Puerto Rico Opportunity Zone Funds: The Last Frontier
INSIGHT ARTICLE |
On May 14, 2019, Puerto Rico became one the first jurisdictions of the United States to sign a state bill to complement the Qualified Opportunity Zone (QOZ) laws introduced by the Tax Cuts and Job Act of 2017 (TCJA). Puerto Rico’s act, denominated as the “Puerto Rico Opportunity Zone Development Act of 2019”, was introduced to address some of the concerns that investors expressed for the tax treatment of capital gains generated from an investment in a Qualified Opportunity Fund (QOF) located in Puerto Rico. This is significant in that most of the provisions of the US Internal Revenue Code of 1986, as amended (the US Code), consider Puerto Rico a foreign jurisdiction. On July 1, 2019, the Governor of Puerto Rico signed into law the Incentives Code of Puerto Rico, which resulted in a comprehensive codification of incentives laws in Puerto Rico, including the Puerto Rico Opportunity Zone Development Act of 2019.
TCJA special rule for Puerto Rico
The TCJA introduced sections 1400Z-1 and 1400Z-2 into the US Code to designate certain socially and economically distressed urban, suburban, and rural areas of the United States as QOZs. Through section 1400Z-1, the TCJA created a special rule for Puerto Rico, which expressly states that every designated census tract low-income community in Puerto Rico will be deemed a QOZ. Subsequent to the TCJA, 26 additional low-income census tracts were added to the now more than 850 communities that qualify as a QOZ, which make up almost ninety-five percent of Puerto Rico. The Incentives Code of Puerto Rico (the Incentives Code), was enacted to clarify how an investment in one of the above Puerto Rican QOZs would be taxed by the Puerto Rico Treasury Department (the PRTD), the island’s taxation authority.
Incentives code of Puerto Rico
The Puerto Rico Opportunity Zone Development section of the Incentives Code was introduced for the purpose of addressing investor questions, as well as creating a combination of favorable tax rates and expedited permit processes to encourage investment in the island. These favorable tax rates include income, real and personal property, municipal tax exemptions, and transferable tax credits. At its core, the Incentives Code provides additional benefits that the investor would not have available if forming a QOF in the US. The following discussion shows some of the key elements for establishing a proper QOF in Puerto Rico, and the applicable benefits in light of the above legislation.
Pursuant to the Incentives Code, any natural or juridical person that makes an eligible investment is considered an “investor” in a Puerto Rico Qualified Opportunity Fund (PR QOF). Therefore, no limitation in that sense is provided by the Incentives Code, since it allows for the fact that the character of the investor can be represented by either a PR resident, a US resident, or a nonresident alien (all considered residents or non-residents for tax purposes, under the bona fide residency rules of PR or US). Because business entities can also be considered investors, PR and US entities, such as corporations, partnerships, estates and trusts can invest in a PR QOF.
Puerto Rico Qualified Opportunity Zone Fund
In order to benefit from this law, a PR QOF must be established. As a requirement, the PR QOF must be a legal entity organized in Puerto Rico. If the entity is organized as a partnership, it will be considered a corporation for tax purposes. Such fund must comply at all times with the provisions of sections 1400Z-1 and 1400Z-2 of the US Code. This implies that the fund will not need to request an approval from the Internal Revenue Service (IRS) in order to be considered a QOF, but it will need to meet the requirements as detailed in the Internal Revenue Code and proposed Treasury Regulations. Please see our previous articles here and here, as well as our QOZ resource center for more information.
Once a PR QOF is established, generally the investor must contribute its US or PR generated capital gain into the PR QOF within 180 days of realizing the gain. If the investment in the PR QOF is held for at least ten years, the basis in the QOF investment is stepped up to its fair market value at that time, essentially eliminating the tax on the additional appreciation during the QOF investment. As to the original capital gain, if held as an investment in the PR QOF for at least five years, the investor will be able to increase its basis by ten percent. If held for at least seven years, the investor will be able to increase it by another five percent for a total of fifteen percent basis increase and exclusion from gain.
The next step in the process would be for the QOF to engage in operating a business, which can be directly performed by the QOF, or through an Exempt Business. If a PR QOF directly operates the business, it will be subject to the limitation of the ninety percent asset test. In contrast, if establishing an Exempt Business below the QOF, the Exempt Business will be subject to the seventy percent tangible property test. Therefore, through establishing an exempt business under the fund, the fund will be subject to a more flexible structure, fundamentally decreasing its minimum threshold for assets inside the QOZ to sixty-three percent. In order to establish the exempt business, a second Puerto Rico legal entity must be formed. A PR QOF will need to contribute the capital gain that it received from the investor into the exempt business, in exchange for stock or participation. The exempt business will be taxed as a corporation, if organized as a partnership. The Exempt Business will be able to operate a priority project, which will consist of industries, businesses, or other activities for the production of income that will contribute to the diversification, recovery, or social and economic transformation of the community. In an effort to identify which projects may fall under such criteria, the PR Government will issue a priority projects list, which will contain commercial activities or eligible businesses per geographical areas that are eligible for expedited permits and evaluation processes.
