Act 22 of Puerto Rico Creates a Tax Haven for Americans
Puerto Rico is a beautiful island with many natural wonders, but it also has one very “unnatural” quality that is creating a haven for American citizens; it’s called, Act 22. Passed by the Legislative Assembly of Puerto Rico in 2012, Act 22 is intended to draw wealthy individuals to the island nation in hopes of spurring its sputtering economy. Act 22 is a tax incentive that essentially provides an individual exemption from Puerto Rico taxation on certain investment incomes until December 31, 2035.
The exemption is broadened to other types of income through related legislation, namely Act 20 and Act 273. Together, this legislative package allows U.S. citizens to achieve an effective tax rate of sub 4% on much of their income, all without giving up their U.S. citizenship. I’ve written about the tax benefits of Puerto Rico before, and you are welcome to read about such benefits there. In this article I will explore the different avenues to achieving such benefits.
The tax incentives being offered by Puerto Rico are somewhat “unnatural” because the island is a commonwealth of the United States and its residents are U.S. citizens. So how can a U.S. territory simply turn off U.S. federal taxation? Subpart D of the U.S. Internal Revenue Code seeks to synthesize and coordinate federal taxation with the taxation of U.S. possessions and Puerto Rico. Section 933 allows a specific exclusion from federal taxation for income derived by bona fide residents of Puerto Rico from sources within Puerto Rico. A similar rule is provided for the U.S. Virgin Islands and other U.S. territories. This permits the territory to institute its own tax rates for its residents – but only for income that is sourced to the same territory. For example, a bona fide resident of Puerto Rico pays Puerto Rico tax (not U.S. federal tax) on dividends from Puerto Rico companies. However, that same resident would pay U.S. federal tax on a dividend from a U.S. company, say IBM or General Electric. Normally, the difference is not material since most U.S. territories have a tax code that mirrors the U.S. tax code (in fact, they are called “mirror code jurisdictions”). While Puerto Rico is not a mirror code jurisdiction its tax rules (and rates) are not dissimilar to the U.S. mainland. This is why Act 22 is revolutionary. The Act, by introducing a 0% tax rate on certain investment income, wildly distorts the coordination of the U.S. territory tax systems.
When I explain the tax benefits available to U.S. high net worth individuals from migrating to Puerto Rico the typical response I get is, “I don’t want to live in Puerto Rico all year long.” How many days per year do you really need to live on the island of Puerto Rico in order to achieve the desired benefits? The truth is – zero! Of course, that’s extreme, but theoretically possible. If you know anything about the residency rules surrounding Puerto Rico you’re already asking yourself if the author has been spending way too much time in the sun down in San Juan. Everyone knows the rule is that you must be present on the island of Puerto Rico for 183 days or more per year in order to be classified as a bona fide resident (the “Presence Test”). However, rather than lounging on the beautiful Flamenco Beach (e-mail me, I can tell you how to get there), I’ve been toiling away in New York reading the Internal Revenue Code. In it, you will find that the 183-day rule is but only one of five different tests an individual can meet in order to satisfy the Presence Test and be deemed a bona fide resident of Puerto Rico. Of course, in order to be a true resident and achieve the tax benefits one must also meet the Tax Home and Closer Connection Tests (more on that later).
The other ways to satisfy the Presence Test include, (i) being present in Puerto Rico for 549 days in a 3-year period (with a minimum 60 days each year); (ii) being present in the U.S. 90 days or less; (iii) having U.S. earned income less than $3,000 and spending more time in Puerto Rico than the U.S.; or (iv) having no significant connections to the U.S. Of particular note, only the 183-day and 549-day tests require any actual time on the island of Puerto Rico. The last three tests have no requirement of a minimum presence within Puerto Rico (although, the third test compares your Puerto Rico time to your U.S. time). Importantly however, no matter what test one looks to, the individual cannot be present in the U.S. for 183 days or more without become subject to full U.S. taxation. That has nothing to do with Puerto Rico but is rather a general rule all non-U.S. citizens must be wary of.
People often dismiss the third test above since they obviously make more than $3,000 per year. However, the test is “U.S. earned income” of less than $3,000. If all of your income is investment earnings or you establish your management company in Puerto Rico and that is where you draw your salary from you have no U.S. earned income. Of course, for that test you still must spend more time in Puerto Rico than the U.S. which does not fit everyone’s lifestyle. Likewise, if you are fond of seeing friends or relatives often and can’t rely on them coming to visit you outside the U.S., test number two may also not be feasible since you can’t be in the U.S. more than 90 days per year. However, many people are able to strike a balance of being in the U.S., Puerto Rico and other places in the world in a manner that meets one or more of these tests.
