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Where Do We Go From Here?
The end of federal tax incentives on the island
By MARIALBA MARTINEZ
October 14, 2004
The end of an era
Congress recently passed bills making federal taxes for manufacturing operations on the island higher than for those on the U.S. mainland and opening a yearlong window to siphon billions in retained earnings from Puerto Rico. Will former Section 936 companies leave the island, or will they stay and take advantage of our local resources?
Dec. 31, 2005 will mark the end of 84 years of federal tax incentives for Puerto Rico.
On that date, the phaseout of Sections 936 and 30A of the U.S. Internal Revenue Code (IRC) will be complete, and the future viability of Puerto Ricos manufacturing industry without federal tax exemptions will be tested.
For the past two years, Puerto Ricos business and government leaders have been working on short-, mid-, and long-term economic development alternatives for the island.
But last week, another bombshell from Washington, D.C., was dropped on the battle-scarred fields of the islands manufacturing industry. Gov. Sila Calderons unbridled determination to push for an unlikely amendment to IRC Section 956 as a substitute for Section 936, instead of lobbying for an extension of Section 30A, combined with the prolonged absence from the halls of Congress of Popular Democratic Party gubernatorial candidate & Resident Commissioner Anibal Acevedo Vila, brought dire consequences of yet unaccountable proportions.
This past weekend, Puerto Rico was excluded from a 9% tax cut on domestic manufacturing incomeworth $140 billion and representing the largest federal tax cut in 20 years to U.S. manufacturing firms operating on the U.S. mainland. As a result, and for the first time in more than 84 years, the local manufacturing operations of U.S. manufacturing companies will be taxed at a higher rate than those on the U.S. mainland. Manufacturing income from U.S. manufacturing firms operating in Puerto Rico will be taxed at 35%, while the income of stateside manufacturers will be taxed by the federal government at 32%a tax disincentive to manufacturing investment on the island.
Another tax incentive pushed by Acevedo Vila will, according to staff from Congress Joint Committee on Taxation, operate as an incentive to disinvest from Puerto Rico. It includes controlled foreign corporations (CFCs) on the island (now most of the former 936 companies) in a one-time, one-year 85% tax cut on income taken out of CFC locations and reinvested in the States.
"[Gov. Calderon and Acevedo Vila] wasted tens of millions of dollars lobbying for the ridiculous effort to recreate the old 936 as the 956 amendment, after the proposal had been rejected by the chairman of the House and Senate tax committees and by the U.S. Treasury Department," said Jeffrey Farrow, government affairs consultant at Lisboa Inc. and a member of the White House Interagency Task Force on Puerto Rico under President Bill Clinton. "All Acevedo Vila has produced is a tax disincentive to manufacturing investment in P.R. and a tax incentive to manufacturing disinvestment from P.R.!"
Given this situation, Puerto Ricos manufacturing industry now must ascertain how to achieve a transformation that will allow its effective insertion into the new, knowledge-based global economy while retaining and expanding its employment base on the island.
"I believe most U.S. companies here have already made adjustments to their tax structures," said Carlos Bonilla, tax adviser to Eli Lilly & Co. and executive committee member of the Puerto Rico Pharmaceutical Industry Association (PRPIA). "The end of Section 936 will be largely unnoticeable. One of the possible effects will be that the islands pharmaceutical companies will increase their production of blockbuster products [products that sell more than $500 million annually]. The only way to maximize earnings in Puerto Rico will be by becoming a CFC. If companies manage their finances well, it will still be worth transferring [the production of] new products to Puerto Rico."
Astrid Navarro, Merck Sharp & Dohme Corp.s director of finance & administration and PRPIA Finance Committee chairwoman, added, "We understand there shouldnt be an impact on the commercial [sales & marketing] area. There are many pharmaceutical companies in Puerto Rico, and the majority have a commercial division, though not necessarily a manufacturing operation. [The end of Sections 936 and 30A] shouldnt have a direct impact on Puerto Ricos market. As long as each company continues to improve its bottom line, we will continue increasing our work force."
