Puerto Rico - The New Tax Haven

Puerto Rico is an unincorporated territory of the United States. It has a special relationship with the United States. Puerto Rico has U.S. citizenship for its residents, but has its own Olympic team and a tax system that allows individuals and companies to avoid paying U.S. income taxes.

Puerto Ricans were granted U.S. citizenship in 1917. Since 1948 they have elected their own governor. Puerto Rican citizens may not vote in U.S. presidential elections because the territory is not a state.

A democratically elected bicameral legislature is in place but the United States Congress legislates many fundamental aspects of Puerto Rican life. Specifically, the Foraker Act of 1900 extended all U.S. laws "not locally inapplicable" to Puerto Rico, and specifically exempted citizens of Puerto Rico from compliance with U.S. Internal Revenue laws.

On January 17, 2012, the Puerto Rican legislature enacted Act 22, "The Act to Promote the Transfer of Investors to Puerto Rico." Act 22 has generally eliminated the taxation for new residents on Puerto Rican-sourced passive or investment income. The law exempts new residents from the island's already small 10% capital gains tax. Thus, Puerto Rico now offers the ability to eliminate (or substantially reduce) new residents' federal income tax on certain income and eliminate any state taxation without giving up their U.S. citizenship.

The theory of the new law is to incentivize people who are not already residents of Puerto Rico to become residents. To incentivize them, the act exempts these individuals who become residents from income tax on their interest and dividend, income and certain long term capital gains from the sale or exchange of securities.

The territory's leaders are trying to lure mainland residents such as hedge-fund billionaire John Paulson. Moving to Puerto Rico could allow Paulson and other high income taxpayers to shelter income from the U.S. income tax (and state income taxes) without giving up their passports. Puerto Rico is a four-hour flight from New York City, has a nice climate, and as one commentator put it, doesn't have another obvious strategy for economic growth.

To be considered a resident for these purposes, you must spend at least 183 days per year in Puerto Rico. New immigrants who have not lived in Puerto Rico in the previous 15 years may be exempt from US taxes on capital gains accrued after they move there in addition to income derived from Puerto Rican domiciled businesses. To qualify, the person must prove they have substantial family and social connections on the island. Any person who moves to the island signs a contract with the Puerto Rican government that guarantees the tax break through Dec. 31, 2035.

"In addition to the ten wealthy individuals who have already relocated to Puerto Rico to take advantage of the new laws," reports Bloomberg., "Forty more are currently talking to the government about moving and have brought their families to look at housing and schools," said Alberto Baco Bague, Secretary of Economic Development and Commerce of Puerto Rico. "About 35 percent are hedge-fund managers," he added.

"Puerto Rico, eager for economic growth, is making an unusually direct pitch to wealthy Americans that risks a political backlash from Congress," said John Buckley, a former tax counsel for Democrats on the House Ways and Means Committee. "They're walking a fine line," Buckley said. "This would be the first time that Puerto Rico would kind of deliberately erode the U.S. tax base for individuals."

Under the new law, interest and dividend income from all sources is exempt from Puerto Rico income tax (including the alternative basic tax). The interest and dividend income will also be exempt from United States federal income tax, but only if it constitutes Puerto Rico source income. Generally, interest and dividends paid by corporations organized under the laws of Puerto Rico constitutes income from sources within Puerto Rico. Conversely, interest and dividends from corporations organized in the United States and elsewhere outside of Puerto Rico will be exempt from Puerto Rico income tax, but will be subject to US Income tax.

The income tax exemption is also applicable to long term capital gains attributable to the increase in value of securities after the date that the individual establishes domicile in Puerto Rico. Thus, the gains recognized from securities acquired after establishing domicile in Puerto Rico will be exempt. However, gains derived from securities acquired prior to establishing domicile in Puerto Rico generally will be exemptonly to the extent that the gain is attributable to the increase in value of the securities after the individual is domiciled in Puerto Rico.

The portion of the gain attributable to the increase in value of securities prior to establishing domicile in Puerto Rico will be subject to the Puerto Rico capital gains tax rate at a reduced 5% rate.

Most importantly, the long term capital gains exempt from Puerto Rico income tax generally will also be exempt from United States federal income tax.