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IRS changes definition of Puerto Rico resident and income-source rules

Changes to Section 937 broaden the impact of federal taxation to U.S. possessions, Puerto Rico included


May 13, 2005
Copyright © 2005 CARIBBEAN BUSINESS. All Rights Reserved.

Until recently, the definition of a bona fide resident of a U.S. possession, such as Puerto Rico, was determined in a subjective manner, based strictly on the declaration of an individual’s intentions with respect to the length and nature of his or her stay in the possession. However, under new Internal Revenue Service (IRS) regulations issued April 6 and published April 11 in the Federal Register, that subjectivity no longer holds up.

New Section 937 of the Internal Revenue Code (IRC), created under the American Jobs Creation Act (AJCA) of 2004, includes changes regarding Puerto Rico’s residency requirements and income source rules for federal tax purposes.

AJCA was enacted Oct. 22, 2004, while Puerto Rico’s nonvoting representative to Congress was campaigning on the island for governor of the U.S. possession of Puerto Rico. These new federal taxation rules applying to U.S. possessions were approved last year without a representative vote from U.S. citizens residing in Puerto Rico.

Since then, neither Gov. Aníbal Acevedo Vilá, who was at the time resident commissioner, nor any other Commonwealth representative, has publicly addressed the potentially serious effect these changes will have for Commonwealth residents.

New meaning to P.R. residents

These regulation changes alter the meaning of being a Puerto Rico resident, making it more difficult to qualify for federal tax exemption, be it for personal income or capital gains. The new definition of residency establishes that in order to be a bona fide resident of a U.S. possession, the person must be present for at least 183 days during the tax year in the possession in question, be it Puerto Rico, Guam, American Samoa, the Northern Mariana Islands, or the Virgin Islands.

The person mustn’t have a closer connection to the U.S. or a foreign country than to the possession. If an individual becomes or ceases to be a resident of a possession under the new requirements, the person must give notice to the IRS. There are several exceptions to the rule, some regarding government officials and medical needs.

AJCA 2004 regulation changes, which are in effect for tax years beginning after Oct. 22, 2004, further revised certain aspects of the provisions in effect to prevent individuals who live and work in the U.S. from taking advantage of certain provisions to inappropriately reduce their combined U.S. and possessions tax.

The potential consequences of all these changes could be serious for possession residents. John T. Belk III, a partner of Sierra, Serapion, Attorneys & Counselors, which publishes a monthly Tax & Commerce Review, explained that in certain circumstances, the new definition may create additional complexity and the potential for double taxation of possession-source income.

"For example, bona fide residents of Puerto Rico are exempt from U.S. tax on their Puerto Rico-source income, and they aren’t required to file a U.S. tax return on that income," he said, adding, "If they fail to meet the new definition, they would be subject to U.S. federal tax and Puerto Rico tax on their Puerto Rico-source income.

"This would happen even if the individuals weren’t receiving any benefit under Puerto Rico’s economic development program. The individual would be required to file two tax returns and rely on the foreign tax credit to eliminate potential double taxation." However, Belk also said it was still unclear if individuals will qualify for receiving these tax credits under these circumstances.

Section 937 also changed taxation-source rules. Source rules determine if taxing jurisdiction of income is U.S.-source income or possession-source income. In the case of Puerto Rico, the sourcing rule determines if only local taxes apply to any income or if federal taxes must be paid. The new rule provides that an item of income won’t be considered a possession source if such item of income comes from sources within the U.S. or income effectively connected with the conduct of trade or business in the U.S.

Another important change presented in Section 937 provides that income from the sale of securities, including stock, by a bona fide resident of Puerto Rico won’t be sourced on the island if such stock was acquired by the bona fide resident of Puerto Rico before becoming a resident, and the Puerto Rico resident seller hasn’t been a resident of the island for the 10 years preceding the year of the sale.

This means any sale of securities after April 11 will be subject to federal income taxation unless the individual sells the stock after a 10-year period of residency on the island. There are certain exceptions to the rule, including the determination of the source of dividends and interest from local corporations.

Commonwealth status doesn’t guarantee federal income-tax exemption

Under Section 933 of the IRC, Puerto Rico residents are exempted from paying federal income tax on Puerto Rico-source income. This exemption has nothing to do with the island’s commonwealth status. Commonwealth immunity from federal taxes is a common yet mistaken assumption. Puerto Rico residents have been paying federal taxes for decades. Federal employment taxes for Social Security, Medicare, and unemployment insurance apply to residents of Puerto Rico.

Federal employees in Puerto Rico also pay federal income taxes. Even bona fide Puerto Rico residents (and of certain other possessions) are subject to U.S. federal income tax on their worldwide income.

Just as Section 936 was eliminated and its benefits set to expire Dec. 31, the same can happen with Section 933. "I don’t know that they asked the current or the prior resident commissioner about this [Section 937]. They don’t have to consult with us about how they change the internal revenue code," said Belk, explaining that Section 933, which provides income tax exemption for Puerto Rico, could be altered from one day to the next without any local input. A revision of this kind could mean island residents would no longer be exempt from paying federal income tax in their Puerto Rico-source income.

The current regulation changes are collectively just one of a series of unilateral congressional and federal government actions that evidence the inability of island residents to shape their own future or influence federal actions concerning the Commonwealth, as well as any future revisions to federal tax laws applying to Puerto Rico.

Comments requested by the IRS

The new regulations are what the IRS and Treasury Department call Temporary & Proposed, which means they are in complete effect. However, the IRS is open to comments or feedback regarding the new regulations.

Congressman Charles Rangel from New York, ranking Democrat on the Ways & Means Committee of the U.S. House of Representatives, voiced his concerns in a letter directed to the U.S. treasury assistant secretary for tax policy, Greg Jenner. In the closing remarks of the letter obtained by CARIBBEAN BUSINESS, he states, "I would urge you to work closely with the possession governments. I believe they are sincere in their desire to avoid abuses. A more measured and thoughtful approach than what passed the Congress is necessary."

A legal representative of the U.S. Virgin Islands also sent a memorandum requesting "guidance on possession tax issues." At one point, the communication stated, "In short, a 183-day residency requirement is unrealistic for many individuals residing on tiny islands in the Caribbean… the Treasury should prescribe exceptions to the 183-day requirement for days spent outside the territory for reasonable, nontax-avoidance purposes, including ordinary and necessary business travel."

The IRS is open to receive comments until July 11. Requests to speak and outline topics of discussion at the public hearing scheduled for July 21 at 10 a.m. must be received by June 30. Comments can be sent to Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C. 20044.

This Caribbean Business article appears courtesy of Casiano Communications.
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