Without the active benefit of a federal tax exemption on the income of U.S. corporations doing business in U.S. possessions over the past decade, some sectors of the islands manufacturing industry have strengthened while others have struggled and still others have disappeared, each trying to measure up to competitors in countries such as Singapore and Ireland.
Supporters of Section 936 allege the tax incentives repeal has cost the island approximately 43,000 jobs. Detractors say global economic conditions affecting Puerto Rico and the U.S. mainland simply accelerated the inevitable transfer of companies in manufacturing sectors such as apparel, textiles, electrical / electronic, and leather products to countries with lower labor and other business costs.
"The island is still in denial about Section 936," said Manuel Reyes, the Puerto Rico Manufacturers Associations legislative director. "In the past three years, the Calderon administration has approved 27 economic development laws that were limited to tax incentives and government purchases, but there has been no massive campaign to promote the island. Its been as if Section 936 was a huge bubble that protected us from the islands inefficiencies and economic reality. Now, we have to deal with problems that not even the government wants to tackle, such as the islands infrastructure and transportation problems, energy costs, and excessive labor legislation."
Puerto Ricos support in Congress of federal incentives for the island has also depended on the direction of whichever political party is in power at the time. Millions of dollars have been lost in attempts to tie federal incentives to the islands political status, as Calderon did with her proposal to amend Section 956 while Congress was trying to safeguard the economic future of the States manufacturing industry. Also lost was the goodwill of U.S. legislators who were prepared to extend the friendlier Section 30A wage credit.
Nevertheless, it now appears the local political parties may be starting to realize that Puerto Ricos economic development cant depend on federal incentives alone. Former Gov. Pedro Rossello, the New Progressive Partys gubernatorial candidate, has said that while he does favor federal tax incentives tied to job creation, such as Section 30A, other, equally important factors must be addressed to make Puerto Rico attractive to business investment.
"We will revise local tax incentives currently in place for different sectors of the economy and reformulate them as incentives geared toward the economic development activity we need to promote," Rossello told CARIBBEAN BUSINESS this summer (CB July 22). "Traditional tax incentives, call them Internal Revenue Code Sections 936 or 30A or whatever, are becoming less important."
Popular Democratic Party (PDP) gubernatorial candidate Anibal Acevedo Vilas position on federal incentives has been more difficult to gauge. In 2000, when Acevedo Vila was elected resident commissioner in Washington, the PDP supported Section 30A and committed to lobbying for its extension.
Later, however, Acevedo Vila backed the Calderon administrations switch to push Section 956, even though the offer to extend Section 30As wage credit had been made. Acevedo Vila now says that he still believes Section 956 has a chance at congressional approval and that he favors federal incentives as part of his economic development proposal, though he wouldnt rely on them.
"I will fight for new federal incentives, but my economic development proposal doesnt depend on them. To me, that distinguishes me from others," Acevedo Vila told CB. "I will also fight for federal incentives without dragging in any kind of philosophical problem related to status. [The possibility of achieving in Congress the proposed amendments to] Section 956 has been looking brighter, and perhaps [I will fight for] that one or for some other."
Why did Section 936 disappear?
To understand Section 936s repeal, the final version of a series of tax incentives begun in 1921, one must know what its initial objective was and how it ceased to be a job-creation tool for Puerto Rico.
The original tax exemption for U.S. corporations operating in U.S. possessions was enacted as part of the federal governments Revenue Act of 1921 (which became Section 931 of the new IRC of the Tax Act of 1954). The law exempted from U.S. tax the foreign income of U.S. corporations that derived 80% of their gross income from foreign sources (i.e., the possessions) and 50% or more of their gross income from the active conduct of trade or business in the possessions.
As part of the Tax Reform Act of 1976, the tax benefits for U.S. possessions were modified and IRC Section 936 was created. Section 936 allowed a credit against taxes for income derived from the active conduct of trade or business in a possession and on qualified possessions source investment income (QPSII), which is income attributable to the investment in the possession of funds derived from the active trade or business in the possession. It also paved the way for corporations to benefit richly by filing for tax benefits in two ways: on income derived from the active conduct of business in a possession and on QPSII.
