Earlier this year, the Large Business and International Division of the IRS announced the initiation of a campaign targeting taxpayers who have taken advantage of tax incentives under Puerto Rico Act 22, “Act to Promote the Relocation of Individual Investors to Puerto Rico”, (now part of Act 60). The IRS’s selection of Act 22 tax benefits as the target for such a campaign indicates that the IRS has identified significant noncompliance and abuse related to the Puerto Rican tax incentives. This campaign appears well underway. The IRS has already sent information requests to individuals that have taken advantage of the tax benefits and incentives available to newly relocated Puerto Rican residents. According to recent statements in September of 2021 by the Secretary of the Department of Finance of Puerto Rico, Francisco Pares Alicea, and John Siddons of IRS criminal investigations, more than 20 IRS agents and accountants are on the island collaborating with the Puerto Rican government to identify cases of tax evasion.
The Puerto Rican tax incentives have captured much interest recently. The widespread adoption of remote work in many industries such as finance, law, marketing, and others has made it possible for many more working individuals and businesses to move their lives and operations to Puerto Rico. Recent high-profile controversies and news stories have sensationalized the topic of Puerto Rican tax incentives. For example, recent articles have highlighted how high profile and plaintiffs’ attorneys have embraced these incentives and moved their operations to Puerto Rico. Other controversial figures, including hedge fund managers and cryptocurrency barons, have taken advantage of the favorable tax treatment arising from relocating to Puerto Rico for many years now.
The unveiling of the IRS campaign has only added to the intrigue of the Puerto Rican tax incentives, leaving many interested taxpayers wondering if they should abandon their plans to take advantage of them. However, the US and Puerto Rican tax benefits for bona fide residents of Puerto Rico remain available, and careful attention and adherence to the various requirements under Puerto Rican and US tax laws should minimize the risk of facing a dispute with the IRS.
The following discussion summarizes the tax incentives and benefits available to US citizens and residents that relocate to Puerto Rico, discusses the implications of the IRS’ campaign targeting taxpayers utilizing Act 22 benefits, and describes the issues related to the US tax benefits for Puerto Rican resident investors that the IRS will likely target.
Background of the tax rules and incentive programs in Puerto Rico
Establishing residence in Puerto Rico may yield significant tax benefits to US citizens and residents. Generally, section 933 of the Internal Revenue Code exempts from US taxation income derived from sources within Puerto Rico for bona fide residents of Puerto Rico. To qualify as a bona fide resident, a taxpayer must meet the requirements of section 937 (discussed in more detail below). The purpose of the exemption under section 933 is to give Puerto Rico the primary jurisdiction to tax the income of its residents on Puerto Rico sourced income. Therefore, the exemption only results in a reduction of tax liability if Puerto Rico imposes lower taxes. Indeed, Puerto Rico offers generous incentives to US citizens, residents and businesses who relocate to Puerto Rico and to non-U.S. persons as well.
Newly relocated residents of Puerto Rico enjoy several tax incentives intended to encourage people to move to Puerto Rico and boost the local economy. Puerto Rico Act 22 (now part of Act 60) exempts from taxation certain investment income of recently relocated Puerto Rican residents. Act 22 provides new residents an exemption from taxation on interest and dividends from Puerto Rican sources and on capital gains earned after the taxpayer relocates. Additionally, Act 20 (also incorporated into Act 60) significantly reduces the tax rate for businesses that export goods or services outside of Puerto Rico to 4%, from the ordinary 37.5% corporate tax rate in Puerto Rico. Both tax incentives on their own are quite favorable and when combined can result in significant tax savings. For now, the current IRS campaign focuses on individual investors that claim benefits through Act 22.
Perceived abuses addressed by the campaign
While the campaign does signal higher scrutiny of those who take advantage of the tax incentives under Act 22, it does not signify that the Puerto Rican tax incentives are illegal or per se abusive from a US tax standpoint. The benefits under Act 22 and the US tax exemption under section 933 remain available to US taxpayers that can meet the specific qualification requirements. Rather, the campaign appears directed to noncompliance for the following reasons: 1) failure to qualify for the bona fide residency requirements of section 937 and 2) incorrect application of the income exclusion to income that is not covered by the exclusion under section 933.
The bona fide residence tests require the taxpayer to meet the following conditions: (i) the taxpayer must be physically present in Puerto Rico for at least 183 days; (ii) the taxpayer must have no tax home outside of Puerto Rico; and (iii) the taxpayer must not have a closer connection to the United States or other foreign country. The bona fide residence test is not an easily applied bright line test. Bona fide residence qualification depends on all facts and circumstances of an individual’s personal activities and business dealings. The IRS campaign will focus on taxpayers that claim the exemption under section 933 but do not meet the qualification tests to be bona fide residents of Puerto Rico. Notably, taxpayers that claim these benefits but maintain significant ties to the United States should be prepared to support their positions in case the IRS sends any inquiries or initiates an examination.
Additionally, the exemption under section 933 applies only to certain income sourced to Puerto Rico. Bona fide residence in Puerto Rico will cause much income, including capital gains, to be sourced to Puerto Rico and exempt from US taxation. However, this provision is not a blanket exemption from US income tax. For example, US sourced dividends and income connected with a business in the United States is subject to US taxation, and section 933 does not exempt such US source income, nor does it exempt income that is from non-U.S. or non-Puerto Rico sources (e.g., from European sources). The recent IRS campaign aims to promote the proper reporting and payment of taxes on income from non-Puerto Rico sources.
What to expect from the announced campaign
A formal campaign focuses IRS resources on a specific issue and involves a systematic approach to targeting identified areas of noncompliance and lost revenues. As part of the campaign, the IRS has already begun gathering the names of US citizens and residents who have availed themselves of the section 933 exemption. The IRS can identify these taxpayers by reviewing federal returns that have excluded income under section 933 and through information sharing with the Puerto Rican Department of Treasury. The IRS may send notices to the taxpayers identified in the campaign to encourage some to correct any non-compliance voluntarily. The IRS has already begun requesting information from individuals that fall within the scope of the campaign. After collecting this information, the IRS will likely initiate formal audits.
State taxes and continuing domicile are also a concern for many newly relocated Puerto Rican residents
Individuals relocating to Puerto Rico to take advantage of the tax incentives should also consider the state tax residency laws of the state from which they are moving. State laws establish jurisdiction to tax based on the individual’s domicile, which is where the individual intends to remain indefinitely based on all the facts and circumstances. Establishing residency in Puerto Rico for federal tax purposes may not change a taxpayer’s original state domicile. State taxing authorities do challenge changes in residency, especially when taxpayers relocate with the sole intent to reduce tax liabilities. Therefore, state taxes are an important consideration when planning a move to Puerto Rico.
US taxpayers that have taken advantage of the Puerto Rican tax incentives should evaluate their positions and ensure that they have met the bona fide residence test and that they have only excluded the income covered by the exemption. In some cases, the taxpayer may want to proactively correct any non-compliance. Additionally, anyone seeking to relocate to Puerto Rico should address tax compliance in their planning. The new IRS campaign in this area underscores the importance of developing and maintaining documentation to support the taxpayer’s claim of Puerto Rican residency more than ever.