Take the example of my client Paul and Jen Harrison (not their real names). Paul and Jen are married with three grown children and earn approximately $14 million per year. The Harrison’s had homes in the U.S., London and Singapore. The Harrisons called Manhattan their home when I first met them and were subject to roughly 50% maximum taxation on their income (federal, state and city combined). When we spoke about tax reduction alternatives I suggested the notion of changing their domicile, the Harrison’s were amenable to moving to Florida, which would significantly reduce their tax, but not Puerto Rico.
However, after reviewing their most recent three year travel log (which they kept for California residency purposes), I explained to them that with fairly modest changes they could have qualified as Puerto Rico residents and would save approximately $5 million per year (based on their particular tax situation). They spent an average of 45 days per year in London, 30 days in Singapore and another 65 days in travel destinations (primarily outside the U.S.). Thus, on average they were in the U.S. only 225 days per year. They ultimately changed their domicile to Puerto Rico and reduced their time in the U.S. to 182 days. The Harrison’s decided to qualify under test number four above by severing all “significant connections” to the U.S. Ironically, while this test sounds the harshest, it allows the Harrisons to spend up to 182 days per year in the U.S. while spending minimal time in Puerto Rico. We anticipate for 2014 they will spend 182 days in the U.S., 45 days in London, 35 days in Singapore, 56 days in Puerto Rico and 47 days traveling outside the U.S. That’s a prime example of maintaining one’s status as a bona fide Puerto Rico resident while spending only 56 days in Puerto Rico during the year. The “significant connections” with the U.S. that must be severed in order to satisfy the fourth option under the Presence Test include, (i) a permanent home in the U.S., (ii) a current voter registration in any political subdivision of the U.S., or (iii) a spouse or child under the age of 18 whose principal place of residence is in the U.S. unless the child is living in the U.S. with a custodial parent under a custodial decree or the child is in the U.S. as a student. For most people re-domiciling to Puerto Rico all “significant connections” to the U.S. would be severed simply to meet the Closer Connection Test (described below) with the exception of a U.S. residence. Thus, the only thing the Harrisons had to change was to lease or sell their New York apartment.
Of course, like many of my clients who have re-domiciled to Puerto Rico, the Harrisons are discovering that the more they stay in Puerto Rico, the more they like it. They are actually building a guest house on their property to house their visiting children and grandchildren and plan on spending significantly more time in Puerto Rico in 2015.
In deciding how to meet the Presence Test one must be cognizant of the Closer Connection Test as well as the Tax Home Test, both of which must also be satisfied in order to be considered a bona fide resident of Puerto Rico. Under the Closer Connection Test the individual must not have a closer connection to the U.S. or a foreign country than to Puerto Rico during the year. The Closer Connection Test is a facts and circumstances test that focuses on factors such as: the location of the individual’s permanent home; the locations of the individual’s family; the location of personal belongings such as automobiles, furniture, clothing, jewelry, etc.; the location of social, political, cultural and religious organizations; personal banking activities; location of business activities, driver’s license and voter registration.
The Tax Home Test states that a person’s tax home is considered to be located at his “regular or principal place of business.” If a place of business is inapplicable in a given person’s situation, the test considers the individual’s regular place of residence. Under this test, the individual must not have a tax home outside Puerto Rico during the tax year.
The Closer Connection Test and Tax Home Test are indicative of the fact that an individual can have multiple residences but only one domicile. There is only one way to test a person’s domicile – facts and circumstances to determine where the person maintains his/her permanent home, the place they always intend to return to.
Piecing the rules together it becomes clear that a U.S. individual can re-domicile to Puerto Rico and take advantage of the tax benefits afforded by Act 22 while spending minimal time on the island. For a U.S. individual living in a high tax state like New York or California, migrating to Puerto Rico can change their effective tax rate from more than 50% to below 4%. Such significant savings with the prospect of spending 183 days in the U.S. and minimal time on Puerto Rico is worth serious investigation.
If you have any questions regarding migrating to Puerto Rico or any other international tax issues, please contact your normal WithumSmith+Brown partner.