Until the laws repeal in 1995, combined federal and local tax incentives attracted U.S. corporations to Puerto Rico in droves, turning the island into a mecca of industrial operations, particularly in the pharmaceutical, electrical/electronics, food products, and apparel/textile sectors. According to the General Accounting Office (GAO), by 1996, combined tax incentives had allowed the local manufacturing industry to become so powerful that it provided 63% of Puerto Ricos $18 billion payroll, or $11.3 billion, of which $3.6 billion was provided by the pharmaceutical sector alone. Corporate earnings invested in local banks were to reach more than $14 billion.
"There were many advantages to Section 936," said Eli Lillys Bonilla during a roundtable with other members of the Puerto Rico Pharmaceutical Industry Association. "One of the most powerful and positive was that it allowed Puerto Rico to offer an incentive to domestic corporations so they would come to the island and create new employment."
An indirect result of these corporations establishing operations on the island was an increased need for workers with the skills to manage these new businesses. People without high school or university diplomas were hired to work as technicians at manufacturing companies, and many received educational opportunities that allowed them to advance to management positions in technology, sciences, engineering, chemical, biology, and biochemical areas.
By the 1980s, however, U.S. congressional leaders had grown apprehensive about the billions of dollars in tax revenue lost from Section 936 companies, and they introduced the first round of amendments to the tax law. A key factor in the repeal of Section 936 was a U.S. Senate-commissioned report by the GAO in 1992 that alerted the federal government to these multibillion-dollar losses from Section 936 manufacturing companies in Puerto Rico, particularly in the pharmaceutical sector.
In 1983, 553 corporations claimed $2 billion in Section 936 tax credits. Ten years later, that amount peaked at $4.6 billion claimed by 395 corporations, then decreased to $1.6 billion claimed by 206 corporations in 1999.
The GAO reported, "The U.S. Treasury will lose $15 billion in tax revenues from 1993 to 1997 due to Section 936. Replacing 936s tax credit with a wage tax credit would [reduce the tax credit to] $2.2 billion during the 1993 through 1997 period. Various industries, including the pharmaceutical industry, have taken advantage of Section 936 by manufacturing products in Puerto Rico. U.S. corporations have been able to combine the federal tax credit with tax benefits granted by the government of Puerto Rico to pay low income taxes."
The principal reason for the repeal was the runaway growth in the rate of corporate tax benefits compared with employee compensation. Congress original intent behind Section 936 was to expand the islands work force and replace jobs lost in the agricultural industry with better-paying jobs in manufacturing. By 1987, however, the amount that manufacturing corporations received in tax benefits per employee was two to seven times greater than the amount they paid in employee compensation.
Singled out was the pharmaceutical manufacturing sector. In 1992, the GAO reported that tax benefits per manufacturing employee were two to four times greater than employee compensation in the electrical / electronic equipment sector and five to seven times greater than in all other industries.
"Section 936 was repealed because of the greed of some corporations," said Farrow of Lisboa Inc. "The law allowed corporations to improperly shift their earnings and attribute income from stateside operations to their Puerto Rico operations. It got to the point that one year, a company claimed around $330,000 in tax credits when measured per employee."
Additional amendments to Section 936 between 1980 and 1986 further restricted the tax benefits available by modifying the tax treatment of income derived from intangible assets and passive investments. Patents and copyrights would be taxable to the parent corporation unless the possessions corporation met a direct-labor or value-added test. Second, income attributable between the U.S. parent company and the possessions corporation could be taxed using the cost-sharing or profit-split method. Third, the percentage of gross income that a U.S. possessions corporation must earn from the active conduct of business or trade decreased 5% annually, having reached 40% during fiscal year 2004.
After Section 936 was repealed in 1995, a grandfather clause allowed corporations that had been approved to claim the tax credit to continue operating (albeit with certain restrictions) through taxable years beginning on Jan. 1, 2006. Restrictions included limiting tax credits to the percentage method with income caps; the income was raised on Dec. 31, 1997 and Dec. 31, 2001. In addition, tax credits were eliminated for QPSII received or accrued after June 30, 1996. U.S. companies with labor-intensive operations still left, however, because their costs would be much lower in other countries and because they no longer had the federal tax incentives to improve their bottom line.