On Aug. 19, 2019, the Committee of Priority Projects in Opportunity Zones approved and adopted the initial Priority Projects, which consisted of: (1) development of residential real property in a low-income housing project, (2) development of residential and/or commercial real property for sale or rent, (3) development of industrial real property for sale or rent, and (4) substantial improvement of an existing commercial property for sale or rent. In order to enjoy the benefits of the Incentives Code, a business must obtain a Tax Exemption Grant (“the Grant”), issued by the Office of Industrial Tax Exemption (the OITE), an office subscribed to the Puerto Rico Department of Economic Development and Commerce (the DDEC). The Grant will be valid for a term of fifteen years, and throughout the Grant, the exempt business will be able to benefit from a flexible tax exemption. This flexible tax exemption provides the grantee the ability to choose for which taxable years it wishes to apply the benefits of the Grant (subject to certain informative requirements). As part of the benefits, the income of an exempt business will be taxed at an eighteen and a half percent rate, which is significantly lower than the regular corporation rate (up to thirty seven and one half percent). Additionally, dividends distributed from the net income of QOZ operations of an exempt business will be completely tax exempt, without losing its tax exempt characterization after being distributed to the PR QOF.
Besides granting benefits at the state level, the Incentives Code also provides benefits at the municipal level. Exempt businesses will enjoy a twenty-five percent exemption on the municipal license tax, the real property tax, and the personal property tax. Furthermore, the Incentives Code grants the municipalities of Puerto Rico the authority to increase these twenty-five percent exemptions up to seventy-five percent through the issuing of municipal ordinances. An exemption of twenty-five percent on construction excise taxes is also available.
For tax return purposes, the exempt business will be able to claim a net operating loss (NOL) deduction of a priority project against the income of other priority projects when both priority projects are inside a QOZ and are owned by the same exempt business. While the tax exemption grant is valid, the sale or exchange of assets used in the operations of the exempt business will not be subject to capital gains if the entity reinvests such proceeds in the purchase of other assets for the exempt business. Moreover, the Incentives Code does not impose a requirement for the minimum number of employees that must be hired by the exempt business. Importantly, an Incentive Code Exempt Business Grant under the Puerto Rico QOZ provisions can’t be combined with other Puerto Rico Tax Exemption Grants. However, investors that comply with the requirements of being a bona fide resident of Puerto Rico for tax purposes can possess a tax exemption grant under Act 22-2012 (Act to Promote the Relocation of Individual Investors to Puerto Rico) , and benefit from a PR QOF structure.
One of the most attractive features of the PR QOZ provisions is that it provides a tax credit of up to twenty-five percent of the investment to the investor, which can be sold or transferred. Moreover, the income from the sale of the tax credit will be completely tax exempt. The Incentives Code allows for the sale of such credits to broker-dealers or underwriters as well. Additionally, the Incentives Code exempts from income tax and municipal license tax all income earned from the issuance of bonds, notes, or loans directly with the exempt business for the development, construction, rehabilitation or improvement of the exempt business.
Lastly, the Incentives Code provides a favorable tax rate of eighteen and a half percent for the withholding of tax payments issued by the exempt business to a foreign entity not engaged in a trade or business in PR. When compared to the regular withholding rate of twenty-nine percent applicable to such businesses, this results in a favorable tax scenario for US licensors of intellectual property that are not interested in establishing operations in the Island.
PR when compared to the U.S.
As stated through this article, the Puerto Rico QOZ provisions of the Incentives Code were enacted for the purpose of providing Puerto Rico an opportunity to compete with the states and attract capital and investment to its underdeveloped cities. Because the vast majority of the land in Puerto Rico is considered a QOZ, Puerto Rico provides a wide array of investment options and opportunities for investors looking to diversify their portfolio. Furthermore, investors willing to relocate to Puerto Rico and become bona fide residents can create even greater benefits from the interplay with the Act 22-2012 Grant. This combination will allow investors to establish a tax structure which exempts them from taxation on the Puerto Rico sourced capital gains, interests and dividends, and can also provide benefits intended to cover active income through the exempt business. In addition, addressing Puerto Rico’s specific needs of housing for the underprivileged and elderly population could represent opportunities for historically underperforming industries, such as construction. As it already has in the United States, the Puerto Rico QOZ provisions have the potential to benefit underserved communities and provide return on investment as it never has before.
 Pub. L. No. 115-97 Act 21 of May 14, 2019 (later repealed by Act 60 of July 1, 2019) 26 U.S.C § 1 2019LPR60 (not yet codified at the date of publishing of this Article) 26 U.S.C. § 1400Z-1 - Z-2 26 U.S.C. § 1400Z-1(b)(3) 2019LPR60, Section 6070.54(a)(17) 2019LPR60, Section 6070.56(b)(2) 2019LPR60, Section 6070.55(a)(16),(20)-(21) 2019LPR60, Section 6070.56 (b) 2019LPR60, Section 6070.55(a)(23) 2019LPR60, Section 6070.60(a) Resolution 19-01 of the Committee of Priority Projects in Opportunity Zones 2019LPR60, Section 6070.60(a)(3)(A) 2019LPR60, Section 6070.59(a) 2019LPR60, Section 6070.56(a) 2019LPR60, Section 6070.56(e) 2019LPR60, Section 6070.58(a) 2019LPR60, Section 6070.57(a)(1) 2019LPR60, Section 6070.58(d) 13 L.P.R.A. § 10851(a)(30
This article was authored by Gerardo Santiago of RSM Puerto Rico, a member of the RSM International network.