Global Tax Alert. Puerto Rico s legislature proposes numerous tax changes for individuals, conduit entities and corporations.

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1 3 March 2015 Global Tax Alert News from Americas Tax Center EY Americas Tax Center The EY Americas Tax Center brings together the experience and perspectives of over 10,000 tax professionals across the region to help clients address administrative, legislative and regulatory opportunities and challenges in the 33 countries that comprise the Americas region of the global EY organization. Copy into your web browser: Services/Tax/Americas-Tax- Center---borderless-clientservice Puerto Rico s legislature proposes numerous tax changes for individuals, conduit entities and corporations Executive summary Puerto Rico s legislature has proposed (HB 2329) numerous changes to the income tax rules for individuals, conduit entities and corporations. These changes are part of a comprehensive restructuring proposal by the Government of Puerto Rico to move to a consumption-based tax system. As such, the proposed modifications to the income tax rules for individuals, conduit entities and corporations are in addition to the transformation of the existing sales and use tax regime to a proposed value added tax (VAT) system. 1 Detailed discussion Individuals The bill would reduce the income tax rates applicable to individuals, as well as the number of itemized deductions as currently provided under the 2011 Puerto Rico Internal Revenue Code (2011 PRIRC). Specifically, the bill would reduce the maximum income tax rate from 33% to 30%. Generally, all of these proposed changes apply for tax year 2015 and forward and transactions occurring after 31 December The bill would eliminate the deduction for contributions to educational contribution accounts and health savings accounts. Deductions would be allowed for charitable contributions, medical expenses, interest paid on student loans, contributions to pension or retirement plans by government employees and contributions to a Puerto Rico individual retirement account. The bill would convert the itemized deduction for mortgage interest on a qualified residence to a tax credit subject to limitation based on the amount of gross income. The bill also would eliminate the personal exemption and exemption for dependents.

2 Preferential tax rates Additionally, the bill would eliminate the preferential tax rate on interest income. Thus, interest income would be subject to ordinary income tax rates. However, the bill would increase preferential tax rates for net longterm capital gains and dividend income. Under the bill, net long-term capital gains would be subject to the ordinary maximum rate of 30%. For dividend income received from a corporation organized under the laws of Puerto Rico or from a foreign corporation with more than 80% of its income effectively connected with a Puerto Rico trade or business, the bill would increase the tax rate from 15% to 30% or subject the dividend income to regular tax rates if more beneficial to the taxpayer. This provision would be effective for distributions made after 31 December Withholding agents would be required to withhold 15% at source for distributions made before 1 April 2015, and 20% for distributions made after 31 March Nonresident individuals also would be subject to income tax withholding at source at the higher rate of 30% on distributions made after 31 March Additionally, the taxation of nonresident aliens would increase from 15% to 30%. Conduit entities In general, the majority of the partnership rules under the 2011 PRIRC would remain intact under the proposed bill. However, the bill would add the term, conduit entities, to define those taxpayers whose net income flows through to their owners. Under the 2011 PRIRC, all those taxpayers are subject to taxation under the provisions of partnership taxation, regardless of whether they are true partnerships. This term would apply to entities that elect to be treated as conduit entities, such as newly created partnerships, limited liability corporations (LLCs) that are treated as flow-through entities in other jurisdictions, and entities subject to statutory conversion. Similar to the rules under the 2011 PRIRC, conduit entities would not be subject to taxation, but their owners would be. Also, under the proposed bill, the owners would be treated as engaged in a trade or business in Puerto Rico. Statutory conversion as of the first tax year commencing after 31 December 2014 All existing special partnerships, corporations of individuals, regular partnerships, and LLCs treated as flow-through entities under the 2011 Code would be deemed converted to a conduit entity. The conversion would be treated as a mere change in identity with no tax cost involved. Holding periods, basis and other tax attributes would carry over to the deemed new entity. Election to convert for first tax year after 31 December 2014 The bill would allow existing entities taxed as corporations for their last tax year before 1 January 2015, to convert to conduit entities. Once the entities elect to convert, they would be deemed to have transferred all assets and liabilities to their owners, followed by a deemed contribution by the owners to the new conduit entity. No gain or loss would result from this transaction, but a deemed distribution of any accumulated earnings and profits as of the conversion date would apply. Such deemed distribution would be considered distributed during the first two tax years and subject to a preferential rate of 10%. Election to convert for tax years commencing after 31 December 2015 For tax years beginning after 31 December 2015, a conversion to a conduit entity would be deemed as a tax-free liquidation, followed by a deemed contribution to the new entity. Conversion costs, such as the recapture of certain benefits and built-in gains, and a deemed distribution of any accumulated earnings and profits as of the conversion date would apply, except that the preferential tax rate applicable to the deemed distribution would be 20%. Effect of the conversions on owners The owners of special partnerships and corporations of individuals subject to statutory conversion into conduit entities would be grandfathered and, as such, would not be deemed as engaged in a trade or business in Puerto Rico as long as the entities do not have a change in ownership. Corporations The bill would reduce the regular income tax, as well as the alternative minimum tax rates applicable to corporations, but increase the special tax rates applicable to passive income. 2 Global Tax Alert Americas Tax Center