"After Section 936s repeal, companies that could have established operations in Puerto Rico encountered problems because the federal tax benefit was no longer available," said Oscar Perez Sosa, assistant legal counsel in the Office of Tax & Legislative Matters at the Puerto Rico Industrial Development Co. (Pridco). "There was a definite decrease in the number of companies interested in the island. Not only were we facing the problem of attracting new companies to Puerto Rico, but labor-intensive companies in manufacturing sectors such as apparel and tuna-canning factories began to close because of the changes to Section 936."
Congress giveth and taketh away tax incentives
The U.S. on governments decision to bestow tax advantages on U.S. corporations for operating in U.S. possessions was made 84 years ago with no input from the Puerto Rico government. U.S. legislators also made the decision to repeal Section 936, most acting to defend their respective states manufacturing economies and backed by the general perception that U.S. corporations were taking excessive advantage of the tax benefits.
In 1995, Puerto Ricos manufacturing industry provided an average 158,000 jobs; by 2003, the figure had fallen by 27% to 116,000. Some industry experts say the decline was due to the repeal of Section 936; others claim it was due to global market fluctuations. Both situations certainly contributed to the decline. U.S. manufacturing companies in Puerto Rico had already been imitating their stateside counterparts since the 1980s, transferring their operations to countries with much lower labor costs.
In a 1997 report commissioned by the U.S. Committee on Finance, entitled "Tax Policy & Puerto Rican Economic Trends," the GAO said the islands economy from 1982 to 1996 was growing in income, employment, and investment, but this growth couldnt be directly attributed to Section 936.
"The faster rate of growth of the gross domestic product compared with the gross national product means that an increasing portion of the income produced in Puerto Rico went to mainland U.S. and foreign investors.... Although investment increased, and unemployment didnt, after the changes to the [Section 936] credit, [the GAO] doesnt know if the rate of change of either of these indicators would have been greater if the credit hadnt been changed," said the GAO in its report.
According to Alexander Odishelidze, president of Employee Benefits Associates Inc. and coauthor of "Pay to the Order of Puerto Rico: The Cost of Dependence to the American Taxpayer," Section 936 hurt Puerto Rico more than it helped. "It helped Puerto Rico with job creation in the 84 years of its implementation, but this was significant for only 15 of those years; between the early 1950s and the 1970s. During this period, the islands employment base grew tremendously, particularly in the pharmaceutical sector, which has always wanted to keep Section 936 going but represents only 2% of the employment base of 1.2 million jobs. In the past 30 years, [Section 936] has done almost nothing for the employment base.
"Unfortunately, Section 936 also gave Puerto Rico the perception of being a tax-gimmick economy, meaning that a successful investment in the island depended on the rise or fall of federal tax incentives. U.S. industrial interests were perceived as having hijacked Puerto Ricos political process. By keeping the current [political] status of the island going, it benefited the industries, but the people of Puerto Rico havent been part of that process," said Odishelidze.
The merits of Section 30A
Section 30A, a wage credit that existed under Section 936, was enacted in 1995 and became the only new federal tax benefit for corporations interested in establishing operations in Puerto Rico. Section 30As effectiveness at attracting corporations to the island became the subject of numerous debates.
Like Section 936, Section 30A is scheduled to end on Dec. 31, 2005, but some say it can be saved and extended if the right amount of pressure and the right political contacts are brought to bear.
"Section 936 is long dead in Washington, D.C., but Section 30A could possibly get an extension with a new government [administration] in Puerto Rico," said Farrow. "In 2001, Gov. Calderon and Acevedo Vila squandered the opportunity they had inherited to extend Section 30As tax incentive for job-creating investments in Puerto Rico, a tax credit for real economic contributions to the island.... The extension was supported by virtually all Democrats and several Republicans on the tax committees of both chambers of Congress, as well as by the U.S. Treasury Department. This [pursuance of Section 956 and disregard of Section 30A has been] one of the most counterproductive efforts made in Washington to help the islands economy."
In September 2004, 15 months before the scheduled end of Sections 936 and 30A, CARIBBEAN BUSINESS conducted an informal survey of 195 randomly selected U.S. manufacturing companies doing business in Puerto Rico. It found there were 140 Section 936, 43 Section 901 (controlled foreign corporations, or CFCs), and 12 Section 30A companies on the island.
