The Commonwealth of Puerto Rico (the “Commonwealth”) imposes an income tax on the taxable income of individuals and corporations. Taxable income, however, does not include interest on obligations issued by the Commonwealth or instrumentalities or political subdivisions thereof, such as the Puerto Rico Industrial, Tourist, Educational, Media, and Environmental Control Facilities Financing Authority, an affiliate of the Government Development Bank for Puerto Rico (AFICA). In addition, interest on bonds issued by the Commonwealth or such instrumentalities or subdivisions is not subject to income taxation by any other state or territory of the United States. The exemption from Commonwealth, all other state or territory and federal income taxes is often referred to as triple tax exemption.
Puerto Rico’s constitutional status is that of a territory of the United States, and, pursuant to the territorial clause of the U.S. Constitution, the ultimate source of power over Puerto Rico is the U.S. Congress. The relationship between the United States and Puerto Rico is referred to as commonwealth status.
The people of Puerto Rico are citizens of the United States but do not vote in national elections. They are represented in Congress by a Resident Commissioner who has a voice in the House of Representatives but no vote (except in House committees and sub-committees to which he belongs).
Most federal taxes, except those such as Social Security taxes, are not levied in Puerto Rico. No federal income tax is collected from Puerto Rico residents on income earned in Puerto Rico, except for certain federal employees who are subject to taxes on their salaries. Income earned by Puerto Rico residents from sources outside of Puerto Rico, however, is subject to federal income tax.
The Constitution of Puerto Rico limits the amount of general obligation debt that the Commonwealth can issue. Fiscal responsibility for the Commonwealth is shared among the Department of the Treasury, the Office of Management and Budget, and the Government Development Bank for Puerto Rico.
Commonwealth Income Tax:
Only certain Puerto Ricans are required to pay federal income taxes. Income derived from sources within Puerto Rico by an individual who is a bona fide resident of Puerto Rico for an entire taxable year generally is excludable from gross income for federal income tax purposes, even if the resident is considered a U.S. citizen. Puerto Ricans are required to pay federal income tax on income earned outside of Puerto Rico or if they are employees of the federal government. (See I.R.C. 933. See also An Overview of the Special Tax Rules Related to Puerto Rico and an Analysis of the Tax and Economic Policy Implications of Recent Legislative Options, JCX-24-06 (Jun. 23, 2006).)
The Commonwealth imposes a separate income tax in lieu of the federal income tax under the recently implemented “Internal Revenue Code for a New Puerto Rico” (the “P.R. Code”). The regular tax rate applicable in 2013 for individuals ranges from 0% (up to the first $9,000 in net taxable income) to 33% (for net taxable income in excess of $61,500) on taxable income considering worldwide income. Deductions and exemptions are available. Similar to the federal regime for foreign source income, nonresidents of the Commonwealth are taxed only on their income from sources within Puerto Rico or income effectively connected with the conduct of trade or business within Puerto Rico. P.R. Code § 1021. The P.R. Code imposes a corporate “normal” tax of 20% of the net income subject to normal tax plus a “surtax” that ranges from 5% to 10% in 2013 on net income that is subject to the surtax. P.R. Code § 1022.
Exemption from Income Tax:
Gross income for purposes of calculating taxable income under the P.R. Code excludes interest on “the obligations of the Government of Puerto Rico or any instrumentality or political subdivision thereof.” Section 1031.02(a)(3)(B) of the Internal Revenue Code for a New Puerto Rico, Act No. 1-2011 of the Legislature of Puerto Rico, approved January 31, 2011, as amended. This exemption also extends to interest on bonds issued by AFICA, which is an instrumentality of the Commonwealth.
AFICA, an affiliate of the Puerto Rico Government Development Bank (GDB), is a public corporation created under Act 121 of the Legislature of Puerto Rico, adopted on June 27, 1977, and is empowered under Section 1255(l) of Title 12 of the Laws of PuertoRico to “issue bonds of the Authority in evidence thereof for the purpose of providing funds to pay for all or any part of the cost of one or more projects and any refinancing bonds.” AFICA serves as conduit issuer of private activity revenue bonds to finance the acquisition, construction and equipping of industrial, tourist, medical, educational, pollution control and solid waste disposal facilities.
GDB is a public corporation of the Commonwealth of Puerto Rico that is governed by a seven-member board of directors appointed by the Governor of the Commonwealth with advice and consent of the Commonwealth’s Council of Secretaries. GDB serves as fiscal agent and financial advisor to the Commonwealth and its agencies and municipalities, as lender to public and private sectors, and as depository of Commonwealth funds.
Bonds issued by AFICA are special and limited obligations of the authority and, except to the extent payable from bond proceeds and investments thereof, are payable solely from and secured by a pledge and assignment of the amounts receivable under the loan agreements between AFICA and the conduit borrowers. AFICA imposes a placement fee which, according to the authority’s 2011 audit, generally represents one percent of the face value of the bonds issues, except for bonds issued to finance educational, medical or environmental control facilities or other projects otherwise eligible to be financed in the tax-exempt bond market, for which the placement fee is one half of one percent. AFICA has issued over $6 billion in revenue bonds.
