends received from a domestic corporation subject to federal income taxation multiplied by the applicable percentages of 70%, 80%, or 100%," said Vanesa Franco-Fernandez, a lawyer at Fiddler, Gonzalez & Rodriguez PSC who explained the purpose of the IRC section is to relieve companies from being taxed twice on the same income. "We propose amending the law so that a corporation organized under the laws of the U.S., or any foreign corporation that derives at least 80% of its income from active trade or business within a U.S. possession [such as Puerto Rico], is considered a domestic corporation."

According to Franco-Fernandez, the amendment to Section 243 would allow a U.S. corporation receiving dividends from a Puerto Rico corporation or CFC doing business in Puerto Rico to claim the appropriate deduction against its federal tax liability for the dividends received. For example, under the current law, if a Puerto Rico corporation declares a $10,000 dividend, it won’t pay local taxes but will be subject to federal taxes of $3,500 (35% of $10,000). With the DRD benefit, no local or federal taxes would be paid, thus making it more attractive to operate in Puerto Rico than in other U.S. tax jurisdictions.

A second proposal to amend the definition of a CFC was presented by PRMA Tax Committee Chairwoman Amaya Iraolagoitia, a certified public accountant (CPA) at law firm McConnell Valdes. According to Iraolagoitia, the PRMA proposal excludes entities organized in U.S. possessions from the current CFC definition, but imposes a requirement that they be involved in the active conduct of trade or business within the U.S. possession.

The PRMA Tax Committee also suggested amending current local tax laws to make them more aggressive and attractive to corporations choosing sites for new operations. Recommendations included a 2% to 7% flat tax on industrial development income and a 0% tax on pioneer industries; 100% tax exemption on income from foreign corporations and a 90% tax exemption on property; a 60% tax exemption on municipal licenses (patentes); exemption from excise taxes; special deductions and credits; and a 100% investment tax credit on the purchase of companies that are set to close.

Iraolagoitia also suggested recognizing limited-liability companies in Puerto Rico and companies earning interest outside Puerto Rico, as well as extending a 0% tax on their income or treating it as tax-preferential income under the local incentives law.

"The tax incentives currently offered by the government are aggressive, but regulations have to be improved and barriers eliminated," said Iraolagoitia. "We must improve the environment in which these companies operate and eliminate negative government experiences and procedures. If funds can be repatriated to the U.S., the country will benefit from the influx of capital and the entry of millions of dollars into parent companies," said Iraolagoitia.

Looking for consensus from local industries

Concerns about the proposals arose from different sectors. Fernando Goyco-Covas of Adsuar Muñiz Goyco & Besosa PSC said, "These proposals have great benefits [for the local manufacturing industry], but my concern is that they aren’t much different from those amendments that have already been presented before the U.S. Congress [IRC Section 956]. Because this proposal is for wholly owned subsidiaries, they wouldn’t pay taxes, compared with other proposals the U.S. Congress has already rejected since it wants to collect as many taxes as it can."

Jose G. Arias, managing director of investment banking at UBS, is concerned about how the DRD proposal would affect corporate shareholders. "Within the investment industry, we had already developed a similar proposal, although it wasn’t as ambitious," he said. "[The proposal] would extend to Puerto Rico corporations but exclude the DRD CFCs in order to level the playing field and strengthen the market’s ability to raise capital for local companies.

Eli Lilly’s tax adviser, Carlos Bonilla, called the amendments neutral and said they are something all political parties could back, something indispensable according to previous efforts by the island. "We are trying to get Puerto Rico companies treated as domestic companies under U.S. law," he said. "These mustn’t be laws that distance the island from the U.S.; they must be laws based on the value of justice for all U.S. citizens. From a promotional point of view, they would have a significant effect since Puerto Rico’s tax incentives are the best available within a U.S. territory."

According to Bonilla, corporations such as distributors and suppliers of specialized products to the island’s pharmaceutical industry would consider establishing operations locally if not for current costly tax alternatives. These companies are small enough that they don’t belong to foreign parent companies, through which they could invest income gained in Puerto Rico, but are midsize or large companies with plenty of clients on the U.S. mainland and in Puerto Rico.

"For Puerto Rico’s nascent research & development [R&D] program, establishing the development part of R&D operations would be feasible under this proposal," said Bonilla. "Another suggestion would be to eliminate taxing foreign companies’ income [so they could invest it in local projects]."

Amgen’s director of finance, Jaime Arraya, also encourages the government to take another look at its current structure of tax incentives. "The current tax structure doesn’t attract the pharmaceutical companies that we really want to attract. We must do something to motivate them to come here rather than to Ireland or Singapore. We are the ones who give neutral proposals certain partialities. It is important that we can create consensus and go to the U.S. Congress with one voice," he said.

Tax law expert & CPA Ralph J. Sierra, partner of Sierra / Serapion PSC and member of the PRMA Tax Committee, gave a detailed account during the PRMA Summit of the circumstances from 1921 to 1996 under which U.S. tax incentives were granted to Puerto Rico. "Over the years, the basic reasons why manufacturing companies would establish operations in Puerto Rico have disappeared, including low wages, reasonable electricity costs, and a dependable infrastructure. With globalization, even Puerto Rico’s proximity to the U.S. mainland is no longer a competitive element.

Before the 1990s, U.S. legislators were at least kept informed of the status of Puerto Rico’s economy, sponsoring visits from congressmen to the island, and there was a unity of purpose when submitting proposals for tax benefits," added Sierra. "Unfortunately, this is no longer true. The government has become politicized, without unity of action. Facing this, Congress will do whatever it wants."

This Caribbean Business article appears courtesy of Casiano Communications.
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