Can Establishing Puerto Rican Residency Avoid Subpart F and GILTI Inclusions?

As a U.S. territory, Puerto Rico can offer significant tax benefits to U.S. citizens. With proper planning, U.S. citizens establishing residency in Puerto Rico can avoid Subpart F income, and GILTI (Global Intangible Low-Taxed income) inclusions. A U.S. citizen can relocate to Puerto Rico without terminating his or her citizenship or triggering an exit tax.

An Overview of the Controlled Foreign Corporation Rules and U.S. Taxation of CFC Income

Where a foreign corporation is characterized as a “Controlled Foreign Corporation” (“CFC”), its “United States Shareholders” are taxed annually on the “Subpart F income” and “Global Intangible Low-Taxed Income” (“GILTI”) of the CFC, whether or not such earnings are distributed at the time, and on the CFC’s increased investment in certain U.S. property. A CFC is classified as a foreign corporation in which more than 50 percent of its stocks are owned (by vote or value), directly or indirectly by “United States shareholders.” Under U.S. tax law, a U.S. shareholder is a U.S. person that owns directly, indirectly, or constructively, at least ten percent of the foreign corporation by voting power or by value.

As discussed above, CFCs are taxed annually on Subpart F income and GILTI. Under Section 954 of the Internal Revenue Code, Subpart F income is defined as foreign base company income. Foreign base includes a category of income known as personal holding company income which consists of dividends, interest, royalties, rents, annuities, and net gains from certain property from the sale or exchange of the following types of property: 1) property that produces income that produces dividends, interest, royalties, rents, or annuities; 2) an interest in a trust, partnership, or real estate mortgage investment company; and 3) property that does not give rise to any income.

Subpart F income is not classified as a dividend under the Internal Revenue Code. See Notice 2004-70, 2004-2 CB 724. Therefore, Subpart F income cannot be treated as a qualified dividend and as a result, Subpart F income is taxed as ordinary income to CFC shareholders whether or not such income is distributed to its shareholders. A U.S. shareholder’s GILTI is the shareholder’s “net CFC tested income” for the tax year, less the shareholder’s “net deemed tangible income return” for the year. Net CFC tested income is generally the shareholder’s ratable share of net income or loss of all CFCs of which the individual or entity is a U.S. shareholder, less certain amounts subject to U.S. tax and net deemed tangible income return which is typically 10 percent of the shareholder’s pro rata share of the tangible depreciable property of all CFCs. In other words, GILTI typically excludes a 10 percent return on tangible assets from CFC net tested income from U.S. taxes. However, this deemed return is reduced by a net interest expense of any CFC that is “taken into account” in determining the shareholder’s net CFC tested income for the tax year.

For individual shareholders, GILTI is taxed at ordinary income tax rates. Currently, ordinary income may be taxed at a maximum rate of 37 percent.  However, individual CFC shareholders can make an election under Section 962 of the Internal Revenue Code to tax GILTI at the corporate tax rate which is 21 percent. By making a Section 962 election, an individual shareholder can further reduce the tax on GILTI to 10.5 percent.

Under Treasury Regulation Sections 1.951A-1(d)(2) and 1.951-1(e), a U.S. shareholder’s Subpart F and GILTI taxable amounts are based on a hypothetical distribution of earnings and profits (“E&P”) at the end of the CFC’s tax year. If a CFC has only one class of outstanding stock, the amount of the corporation’s allocable E&P is determined as if the hypothetical distribution was made pro-rata with respect to ownership of the CFC’s stock. In cases of multiple classes of stock, the regulations looks to the distribution rights of each class of stock on the hypothetical distribution date and utilizes an “all facts and circumstances” test that considers terms of each stock class, agreements among shareholders, “and, if to the extent appropriate fair market value of shares of stock.” See Treas. Reg. Section 1.951-1(e)(3). But, the regulations excludes “distribution[s] in liquidation” from the determination of allocable E&P for purposes of the hypothetical distribution. See Treas. Reg. Section 1.951-1(e)(4)(i). A restriction or limitation on a distribution of E&P by a CFC is typically not taken into account in determining the amount of a CFC allocable E&P under the hypothetical distribution rules. See Treas. Reg. Section 1.951-1(e)(5)(i).With that said, the right to periodically receive a fixed amount (whether determined by terms of a certain amount of U.S. dollars or foreign currency, or otherwise) with respect to a class of stock of which the distribution of which it is a condition precedent to a further distribution of the E&P that year with respect to any class of stock is not a restriction or other limitation on distribution of E&P by a CFC. See Treas. Reg. Section 1.951-1(e)(5)(iii).

