Puerto Rico Tax NewsAlert Internal Revenue Code for a New Puerto Rico, Act 1 of January 31, 2011 As part of the anticipated tax reform of the Puerto Rico (PR) government, Act 1 of January 31, 2011, known as the Internal Revenue Code for a New Puerto Rico (hereafter referred to as "Act 1" or the New Tax Code"), represents the second phase of what has been described by the Executive Branch of the PR government as one of the most comprehensive piece of PR tax legislation since the PR Internal Revenue Code of 1994, as amended (the 1994 Code). Act 1, effective on January 1, 2011, for taxable years beginning after December 31, 2010 (unless otherwise provided), introduces not only a new PR Internal Revenue Code, but also a new codification. This NewsAlert summarizes the salient points of the New Tax Code. Since our summary is not intended to cover all aspects of the legislation, we encourage you to contact us to discuss the specific provisions of the New Tax Code that may affect your business. Corporate income tax Regular corporations The New Tax Code includes significant changes in the way entities that in the past were treated as regular corporations for income tax purposes will be taxed, as further explained in the "Partnerships and LLCs" section below. The normal tax introduced by Act 1 is 20%, applicable only to corporations and certain partnerships and limited liability companies (LLCs) treated for income tax purposes as corporations (corporate taxpayers). Corporate taxpayers will further be subject to simplified surtax rates, as follows: (i) 5% for income up to $1.75 million and (ii) $87,500 plus 10% of income in excess of $1.75 million for a maximum nominal tax rate of nearly 30%. This latter 10% surtax might only be applicable up to 2013, leaving the maximum nominal tax rate at nearly 25% from 2014 thereafter, provided certain fiscal and economical conditions are met. The determination of the applicable surtax rate will be made on a consolidated basis for controlled groups and related companies, whereas the net taxable income of all the entities subject to tax in PR within said groups will be combined for the determination of the 5% or 10% applicable surtax rate. The surtax credit of $25,000 established by the 1994 Code was changed by Act 1 for a deduction of $750,000. The 5% recapture or recovery of tax for differences in tax rates was eliminated, resulting in an effective tax rate of nearly 30%. The 5% temporary special surtax applicable up to 2012 was also eliminated. In regard to the alternative minimum tax (AMT), the tax rate was reduced from 22% to 20%. In addition, for certain companies purchasing personal property from related parties, the tentative AMT will now be the greater of the above-mentioned 20% or 1% of said purchases of personal property. The temporary adjustment related to expenses paid or incurred for services performed by a related party outside PR is now a permanent adjustment in the determination of the alternative minimum net income. Notwithstanding the above-mentioned changes introduced by Act 1, corporate taxpayers may elect to be taxed based on the provisions of the 1994 Code. 1 March 1, 2011
The election should be made with the return for the taxable year 2011 and will be final and irrevocable for said year as well as the next four taxable years (i.e., five years in total). PwC observation: Due to the reduction in corporate income tax rates companies should pay special attention to the estimated tax payments in connection with the taxable year 2011 since these are usually based on 100% of the prior year s tax liability (i.e., safe harbor rule), which could be as high as 40.95% for 2010, resulting in a potential overpayment of the income tax liability for the year 2011. Small and medium businesses (with less than $5 million in gross revenues under the 1994 Code) should continue to experience reduced tax rates since, due to their size, their tax rate is expected to range from 20% to 25% (versus 25% to 30% under the 1994 Code). Other legal entities Special partnerships and corporations of individuals The special partnership (SP) election is no longer available for taxable years beginning after December 31, 2010. Furthermore, the 50% loss limitation from an SP where partners offset said losses against other ordinary income is no longer available, unless the partner elects to be treated under the provisions of the 1994 Code, as further explained in the "Individual income tax" section below. Instead, losses from an SP, corporations of individuals (known as S corporations for US tax purposes), and regular partnerships, as applicable, are to be netted pursuant to the order established in the provisions of the New Tax Code, and any remaining losses should be carried forward to future years. In the case of an SP, the estimated payment requirement in connection with the distributive share of a resident partner or a nonresident US partner changed from 33% and 39% for individuals and corporations, respectively, to 30%. For corporations of individuals, the estimated payment requirement in connection with the distributive share of a resident partner or a nonresident US partner changed from 33% to 30%. For SPs and corporations of individuals, audited financial statements will be required to the extent the volume of business of an entity exceeds $3 million, following the provisions summarized in the "Audited financial statements" section below. PwC observation: Because of the reduced corporate tax rates introduced by Act 1, i.e., from 25% to 30%, entities with tax elections under the SP or corporation of individuals regime may need to reassess their tax position to determine whether maintaining said elections is tax effective (in other words, taxing their distributive share of income at the individual tax rates, which will decrease progressively over the