U.S. Tax Planning Opportunities for Bona Fide Residents of Puerto Rico
March 8, 2022
At a glance:
- The main takeaway: There are several lucrative tax benefits and incentives available to certain U.S. taxpayers who relocate to Puerto Rico.
- Impact on taxpayers: Before relocating, it’s important for taxpayers to ensure and document that all U.S. and Puerto Rican requirements are met in preparation of any audit.
- Next steps: Consult with international tax specialists and advisors to conduct appropriate tax planning before making the move. Aprio’s International Tax team stands ready to help.
The full story:
Over the years, the Puerto Rican government has created several tax incentives and credits to make Puerto Rico a destination for economic development and investment. In this article, we’ll explore the tax planning opportunities available to taxpayers who become “bona fide residents” of Puerto Rico, and whether you could benefit.
Understanding the Puerto Rico Incentive
Generally, Act 60 encourages individual investors to become bona fide residents of Puerto Rico by exempting dividends, interest, and capital gains from Puerto Rico tax (as long as an investor accrued those capital gains after becoming a Puerto Rico resident). Further, Act 60 provides for a 4% corporate income tax rate on export services income, royalties, interest, and many other types of Puerto Rico source income. For United States citizens, becoming a bona fide resident of Puerto Rico presents a compelling alternative to expatriation (i.e., relinquishing U.S. citizenship). While maintaining their U.S. citizenship, U.S. individuals can avoid U.S. federal income tax on capital gains as well as interest and dividends from Puerto Rican sources, in certain instances. Notably, a U.S. individual must meet specific Puerto Rican requirements under Act 60 to qualify (e.g., a resident individual must purchase residential property in Puerto Rico within the first two years) and apply for and obtain a local tax exemption decree.
U.S. Requirements and Implications
In addition to meeting the Puerto Rican requirements under Act 60, investors must also address the U.S. federal income tax consequences. Generally, a U.S. citizen living abroad must report all sources of income on a federal income tax return. However, if a taxpayer is a bona fide resident of Puerto Rico for the entire taxable year, they are exempt from U.S. federal income tax on income derived from sources within Puerto Rico under Internal Revenue Code (IRC) Section 933.
For U.S. purposes, to qualify as a bona fide resident, a person must meet these three tests:
- the Presence Test;
- the Tax Home Test; and
- the Closer Connection Test.
While this article does not discuss each requirement in detail, at minimum, a U.S. citizen should be prepared to spend 183 days or more in Puerto Rico during a given year. A special rule applies to the year of the move.
In addition to excluding capital gain income and interest and dividends from Puerto Rican sources from U.S. federal income tax, a U.S. citizen who is a bona fide resident of Puerto Rico is also exempt from the controlled foreign corporation (CFC) rules with respect to Puerto Rican companies under IRC Section 937. Therefore, if a U.S. shareholder owns stock in a Puerto Rican CFC, they do not need to be concerned about U.S. tax on subpart F and global intangible low-taxed income (GILTI) inclusions as a result of CFC income.
For example, assume a U.S. citizen who is a bona fide resident of Puerto Rico wholly owns 100% of the stock of a Puerto Rican limited liability company (LLC). Further, the Puerto Rican LLC provides consulting services from Puerto Rico to U.S. businesses and earns a fee for such services. In this instance, the services income earned by the Puerto Rican LLC should be subject to tax in Puerto Rico at 4%. The bona fide resident of Puerto Rico should not be subject to GILTI with respect to such services income, and dividends paid to the bona fide resident of Puerto Rico should be excluded from Puerto Rican and U.S. income tax. Finally, capital gains accruing after establishing Puerto Rican residency should likewise be excluded from Puerto Rican and U.S. tax in the event of a sale of the Puerto Rican LLC’s equity. This type of Puerto Rico consulting services structure is quite common.
The bottom line
Over the last couple of years, it is common for U.S. cryptocurrency investors and entrepreneurs, in particular, to relocate to Puerto Rico in an effort to take advantage of the favorable Puerto Rican and U.S. tax benefits noted above. However, of special note, taxpayers should practice caution when considering these types of opportunities, because the Large Business and International Division of the IRS has announced an audit campaign addressing taxpayers who have claimed Puerto Rican tax benefits without meeting the bona fide resident requirements and improperly sourced income. The IRS is concerned that individuals may be excluding income subject to U.S. tax. Accordingly, taxpayers considering a move to Puerto Rico should fully vet the necessary U.S. and Puerto Rican legal requirements, create and ensure compliance with a go-forward operating model, and maintain appropriate recordkeeping with the expectation of heightened IRS scrutiny.
If you want to learn more about the benefits involved with becoming a bona fide resident of Puerto Rico, contact Aprio’s International Tax team for guidance. Click here to schedule a consultation with us today.
About the Author
Jed is a Tax Partner at Aprio who counsels clients on international tax matters and M&A transactions. Jed has a deep knowledge of federal tax law and transactional tax planning, including serving more than a decade as in-house counsel for technology corporations and as a member of multinational professional services firms. He routinely advises multinational clients on a broad array of inbound and outbound U.S. and international jurisdiction tax matters, including repatriation planning, international tax credit planning, holding company and financial structures, foreign exchange matters, internal reorganizations and post-acquisition integrations. His background is invaluable as he works with clients to develop tax saving strategies.