Pridco wasnt able to provide CB with a current list of CFC applications among Pridcos more than 1,400 promoted companies. For Pridco, a promotion refers to a firm commitment by a private company for a future investment and associated job creation in exchange for economic incentives provided by law and administered by the agency.
In 2002, however, Pridcos Office of Industrial Tax said 80 Pridco-promoted companies had filed for CFC status in April, a 19% increase over the 67 applications submitted in July 2001. Pridcos Perez Sosa said about 114 Pridco-promoted corporations have become CFCs since 1989, while 89 have continued operating under Section 936.
Erie Scientific Co. of P.R. in Aguadilla is among the corporations that turned to Section 30A when Section 936 was repealed. The companys 58 local employees manufacture microscope plates.
"We were originally a Section 936 company, but with all the restrictions over the years, we preferred the benefits associated with Section 30A and restructured the company in 1988," said Erie Scientific General Manager Arthur Fernandez. "Headquarters is now considering whether the company will become a controlled foreign corporation [under Section 901]. But if Section 30A is extended, the company will probably continue benefiting under Section 30A in our short- and long-term strategies."
In the pharmaceutical manufacturing sector, Section 30A hasnt much support. "Section 30A was designed to benefit labor-intensive operations that used little technology but manufactured products with high profit margins, which allowed the companies to pay federal minimum-wage salaries," said Eli Lillys Bonilla. "But their permanence depends on the wage level, and there is a lot of competition for this market, including Mexico, Thailand, and India, countries where the labor costs are very low. A wage credit tax was enough for some companies to remain in Puerto Rico, but these were few."
Becoming a Section 901 CFC
Most pharmaceutical and other high-technology companies in Puerto Rico have opted for Section 901, which converts U.S. companies operating in foreign countries into CFCs. For U.S. tax purposes, Puerto Rico and other U.S. possessions are considered foreign countries. Under Section 901, a CFC receives a tax credit for taxes it pays to a foreign country in which it operates.
The adoption of Section 901 has been slow since many corporations have preferred to continue under Section 936 through the phaseout period, which ends Dec. 31, 2005. The latest U.S. Possessions Corporation Returns Report shows there were 197 corporations reporting $1.6 billion in Section 936 tax credits in 1999, a 33% decline from 1997, when 295 corporations reported $2.8 billion in Section 936 tax credits.
"There are three reasons why Section 901 is advantageous to the pharmaceutical sector," said Bonilla. "Section 901 can provide greater tax benefits than Section 936, but it depends on the tax structure established by the company. While Section 936 had clear regulations, with hypothetical questions and answers to help a company, Section 901 is made up of sections that specify only that the company must be established outside the U.S., what percentage should be owned by its parent company, and that the company doesnt have to pay taxes on its earnings because it exists outside the U.S.
"The real challenge is how the company computes its earnings and what percentage will be attributed to the operations in Puerto Rico, a difficult and very technical calculation," continued Bonilla. "This estimate is the source of most discrepancies and audits by the IRS [Internal Revenue Service], because the regulations final interpretation is up to the federal agency. To comply with IRS criteria is more of an art than a science, never exact, and the many estimates and assumptions must be defended in case of an audit. These difficulties are why Section 901 has rarely been used. But if a company does its homework, invests in a good earnings-assignment determination process, and works with the IRS, it can be very valuable."
Other sectors of the local manufacturing industry still havent decided what to do when Section 936 ends. The Puerto Rico Manufacturers Association (PRMA) has been making recommendations to its members and others doing business on the island. Despite the associations efforts, however, recovering from the loss of Section 936 has been difficult for PRMA members not in the pharmaceutical industry.
"Section 936 was a powerful incentive for companies to establish operations in Puerto Rico. From its establishment, thousands of companies came and left Puerto Rico, but for every 100 companies that left, another 110 companies arrived," said William Riefkohl, executive vice president of the PRMA.