next years, versus the already reduced corporate tax rates, including the dividend tax of 10%). Partnerships and LLCs (now pass-through entities) Partnerships will no longer be subject to tax at the entity level, unless they elect to be treated as a corporate taxpayer, an election that will be available only for partnerships in existence as of January 1, 2011. Instead, the partners will be subject to tax on their distributive share of the partnership s income, with certain preferential items to be reported separately to the partners because of the special tax treatment (such as capital gains, certain dividends, and income tax withholding made to the partnership). LLCs will be taxed as corporate taxpayers unless they elect to be treated as partnerships (i.e., pass-through entities). Said election will be made automatically (i.e., pass-through treatment in PR) to the extent the LLC is treated as a pass-through entity in the United States or other foreign jurisdiction. Partners and members of a partnership and LLC, respectively, will be deemed to be engaged in a PR trade or business as it relates to their distributive share of income or loss on the partnership and LLC in PR. Accordingly, their distributive share of income will be subject to estimated payment requirements, as follows: (i) 30% for LLC members and corporate partners in a partnership and (ii) 33% for individual partners in a partnership. PwC observation: LLCs engaged in a trade or business in PR as of January 1, 2011, that are treated as pass-through entities in the United States or another foreign jurisdiction should immediately analyze the possible effect of automatically becoming a pass-through entity for 2 March 1, 2011
PR tax purposes, such as potential 10% dividend tax on accumulated earnings and profits and other recapture provisions. They also should analyze any potential implications this tax treatment may have on their members, for those deemed to be engaged in a PR trade or business. Tax return due dates and extensions The tax returns for partnerships, LLCs, corporations of individuals, and SPs will have a filing deadline of March 15 in the case of calendar year taxpayers (or the 15th day of the third month following the close of the taxable year), which could be extended up to three months upon filing of an extension of time in this regard. The due date for filing the informative statement to the partners, members, and shareholders remains the same. Individual income tax With respect to individual taxpayers, the New Tax Code focuses on simplified reporting and administration by reducing the types of filing status and number of personal deductions available. Filing status The New Tax Code reduces from five to three the categories of filing status. These are: 1. Individual taxpayer (individual) includes (a) unmarried individuals, (b) married individuals who are separated for a continuous period of 12 months including the last day of the tax year and have been living in separate households for an uninterrupted period of 183 days (within the continuous 12 months period), and (c) married taxpayers with prenuptial agreements expressly stating that the marriage would follow total asset separation. 2. Married taxpayers living together and filing jointly (MFJ) 3. Married taxpayers living together and filing separately Personal and dependent exemptions Personal exemption amounts would gradually decrease during the years 2011 through 2015 from $3,500 for individuals ($7,000 for MFJ) to $750 for individuals ($1,500 for MFJ). The exemption for dependents would remain at $2,500. The following changes have been made to the definition of dependents: (1) qualified university students may earn up to $7,500 without being disqualified as a dependent, and (2) each divorced parent with a joint custody agreement of a minor child would get 50% of the exemption for the dependent, unless a written waiver is obtained from one of the parents. What used to be the veterans deduction is now called the veteran's exemption. The amount of $1,500 remains unchanged. Deductions available to individual taxpayers Deductions will be reduced for the following: 1) mortgage interest paid on qualified residential property (30% of adjusted gross income [AGI] limitation still applies for taxpayers under 65 years old), 2) contributions to charitable organizations limited to 50% of AGI, 3) qualified medical expenses in excess of 6% of adjusted gross income (medical expenses now include prescriptions), 4) interest paid on student loans, 5) contributions to government retirement systems, 6) contributions to IRAs (now the contribution is on top of the maximum amount allowed for employer-sponsored retirement plans), 7) contributions to educational IRAs, 8) health savings account, 9) purchase of medical technology equipment for the handicapped or for specialized treatment, and 10) casualty losses of primary home. Some of these provisions may have changed from the current code. Also, it is now required to include with the tax return supporting evidence for each deduction claimed. Standard deduction will be eliminated. There will also be an additional special deduction for certain taxpayers (those with compensation from services rendered, pensions, or alimony). The deduction will range from $9,350 to $2,350 for taxable years 2011 to 2014, respectively. There will be a 3 March 1, 2011
