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Mary Bernard
New Puerto Rico Tax on Foreign Companies

Certain foreign companies that were not previously subject to tax in Puerto Rico, may be subject to income tax or the new special excise tax, thanks to a newly enacted law.

November 11, 2010
by Mary Bernard, CPA

The Governor of Puerto Rico, Luis Fortuno, recently signed into law Act 154 which is designed to pay for a reduction in taxes for Puerto Rico resident individuals and corporations. This Act may strongly impact foreign companies with manufacturing operations in Puerto Rico.

Effectively Connected Rules

In expanding the definition of being engaged in a trade or business in Puerto Rico, Act 154 changes the rules determining effectively connected income. Under this new definition, certain nonresident alien individuals and foreign corporations or partnerships (foreign taxpayers) may now be subject to income tax or the newly created excise tax on the sale of products manufactured in Puerto Rico.

Under the new law, an office or fixed place of business of a resident entity in Puerto Rico is treated as the office or fixed place of business of a foreign entity if the resident entity:

  1. Has authority to negotiate on behalf of the foreign taxpayer and is not a general commission agent, broker or other agent of independent status acting in the ordinary course of business; or
  2. Is a member of a controlled group of the foreign taxpayer (more than 50% ownership) and for the current tax year and any of the three preceding years:
  • The total gross receipts from sales of personal property manufactured in whole or in part in Puerto Rico or services rendered in Puerto Rico for or on behalf of the foreign taxpayer are at least 10 percent of the gross receipts of the resident entity;
  • The sales of personal property manufactured in whole or in part in Puerto Rico or services rendered in Puerto Rico by the resident entity to the foreign taxpayer represent at least 10 percent of the cost of property or services purchased by such foreign taxpayer;
  • The foreign taxpayer engages in transactions with the resident entity related to personal property manufactured in whole or in part in Puerto Rico or services rendered in Puerto Rico that represent at least 10 percent of the commissions or other fees earned from similar transactions by such foreign person; or
  • The amount of the sales made by the resident entity of personal property manufactured in whole or in part in Puerto Rico or services rendered in Puerto Rico that are facilitated by the foreign person that when considered in connection with the activities noted before, represent at least:
  • Ten percent of the total gross receipts of the resident entity in Puerto Rico; or
  • Ten percent of the total gross receipts of the foreign person related to facilitation services of a similar type.
  • Apportionment Factor

    If the foreign person will be subject to tax based on the above requirements, the income to be sourced to Puerto Rico must be determined based on a formula. The numerator is the sum of the person’s property, payroll, sales and purchases factor and the denominator is four. If this apportionment factor results in a greater allocation of income to Puerto Rico than the foreign person deems reasonable, a request to use an alternative method of allocation can be made to the Secretary of the Treasury.

    Alternative Special Excise Tax

    Under certain conditions, the effectively connected rules would not apply, but a special excise tax would be imposed instead of the income tax. If gross receipts from the sale of personal property manufactured in Puerto Rico or services performed in Puerto Rico exceed $75 million for any of the preceding three years, the special excise tax would apply.

    The special excise tax applies to the value of purchases made by the foreign person of personal property manufactured in Puerto Rico, or services rendered in Puerto Rico. The value of the personal property is determined by the bill issued for the sale of the property or services. Where no bill is issued, the fair market value of the property or service is used. Beginning January 1, 2011, the excise tax rate will be applied at the rate of four percent, with reductions annually to a rate of one percent by January 1, 2016.

    Concerns

    Effective January 1, 2011, companies that may not have been subject to Puerto Rico taxes may now be deemed to have connected income effectively and be subject to income or excise tax. Industry groups such as the Pharmaceutical Research and Manufacturers of America (PhRMA) and the National Association of Manufacturers (NAM) issued statements in opposition to the new law. John Engler, CEO of NAM, stated that US-based manufacturers in the chemical, pharmaceutical and biotechnology industries account for approximately 80 percent of all manufacturing jobs in Puerto Rico. “The imposition of this tax could jeopardize the jobs of over 100,000 people and could damage business relationships that have taken years to develop between the affected companies and the government of Puerto Rico,” according to Engler. “These manufacturers provide stable and high-paying jobs for Puerto Ricans. The Puerto Rican government’s decision to impose this discriminatory tax could profoundly impact companies as they consider both existing and future operations.”

    John Castellani, president of PhRMA, released a statement in opposition to the law stating that “this could significantly reduce the ability of PhRMA’s members to operate in the Commonwealth and to continue to make significant investments in researching and developing innovative new medicines for patients.”

    Criticism was also presented of the passage of this significant new tax increase within 48 hours with no public hearings. Predictable tax policies are critical in helping foster innovation in Puerto Rico, according to Castellani. The industry groups feel the public and all relevant stakeholders should be involved in the process of developing and vetting such major tax policies. As a result of this Act, multinational corporations may have significant tax implications involving tax liability, supply chain analysis as well as accounting for uncertain tax positions.

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    Mary F. Bernard, CPA, is director — income/franchise tax, at the Dallas, Texas-headquartered tax services firm of Ryan. Bernard formerly worked as principal, director of State & Local Tax Services, at Providence, RI-basedKahn, Litwin, Renza & Co., Ltd.