"Luring companies to the island has become much more difficult without a tax mechanism like Section 936," added Riefkohl. "Perhaps companies in the apparel, leather, electronics, and food sectors would have eventually closed their local operations because of high labor costs, but not having Section 936 simply gave those sectors a push out of the island."
Riefkohl criticized the lack of alternatives to Sections 936 and 30A. "Practically nothing has been done to compensate for the loss of Section 936. Even today, we are still waiting to see if the tax benefit will be extended. This administrations effort last year to amend Section 956 was simply a way to reinsert the island into the federal governments tax-incentives structure. What it should have done is create a program that overcomes Puerto Ricos inefficiencies and deals with the reality."
Today, there is consensus on the need to enhance Puerto Ricos global competitiveness. Concerns about infrastructure, energy, water processes, education, government permits, and worldwide promotion of the island are shared by all manufacturing sectors.
"Puerto Ricos insertion into the global race is a reality we must face. Every day, we compete with industrialized countries such as Singapore and Ireland, as well as with emerging countries such as China and India, to attract new manufacturing operations and products," said Agustin Marquez, executive director of the Puerto Rico Pharmaceutical Industry Association. "Though its true economic incentives are significant and make a difference in decision-making processes, we must also work hard to provide the education needed to participate in the new, knowledge-based economy. Universities must be aligned with the manufacturing industry to recognize and respond to new economic trends. In the area of government permits, there is no reason why the technology we use daily cant yield faster, more effective processes. To do better what we already do well should be our goal; we should reduce energy costs, provide good water-quality systems."
Where is Puerto Ricos manufacturing industry headed?
One new proposal making the rounds of the islands manufacturing industry is an amendment (yet another one!) to IRC Section 243, which grants corporations a special 70% to 80% tax deduction on dividends from a domestic corporation that is subject to income taxes. An amendment would treat certain corporations doing business in U.S. possessions as domestic only for the purpose of allowing their stateside stockholders to take the dividend-received deduction. Corporations must derive at least 80% of their income from the active conduct of trade or business in a U.S. possession.
The PRMA recommended the amendment during its annual Business Forum in March. "CFCs cant repatriate earnings to the U.S.," said PRMAs Reyes. " Section 901 works only for multinational corporations with operations around the world. An amendment to Section 243 would allow domestic companies to repatriate their earnings to the U.S. without penalties. It is better than Section 956 because it doesnt make Puerto Rico an exception. Section 243 simply includes Puerto Rico and other U.S. possessions in a section that already exists to avoid double taxation in the continental U.S., where companies doing in business in Florida, for example, can repatriate their earnings to parents companies in New York or in any other state."
The pharmaceutical industry is interested in Section 243 also as a means to attract midsize corporate suppliers to the island. Eli Lillys Bonilla said, "There are many wealthy suppliers in the U.S. that are midsize companies. Perhaps they arent as large as most of the pharmaceutical companies on the island, but they are large enough to report billion-dollar revenues.
"Puerto Rico has never capitalized on this sector to create a niche, even with all the potential customers in this area," continued Bonilla. "If we could develop a mechanism [such as Section 243] so companies could come to Puerto Rico and repatriate their earnings to the U.S. at lower tax rates than if they operated stateside, it could turn into an excellent business opportunity for the island. Why not establish manufacturing plants for items used extensively by other production plants, such as chemicals for raw materials, cotton, lactose, or polyester?"
But how likely is it that the U.S. Congress will approve yet another tax benefit for Puerto Rico? And who would present it before Congress?
"I would recommend initiating a discussion with the islands political candidates, which we have pretty much begun, and then wait until the elections are over," said Bonilla. "At this point, we should put together a well-organized and technical analysis of the proposal. The success of the proposal depends on two factors: that it remains politically neutral and that all business interests support it. It should be perceived as an initiative of Puerto Ricos business sector that has consensus."
Representatives of the local manufacturing industry are optimistic about pulling off an amendment to Section 243 that will entice new companies to establish operations in Puerto Rico, despite the lack of federal incentives. After all, manufacturing companies did migrate to Puerto Rico in the 1970s, when the islands infrastructure was still being developed, and they have not only remained but also have expanded their operations.