phase-out in the rate of a 50 cent reduction for every dollar of gross income in excess of $20,000. It is interesting to note that deductions will be allocated among ordinary income and income subject to preferential tax rates, under a total gross income formula, prior to determining the net income subject to tax under each tax category. Tax rates Ordinary tax brackets will be gradually adjusted over a six-year period. For example, for taxable year 2011, tax rate income brackets will range between $5,000 and $60,000, increasing prospectively through taxable year 2016, reaching to income tax brackets that will range from $16,500 to $121,500 at a maximum rate of 30%. Also, the level of income subject to the gradual adjustment (or so-called "recapture") will gradually increase from $75,000 (current amount) to $500,000 for taxable year 2014. It will be eliminated by the taxable year 2015. The limitation will also be adjusted gradually to account for the changes in exemptions and the adjustments in the income levels. The alternate basic tax (ABT) will apply for taxpayers with net taxable income exceeding $150,000 ($75,000 under the 1994 Code). The special additional tax enacted under Act 7 that would temporarily apply for tax years 2009, 2010, and 2011 has been eliminated starting with tax year 2011 under the New Tax Code. PwC observation: The New Tax Code does not include a provision to exempt dividend income from incentive tax laws for purposes of ABT. Currently, these are exempt from ABT pursuant to the PR Treasury Department Circular Letter Num 09-06 of July 22, 2009. Calculation of tax liability The optional calculation for MFJ taxpayers, when both work, will continue to be in effect. Under such election, the New Tax Code will allow the MFJ taxpayers to calculate the gradual adjustment and ABT as they would have if they were individuals, eliminating completely the marriage penalty. The New Tax Code also includes an election for taxpayers to file their income tax returns under the 1994 Code for tax year 2011 and the following four tax years. However, the election will be binding and irrevocable for the total five years (in other words, for tax years 2011 through 2015). Furthermore, the New Tax Code will exempt some individuals from the payment of estimated tax even if they meet the $1,000 threshold (for example, individuals whose gross income is earned only from pensions and salaries). PwC observation: It would be interesting to see which individuals would really benefit by electing to file under the 1994 Code moreover, when items having more impact such as mortgage interest had already been included as an amendment to the 1994 Code through Act 171 in 2010. In addition, employers will need to monitor more closely which tax tables to use for purposes of tax withholdings for taxpayers electing to file under the Code of 1994. Other topics The New Tax Code also implements a new 10% withholding requirement on other distributions from pension plans (for example, partial distributions after separation from employment) after consideration of any post-tax contributions. The special tax on real property, which was established by Act 7 of 2009, has been eliminated for tax fiscal year 2011. Changes applicable to corporations and individual taxpayers General provisions Act 1 not only changes the definition of what constitutes a brother-sister relationship in a controlled group of entities by reducing the required ownership percentage from 80% to 50%, but also further expands and standardizes the definition of related parties and related group of entities through an interplay of three definitions (i.e., controlled group, related group of entities, and related parties). The New Tax Code also includes as part of the definition of related parties affiliates related through indirect 4 March 1, 2011
ownership that, under the 1994 Code, may have not fallen under said definition. Falling within the definitions of controlled groups, related groups and related parties may result in entities being subject to: (i) consolidated surtax rate determination; (ii) 1% tentative AMT for purchases of personal property from related parties; (iii) 29% withholding tax at source on interest payments made to a non-pr affiliate; and (iv) provisions of Act 154, among others. In regard to tax deductions, they have been eliminated or adjusted as follows: 1. Expenses related to maintenance of boats, vessels, airplanes, and residential property located outside PR, unless the taxpayer is engaged in certain activities involving the use of these assets, are no longer deductible. 2. Intangibles (besides goodwill) acquired after December 31, 2009, will now be amortized over their useful life or 15 years, whichever is lower. 3. Automobile depreciation (and lease deduction, when applicable) increases to $6,000 per year ($10,000 in the case of a salesperson) for a maximum of five years (three years for a salesperson). 4. Automobile maintenance expense will now be deductible based on millage usage, instead of actual expenses, pursuant to guidelines to be established by regulation. 5. Limitation for corporate taxpayers as it relates to donations increases from 5% to 10% of the entity's net taxable income. PwC observation: Under the 1994 Code, certain interest payments from a PR person to an indirect non-pr affiliate may have not been subject to the 29% withholding tax at source since the entities may have not been considered related parties. The new broader definition of this term (i.e., related parties) introduced by the New Tax Code may result in companies that were not previously subject to these requirements, being subject to a 29% withholding tax at source. As such, we encourage companies to immediately assess the potential implications this new provision may have on their intercompany transactions. Sourcing rules Sourcing rules under the New Tax Code remain the same as in the 1994 Code, except for certain new guidelines applicable to the sale or disposition of personal property and transportation rules. To some extent, the income sourcing rules in connection with the disposition of personal property mirror federal rules, as follows: The general rule is that income from the sale or disposition of personal property generated by a PR entity or a PR resident will be considered from