An offering document for AFICA’s recently issued “Higher Education Revenue and Revenue Refunding Bonds, Series 2012 (University of the Sacred Heart Project)” describes the Commonwealth income tax exemption as follows: “In the opinion of [Bond Counsel], under existing law […] the Series 2012 Bonds and the interest thereon are exempt from state, Commonwealth of Puerto Rico and local income taxation.”
In addition to referencing exemption for purposes of Commonwealth income tax (and, of course, exemption from federal income tax), the opinion statement refers to exemption from state income taxation (and therefore opines as to the “triple tax exempt” character of the bonds). Exemption from state income taxation is mandated under 48 U.S.C. 745, which provides that “all bonds issued by the Government of Puerto Rico, or by its authority, shall be exempt from taxation by the Government of the United States, or by the Government of Puerto Rico or of any political or municipal subdivision thereof, or by any State, Territory, or possession, or by any county, municipality, or other municipal subdivision of any State, Territory, or possession of the United States, or by the District of Columbia.”
Puerto Rico tax discussion:
Interest is also exempt under Section 1022.04(b)(2) of the P.R. Code from the “adjusted net book income” of a corporation for purposes of computing the alternative minimum tax imposed by Section 1022.03(a) of the P.R. Code.
Interest is also exempt from the Puerto Rico alternative basic tax under Section 1021.02(a)(2) of the P.R. Code.
Interest is also exempt from Puerto Rico municipal license taxes under Section 9(25) of the Puerto Rico Municipal License Tax Act of 1974, as amended.
The Bonds are exempt from Puerto Rico personal property tax pursuant to Section 3.11 of the Puerto Rico Municipal Property Tax Act of 1991, as amended, and Section 3 of the Puerto Rican Federal Relations Act.
The Bonds will be considered an obligation of an instrumentality of Puerto Rico for purposes of: (a) the non-recognition of gain rules under Section 1034.04(f)(2)(A) of the P.R. Code applicable to certain involuntary conversions; and (b) the exemption from the surtax imposed by Section 1022.05 of the P.R. Code available to corporations that have a certain percentage of their net income invested in obligations of instrumentalities of Puerto Rico and certain other investments pursuant to Section 1022.05(g) of the P.R. Code.
Interest on the Bonds constitutes industrial development income under Section 2(j) of the Economic Incentives for the Development of Puerto Rico Act, or under analogous provisions of similar prior acts, when received by a holder of a grant of tax exemption issued under any of the Acts that acquired the Bonds with eligible funds, as such term is defined in the Acts.
Gain recognized from the sale or exchange of the Bonds will be subject to income tax under the P.R. Code to taxpayers subject to Puerto Rico income tax on such gains, including individuals residing in Puerto Rico and corporations organized under the laws of Puerto Rico.
The P.R. Code does not contain any provisions regarding the treatment of original issue discount. However, under the administrative practice followed by the Treasury Department with respect to the repealed Puerto Rico Internal Revenue Code of 1994, original issue discount was treated as interest.
U.S. Tax Discussion:
Interest or OID on the Bonds owned by an individual is excludable from the gross income of the individual for United States federal income tax purposes under Section 933 of the U.S. Code if (a) the individual is a bona fide resident of Puerto Rico during the entire taxable year in which such interest or OID is to be recognized for purposes of the U.S. Code, and (b) such interest or OID is not, and is not treated as, income effectively connected with, or attributable to, the conduct of a trade or business within the United States by such individual under the U.S. Code. In addition, for U.S. federal income tax purposes, no deduction or credit will be allowed that is allocable to or chargeable against amounts so excluded from the Puerto Rico individual’s gross income.
Interest or OID on the Bonds derived by a corporation organized under the laws of Puerto Rico or by any foreign corporation for purposes of the U.S. Code is not subject to United States federal income tax under the U.S. Code if: (a) such interest or OID is not, and is not treated as, income effectively connected with, or attributable to, the conduct of a trade or business in the United States by such corporation under the U.S. Code; (b) such corporation is not a controlled foreign corporation or a passive foreign investment company under the U.S. Code; and (c) such corporation is not treated as a domestic corporation for purposes of the U.S. Code.
United States taxpayers, other than individuals who comply with the requirements set forth below, may be subject to federal income tax on any gain realized upon sale of the bonds. Pursuant to Notice 89-40, and the regulations issued under Section 937 of the U.S. Code, the gain from the sale of the Bonds by an individual who is a bona fide resident of Puerto Rico will constitute Puerto Rico source income, and therefore will qualify for exclusion from gross income under Section 933 of the U.S. Code, provided (a) the Bonds do not constitute inventory in the hands of such individual, (b) such gain is not attributable to an office or fixed place of business of the individual located outside of Puerto Rico and (c) the individual has been a bona fide resident of Puerto Rico for the shorter of (1) the full period during which the individual has owned the Bonds or (2) each of the ten years preceding the year of the sale. In the case the individual is a bona fide resident of Puerto Rico for the tax year for which the source of income must be determined and the individual was a United States citizen or resident (other than a bona fide resident of Puerto Rico) for any of the ten years preceding said year, the individual may elect to treat as gain from sources within Puerto Rico the portion of the gain attributable to the individual’s holding period in Puerto Rico.
Puerto Rico corporations generally will not be subject to income or withholding tax under the U.S. Code on gain recognized on the sale or exchange of the Bonds, unless the gain is effectively connected, or treated as effectively connected, with the conduct by the Puerto Rico corporation of a trade or business in the United States.