"At the end of the day, this [Section 243 amendment] proposal looks to achieve something like what was attempted with Section 956, except its politically neutral and doesnt pose a threat to the U.S.," said PRMAs Riefkohl. "Whats even more interesting is that a precedent was already set when Congress approved giving local domestic public companies dividends the same tax treatment as U.S. mainland corporations. Its just a matter of how and when the proposal is presented before the U.S. Congress."
Odishelidze: Puerto Rico should focus on issues hindering islands economic development, such as political status
Puerto Rico should accept the end of Internal Revenue Code Sections 936 and 30A with grace and recognize it as an opportunity to focus on issues that would advance the islands economic development, such as the resolution of its political status.
So said Alexander Odishelidze, a leading expert on the self-determination and decolonization process of Puerto Rico and co-author with Arthur Laffer of the recently published "Pay to the Order of Puerto Rico: The Cost of Dependence to the American Taxpayer." According to Odishelidze and Laffer, American taxpayers spend $22 billion annually to maintain Puerto Rico as a dependent colony, which has evolved from a model for development to an industrialists model tax haven.
"If we were to compare employment figures in the past eight years of Puerto Rican Section 936 companies and U.S. manufacturing companies, we would see the same rate, approximately 25%, of manufacturing jobs lost," said Odishelidze, a resident of Puerto Rico. "What the [local] government has done is lobby on behalf of multinational companies on the island so these can continue to collect their tax credits, which amounted to more than $63 billion from 1981 to 2001."
In the book, the authors trace federal tax incentives to companies doing business in the U.S. possession beginning in the 1920s through their repeal in 1995. Though Odishelidze admitted the tax incentives had an impact during a particular 15-year period from the early 1950s to the 1970s, he believes Puerto Rico shouldnt lobby Congress for more tax incentives that are given and taken away with no say from the island.
"There is no need to ask for more federal tax incentives," he said. "Section 936 only worked for a few years. Section 30A is a wage credit tax that has no bearing on the kinds of professionalsengineers and scientistswho are being hired in Puerto Rico today. Unfortunately, the federal tax credits have created an idea that Puerto Rico is a tax-gimmick economy. But Puerto Rico has a lot to offer, and when the federal tax incentives disappear, people will realize the island has come of age."
To Odishelidze, coming of age means tackling head-on the political status of the island, whether it chooses to be a state, independent, or a freely associated republic.
"Our problem is the U.S. Congress can pass any law it wants over Puerto Rico," said Odishelidze. "It isnt any one partys fault. There is simply no vote for Puerto Ricans in the Senate and only a resident commissioner in the House. Even Puerto Ricos lack of infrastructure is related to status. The island is required to operate as a state but has no representation in Congress to make sure it has the resources.
"If the island were a state, it would have two senators and seven representatives. And if the island became independent or a freely associated republic, whatever laws the U.S. Congress passed wouldnt apply to Puerto Rico. Whatever the political status, Puerto Rico must make sure it develops economic drivers to compete with countries such as Singapore, with which the island has much in common, and Ireland," said Odishelidze.
"Since the 1920s, industries on the island, particularly U.S. pharmaceutical companies, have enjoyed a targeted tax break that essentially relieved them of all U.S. corporate income tax on their earnings in Puerto Rico," said Odishelidze. "This tax giveaway no longer accomplishes any meaningful purpose for the Puerto Rican economy. Instead, it benefits a wealthy and well-connected few. Moreover, it punishes the Puerto Rican people, who suffer the fraud of dependency."
Born in Yugoslavia during World War II, Odishelidze migrated to Canada and later to the U.S. seeking the freedom his countrys Communist regime had deprived him of and the American ideal of entrepreneurship. After serving in the Army in the early 1960s, he was discharged in 1963 and got a job in the insurance business. In 1964, Odishelidze moved to Puerto Rico, where he created a network of insurance agents and stockbrokers, leading to his becoming president & CEO of one of the top three insurance/broker-dealer operations of a major U.S. insurance company.
Retired in 1985 at age 44, Odishelidze is now president of Employee Benefits Associates Inc., a consulting firm specializing in areas of finance related to investments, mergers, and acquisitions of closely held businesses, executive compensation, and fringe benefits. He has also written "$...Making It and Keeping It!" and "Puerto Rico at the Crossroads."