The regulations provide detailed rules for calculating income inclusions from so-called lower-tier CFCs. Section 951(a) of the Internal Revenue Code requires U.S. shareholders of certain CFCs who own within the meaning of Section 958(a) stock in such corporations to include their pro-rata share of its Subpart F income. Section 951(b) of the Internal Revenue Code defines a U.S. shareholder with respect to any foreign corporation to include a U.S. person who owns, within the meaning of Section 958(a), 10% or more of the total combined voting power of all classes of stock of such foreign corporation or 10% or more of the total vote or value of shares of all classes of stock of such foreign corporation. For equity interests held by a first-tier CFC, Section 958A0(2) of the Internal Revenue Code and Treasury Regulation Section 1.958-1(b) provide that stock owned directly or indirectly by or for a foreign corporation is considered as being proportionally by its shareholders, partners, or beneficiaries, and that for purposes of reapplying this rule, such stock is treated as actually owned. Attribution under this rule stops with the first United States person in the chain of ownership running from the foreign entity.

Treasury Regulation Section 1.958-1(c)(2) states as follows: “A person’s proportionate interest in a foreign corporation, foreign partnership, foreign trust, or foreign estate will be made on the basis of all facts and circumstances in each case” and that for purposes of determining such proportionate interest, “the purpose for which the rules of Section 958(a) and this section are being applied will be taken into account.” For example, “if the rules of Section 958(a) are being applied to determine the amount of stock owned for purposes of Section 951(a), a person’s proportionate interest in a foreign corporation will generally be determined with reference to such person’s interest in the income of such corporation.” The regulation provides this general rule. But, the regulation goes on to say that “any arrangement which artificially decreases a United States person’s proportionate interest will not be recognized.” Because stock owned for purposes of Section 951 is defined as “within the meaning of Section 958(a),” Section 958(a)(1)(B) includes stock owned with the application of Section 958(a)(2), Section 958(a)(2), and Treasury Regulation 1.958-1(b) include proportionately owned while stopped such chain ownership at the first United States person. Consequently, any stock owned by a U.S. person in a lower-tier CFC is evaluated under the rules of Section 951. However, the determination of the “proportionate interest” must be done “on the basis of all the facts and circumstances” and that “the purpose for which the rules of Section 958 and this section are being applied will be taken into account. The Department of Treasury and the Internal Revenue Service (“IRS”) have promulgated very little guidance in regards to the “proportional interest” rule.

Treasury Regulation Section 1.951-1(e)(7)(iii) Example 2 provides an example for determining the amount of Subpart F income for a CFC with common stock and nonparticipating voting preferred stock outstanding stock and nonparticipating voting preferred stock outstanding by calculating the hypothetical distribution on the preferred stock (4% preferred * $10 per value share * 30 shares = $12), using that amount to determine the proportion of the first-tier entity’s pro-rata share of Subpart F income (i.e., the numerator is the balance of earnings and profits after the preferred distribution ($100 total E&P – $12 preferred stock E&P = $88) and the denominator is the total amount of earnings and profits ($100)) and then finally multiplying such pro-rata share proportion ($88/$100 = 88%) by the amount of Subpart F income ($50) to arrive at $44 of pro-rata Subpart F income. If the first-tier CFC owned all the common stock of a second-tier CFC that also had Subpart F income, it is not clear whether the “facts and circumstances” result in a 0% interest to the preferred shareholders (their preference amount does not change because they still only have a $12 preference) or whether there should be some proportionate amount so the preferred stock also take into account their lower-tier subsidiary’s total E&P and Subpart F income when conducting the same calculation discussed above.