sources within PR. Alternatively, if the seller is a non-pr resident or entity, any income realized from such sale will constitute non-pr source income not subject to tax in PR. There are three exceptions to the above general rule: inventories, property subject to depreciation, and intangibles. In regard to the new transportation rules, all income attributable to travels that begin and end in PR will be entirely considered as PR source income. If travels only begin or end in PR, then only 50% of the related income will be considered as PR source income whereas, in the case of cruise ship-related travel, income by foreign corporations will be considered non-pr source income. Reorganizations Changes in this area could be summarized as follows: Boot relaxation rules are introduced whereas the use of money or other property (including assumption of debt) by the acquirer in a reorganization does not prevent an exchange from qualifying as a Type C reorganization if at least 80% of the target s property is acquired in exchange for voting stocks of the acquirer. A broader definition of a Type D tax-free reorganization is introduced, which resembles the US tax code in many aspects, facilitating the separation of businesses among stockholders with mechanisms such as splitoff, split-up, and spinoff (i.e., divisive reorganizations). 5 March 1, 2011
Comprehensive new guidelines are introduced concerning transfers of tax attributes (for example, NOLs, earnings and profits, and accounting methods) to an acquiring corporation upon the acquisition of assets in another corporation. New guidelines similar to those in Section 382 of the US tax code are introduced limiting the use of NOLs when certain changes in ownership occur. gross income threshold for purposes of the audited financial statement requirement should be made taking into consideration the volume of business of all the entities within a controlled group. In the case of foreign entities, these will be able to submit audited financial statements with their PR operations on a stand-alone basis; in other words, the CFS will not be required. The requirement for audited financial statements will not apply to non-for-profit organizations. Withholding of tax at source The withholding tax at source for payment of services rendered in PR continues to be 7%. However, at the option of the service provider, the withholding agent could increase such withholding to 10% or 15%. Audited financial statements Taxpayers with a volume of business of $3 million or more are required to submit with their tax return financial statements audited by a certified public accountant with license to practice in PR (PR CPA) in accordance with Generally Accepted Auditing Standards (US GAAS). Qualified and disclaimer opinions will be allowed to the extent that the qualification or disclaimer does not result from a restriction in scope. No adverse opinions will be allowed. Taxpayers with a volume of business between $1 million and $3 million may choose to attach to the tax return financial statements audited by a PR CPA in accordance with US GAAS to obtain a Total Waiver Certificate for Withholding of tax at source on services rendered (i.e., 7% withholding), provided the company is in good standing with the PR Treasury. Sales and use tax (SUT) The New Tax Code provides for a credit for purchases of products manufactured in PR for purposes of SUT. In general, the credit will be 10% of the excess of the purchases of eligible products over the average of the purchases of eligible products for three out of 10 prior taxable years. This credit could be carried forward until exhausted. Is important to note that the credit used will be considered taxable income for income tax purposes of the year the credit is taken. PwC observation: The inclusion of the SUT credit as taxable income may result in a reduction of the tax benefit of said credit from 10% to 7% for taxpayers subject to the maximum income tax rate of nearly 30%. Gift and estate taxation The New Tax Code increases from $400,000 to $1 million the standard deduction for estates. All groups of related entities engaged in a trade or business in PR are required to file consolidated financial statements (CFS), which should contain a consolidating schedule, also subject to audit procedures, with columns showing the financial position and the result of operations of the parent company and each of the subsidiaries. Said schedule should also contain the eliminating entries and the consolidated balance sheet. The determination of the 6 March 1, 2011
For more detailed information, please do not hesitate to contact: Tax Partners Víctor R. Rodríguez, 787-772-7958 victor.rodriguez@us.pwc.com Jorge Morazzani, 703-918-3684 jorge.morazzani@us.pwc.com Managing Director Héctor Bernier, 787-772-8035 hector.bernier@us.pwc.com Tax Directors Denisse Flores, 787 772-7569 denisse.flores@us.pwc.com Darycel Collazo, 787-772-7593 darycel.collazo.@us.pwc.com José Osorio, 787-772-8057 jose.osorio@us.pwc.com Berenice Matos, 787-772-8005 berenice.matos@us.pwc.com Tax Managers Viviana Aguilú, 787-772-8039 viviana.aguilu@us.pwc.com José Erba, 787-772-7597 jose.erba@us.pwc.com Eyla Marquez, 787-772-8028 lydia.e.marquez@us.pwc.com Jessica Bonilla, 787-772-8027 jessica.bonilla@us.pwc.com This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding U.S. Federal, state or local tax penalties. This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PwC its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. 2010 PricewaterhouseCoopers LLP. All rights reserved. PricewaterhouseCoopers refers to PricewaterhouseCoopers LLP (a Delaware limited liability partnership) or, as the context requires, the PricewaterhouseCoopers global network or other member firms of the network, each of which is a separate and independent legal entity. 7 March 1, 2011