U.S. Tax Glossary
Controlled foreign corporation: A foreign corporation in which more than 50% of the total voting power or total value of the stock is owned by U.S. shareholders on any day during the taxable year; falls under Section 901 of the Internal Revenue Code.
Internal Revenue Code (IRC): Official name of the federal tax statutes; continually amended by the U.S. Congress. Sometimes renamed to recognize milestone events such as the 1939 IRC, the first attempt by Congress to organize the tax statute into a cohesive unit; the 1954 IRC, which brought into statutory form many doctrines that had been created by the judiciary; and the 1986 IRC, the most recent and comprehensive tax reform and under which it is referred to.
IRC Section 30A: A tax credit based on wage compensation and derived by a corporation from the active conduct of a trade or business in a possession; scheduled to end on Dec. 31, 2005.
IRC Section 243: A special 70% to 80% tax deduction on dividends from a domestic corporation that are subject to income tax; corporations must derive at least 80% of their income from the active conduct of trade or business within a U.S. possession.
IRC Section 901. See controlled foreign corporation.
IRC Section 936: A tax credit created in 1976 against taxes for income derived by a corporation from the active conduct of trade or business in a possession and on qualified possessions source investment income; scheduled to end on Dec. 31, 2005.
Possessions credit: A tax credit equal to a percentage of the U.S. taxes imposed on the business and investment income from a possession. Examples are IRC Sections 936 and 30A.
Qualified possessions source investment income: Income attributable to the investment in the possession of funds derived from active trade or business in the possession.
Taxable income: As defined by IRC Section 63, gross income minus allowed deductions.
Tax base: The amount that is going to be taxed. Tax benefit: The reduction in taxes that occurs when the deduction in question is taken.
Tax credit: A dollar-for-dollar reduction of the tax liability that is considered to be a payment of the tax.
Tax deferral: What happens when an item of income is earned in one period but is subject to taxation in a future period.
Tax-exempt income: Income that isnt subject to taxation. The most typical example is interest earned on municipal bonds (bonds issued by states, cities, and municipalities).
Tax shifting: Occurs when a tax is imposed on one person or entity but in reality is paid by another.
1997 U.S. Possessions Tax Credit, by Industrial Group
Chemicals (includes pharmaceuticals): 60.3%
Electrical & electronic equipment: 7.9%
Instruments & related products & misc. manufacturing: 12.4%
Food & kindred products: 7.3%
Textile mill products: 1.7%
Apparel & other textile products: 1.4%
Total: $2.8 billion
Note: Selected industries shown are based on the Standard Industrial Classification system.
Source: U.S. Possessions Corporation Returns, 1997 and 1999
1999 U.S. Possessions Tax Credit, by Industrial Group
Chemicals: (includes pharmaceuticals) 56.3%
Computers & electrical equipment: 9.3%
Misc. manufacturing: 10.1%
Food manufacturing: 10.4%
Textiles & apparel: 6.2%
Total: $1.6 billion
Note: Selected industries shown are based on the North American Industry Classification System.
Source: U.S. Possessions Corporation Returns, 1997 and 1999
Employee Compensation as a Percentage of Net Income in Select Manufacturing Sectors
Textile products: 83%
Other manufacturing: 81%
Cement, rock, glass, & concrete products: 74%
Furniture & wood products: 72%
Paper products: 68%
Leather products: 60%
Clothing & related accessories: 57%
Tobacco products: 39%
Machinery & metallic products: 15%
Chemicals (includes pharmaceuticals): 8%
Source: P.R. Planning Board & P.R. Industrial Development Co.
Puerto Rico Average Employment Gain or Loss by Manufacturing Sector
Sector: Jobs (In thousands)
Metal products: 0.5
Concrete & cement: 0.5
Beverage & tobacco: 0.1
Rubber & plastic products: -1.0
Medical equipment: -1.2
Equipment manufacturing: -1.3
Electrical equipment: -1.6
Computers & electronics: -4.7
Source: P.R. Planning Board & P.R. Industrial Development Co.
This Caribbean Business article appears courtesy of Casiano Communications.