3 Controlled groups For purposes of a controlled group of corporations, the term corporation would include conduit entities that are limited liability companies or partnerships and would replace shares with units. Normal tax rate applicable to corporations The bill would establish a single flat tax rate for corporations and eliminate the progressive surtax under the 2011 PRIRC, which ranges from 5% to 19% on taxable income exceeding $25,000. Under the bill, the tax rates would be as follows: 2011 Code HB 2329 Normal Tax Rate 20% 30% Maximum Tax Rate 39% 30% Surtax Rate 5% 19% N/A Surtax Exemption $25K N/A Long-term capital gains tax rate The bill would increase the long-term capital gains tax rate from 20% to 30 % for any transactions occurring after 31 December Special tax rate on dividends and/or deemed dividend distributions until 30 June 2015 The bill would establish a special tax rate for dividend distributions, in lieu of any other tax, including the alternative minimum tax or alternate basic tax, as follows: 5% If distribution is made from 1 January 2015 through 31 March % If distribution is made from 1 January 2014 through 30 June 2015 (the date that the 8% special rate would commence seems not to be aligned with the other period) Similarly, the bill would allow corporations to designate a deemed dividend up to the amount of their accumulated earnings and profits without having to make an actual distribution until 30 June In this case, the special tax rate would be as follows: 5% If the election to designate a deemed dividend distribution and tax payment is submitted no later than 31 March % If the election to designate a deemed dividend distribution and tax payment is submitted after 31 March 2015 but no later than 30 June 2015 After 30 June 2015, the tax rate on deemed dividend distributions would revert to 10%, which was introduced under the 2011 Code by Act for tax years commencing after 31 December Alternative Minimum Tax (AMT) The bill would make the following changes to the AMT: Reduce the AMT rate from 30% to 25% Reinstate a disallowance of the amount representing expenses incurred or paid to a related person, including the transfer of costs or the allocation of expenses from a home office to a branch that have not been subject to tax in Puerto Rico (the 51% disallowance of these charges for regular tax purposes would continue in effect) Eliminate the 20% tax component imposed by Act on expenses incurred or paid to a related person Replace the AMT component of purchases or transfers of personal property from a related person with cost of goods sold attributable to inventory acquired or transferred from a related person Eliminate waivers issued under the 2011 Code with no option to request new ones The AMT liability would continue being determined as the excess of the minimum tentative tax over the regular tax. The minimum tentative tax would be modified to be based on the higher of the following two amounts: 25% of the taxable alternative minimum net income The amount resulting from the application of the percentage provided below to the cost of goods sold attributable to inventory acquired from a related person or transferred from a home office located outside of Puerto Rico to a branch engaged in trade or business in Puerto Rico: Global Tax Alert Americas Tax Center 3

4 AMT on purchases of personal property (2011 Code) or cost of goods sold (HB 2329) attributable to inventory acquired or transferred from related person 2011 Code % Purchases HB 2329 % COGS General rule 2.0% 1.5% Alcoholic beverages 0.5% 0.375% Gasoline and crude oil products 0.5% 0.375% Vehicles 1.5% 1.25% Tax depreciation The bill would eliminate the accelerated depreciation method for property acquired after 31 December Taxpayers would have to continue using the recovery period and convention method provided under the proposed bill, which are generally the same as under the 2011 PRIRC. Taxpayers that have used the accelerated depreciation method would have to calculate the adjusted basis of the property as of 1 January 2015, and depreciate the property for the remaining period. Use and maintenance of automobiles The bill would base the deduction for the use and maintenance of automobiles on actual expenses. It also would grant the Secretary the authority to issue guidance through regulations or administrative determination to allow an alternate method for claiming expenses based on a standard mileage rate. Option 94 and other elections HB 2329 would revoke statutorily the Option 94 elections made by taxpayers (individuals and corporations) to remain subject to taxation under the provisions of the code before the 2011 PRIRC. Option 94 lasts for five tax years starting with the year Therefore, tax year 2015 would be the last one under the five-year period if it were not for the proposed revocation. Other elections made under the 2011 PRIRC would remain in effect for corresponding provisions under the proposed bill to the extent the taxpayer complies with the requirements therein. For example, the provision allowing partnerships in existence on the date of the 2011 PRIRC s approval to elect to be taxed as corporations would potentially remain in effect. Prepayment and taxation options at special rates Similar to the prepayment options that were in effect until 31 January 2015, for long-term gains on certain eligible assets and IRAs, the proposed bill would approve additional prepayment extenders generally through 31 March Implications HB 2329 is currently under evaluation through the hearings process in the legislature. Therefore, modifications and revisions to the original proposal could result. Endnote 1. See EY Global Tax Alert, Puerto Rico Governor introduces VAT bill to Legislative Assembly, dated 19 February Global Tax Alert Americas Tax Center

5 For additional information with respect to this Alert, please contact the following: Ernst & Young Puerto Rico LLC, San Juan Israel Maldonado German Ojeda María T. Riollano Rosa M. Rodríguez Global Tax Alert Americas Tax Center 5

6 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. Americas Tax Center 2015 EYGM Limited. All Rights Reserved. EYG No. CM5263 This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com