Budget Proposal Is Potential Blow for Puerto Rico

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A proposal in President Obama's budget to impose a minimum tax on U.S.-controlled foreign income may curb investment in Puerto Rico as the commonwealth struggles to spur economic growth and improve its finances.

"Any potential change in the current tax regime on foreign corporations will affect Puerto Rico's competitiveness in the manufacturing sector," and "could undermine the island's economic recovery," said Gustavo Vélez, chairman of Inteligencia Econ-mica, a consultancy based in Puerto Rico.

The proposal, which is aimed at producing revenue for an increase in infrastructure spending in the U.S., would impose a 19% minimum tax on controlled foreign corporations operating outside the country. It would also apply a 14% tax effective on money already earned and still held overseas. Money taxed under the proposal wouldn't be subject to further U.S. taxes. Under section 901 of the current United States tax code, a subsidiary of a U.S.-based corporation doesn't have to pay taxes to the Treasury unless the subsidiary's profits are repatriated to a location in one of the 50 states. This is true for subsidiaries in Puerto Rico.

American companies have used this aspect of the law as a tax-avoidance strategy in Puerto Rico, which as a non-state U.S. territory falls under those rules. The Puerto Rican government has offered American companies long-term deals in which they pay far less than the 35% U.S. corporate tax rate in return for bringing economic activity to the territory, which has about $73 billion of public debt outstanding. While Puerto Rico was generally considered a foreign land for tax purposes, until 2005 section 936 of the federal code allowed U.S. corporations to bring income from Puerto Rico to the 50 states tax free.

Puerto Rico's current economic difficulties can be traced by to decision by Pres. Bill Clinton in 1995, observers have said. In that year Clinton enacted an end to 936 with a 10-year sunset. In 2005 Puerto Rico's growth rate started to shrink and the economy went into a recession in 2007. The loss of 936 led many labor intensive manufacturers to shift their operations to elsewhere in Latin America from Puerto Rico, Velez said.

Some of the capital-intensive manufacturers, like pharmaceutical and medical device manufacturers, chose to keep operating in Puerto Rico. Revoking section 901 could halt investment by such companies, Vélez said. Some of the companies currently located in the commonwealth may choose to move elsewhere. In the short-term it would hurt Puerto Rico's manufacturing sector, which represents 44% of its gross domestic product, Vélez said. However, theimpact of Obama's proposal wouldn't be as severe as the loss of 936, Velez said. There are about 76,000 employees in the island's manufacturing sector. They have an average wage of $50,000, compared to an average salary of $27,000 on the island. While the U.S. Bureau of Labor Statistics said 928,000 people held jobs in Puerto Rico in December, many economists said the actual employment level is significantly higher because many work "off-the-books" in Puerto Rico.

In recent years Puerto Rico's government has placed a tax on foreign corporations' repatriation of profits from island-based subsidiaries. Act 154 accounts for 20% of anticipated revenue for the General Fund, Velez said. If the U.S. government increases its own taxes on these transfers, there may less of this sort of economic activity in Puerto Rico, and that could reduce Act 154 revenues, he said.

Obama's tax proposal would definitely be a negative for Puerto Rico, if passed, said Municipal Market Advisors managing director Robert Donahue.

A Washington-based lobbyist familiar with the Obama proposal said that it represents the most specific proposal the White House has ever floated along these lines. Former Rep. Dave Camp, R-Mich. and former Sen. Max Baucus, D-Mont., have in the past proposed taxing the foreign income of companies headquartered in the U.S. as part of larger tax reform proposals that have ultimately failed to come together.

The 19% rate going forward would be reduced by 85% of the foreign effective tax rate and is meant to be a minimum rate. Puerto Rico could theoretically raise its own corporate tax in response so that the 19% goes primarily into its own coffers the lobbyist said, but has backed itself into a corner because of the contracts it has signed with many U.S. corporations promising to keep rates low.

The lobbyist said that comprehensive tax reform could sputter again, but that this proposal represents "a trend of international tax policy" that is being adopted by other developed countries. Whenever Democrats and Republicans do come together on tax reform, the lobbyist said, this issue will be on the table.

"I think it's very likely you'll see something along these lines," the lobbyist said.

Gov. Alejandro García Padilla's chief of staff, Victor Suárez said in an email the administration is evaluating the proposal and would take steps as needed to ensure that Puerto Rico isn't "disadvantaged."

"In recent months, I have spoken about this issue with senior officials in the Obama administration and with leaders of the House Ways and Means Committee and the Senate Finance Committee," said Pedro Pierluisi, Puerto Rico's nonvoting representative in Congress. "They understand that Puerto Rico is a U.S. jurisdiction and that jobs in Puerto Rico are American jobs.  I am confident that, if comprehensive tax reform legislation is enacted this Congress or in a subsequent Congress, Puerto Rico will be treated in a fair and thoughtful manner."

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