As discussed above, a U.S. shareholder’s Subpart F and GILTI inclusion amounts are calculated on the basis of a hypothetical distribution of E&P at the end of the year. See Treas. Reg. Sections 1.951A-1(d)(2) and 1.951-1(e). These calculations are based on the distribution rights of each class of stock considering the terms of each stock class, agreements among the shareholders, and in some cases the relative fair market value of the shares of the stock. See Treas. Reg. Section 1.951-1-1(e)(3). As indicated above, the regulations disregard for this purpose many restrictions or limitations on distributions of E&P by a CFC, such as an arrangement that restricts the ability of a CFC to pay dividends on a class of stock of the corporation until a condition or conditions are satisfied (for example, until another class of stock is redeemed). However, the regulations state that the right to periodically receive a fixed amount with respect to a class of stock the distribution of which is a condition precedent to a further distribution of E&P that year in the context to any class of stock is not a restriction or other limitation on the distribution of E&P by a CFC. See Treas. Reg. Section 1.951-1(e)(5)(iii).

Special Rules Applicable to U.S. Citizens that Become Puerto Rican Residents Under Section 933(a)

United States citizens who are bona fide residents of Puerto Rico are subject to a favorable tax regime. Section 933(a) excludes from U.S. federal income tax income derived from sources within Puerto Rico. To be considered a bona fide resident of Puerto Rico for U.S. purposes, a U.S. citizen must satisfy three specific tests: the Presence Test, the Tax Home Test, and the Closer Connection Test.

The Presence Test requires physical presence in Puerto Rico. An individual will be considered to meet the presence test if one of five tests is met: 1) the individual is present in Puerto Rico for at least 183 days during the taxable year; 2) the individual is present in Puerto Rico for at least 549 days during the three-year period consisting of the current taxable year and two immediately preceding taxable years, provided that the individual is present in Puerto Rico for at least 60 days during each of those years; 3) the individual is present in the U.S. for no more than 90 days during the taxable year; 4) during the taxable year, the individual had earned income of less than $3,000 and was present for more days in Puerto Rico than the U.S., or 5) the individual had no significant connection to the U.S. during the taxable year. Under Treasury Regulation Section 1.937-1(c), an individual is considered to have a significant connection to the U.S. if one of three tests are satisfied: 1) the individual has a permanent home in the U.S.; 2) the individual has a current voter registration in any political subdivision of the U.S. or 3) the individual has a spouse or child under the age of 18 whose principal place of residence is the U.S. unless the child is living in the U.S. with a custodial parent under a custodial decree or the child is in the U.S. as a student. A permanent home includes a furnished room or an apartment that may be either owned or rented.

The Tax Home Test requires a person’s tax home to be in Puerto Rico. To satisfy the Puerto Rican Tax Home Test, an individual’s primary base of operations or primary residence must be located in Puerto Rico. A person’s tax home is considered to be located at his or her “regular or principal place of business.” If, due to the nature of an individual’s occupation (or because the individual does not carry on a trade or business), the individual does not have a regular or principal place of business, then the person’s tax home is his or her regular place of residence.

The Closer Connection Test requires a closer connection to Puerto Rico. The Closer Connection Test is a facts and circumstances test. An individual is considered to have a closer connection to Puerto Rico than the United States if the individual maintains more significant contacts with Puerto Rico than the United States. The factors used to determine if an individual has a closer connection to Puerto Rico than the United States are as follows: 1)  the size, cost, and nature of the individual’s home or other dwelling and whether those places are owned or rented. The test also considers the area in which the houses and other dwelling places are located; 2) the location of family and close friends; 3) the location of important personal possessions (e.g., artwork); 4) the location of personal belongings such as automobiles, furniture, and clothing; 5) the places where church and club memberships are maintained; 6) the location of business interests; 7) the location of business interests; 8) the location of the jurisdiction in which the individual holds a driver’s license; 9) the location of the jurisdiction in which the individual votes; and 10) the country of residence designated by the individual on forms and documents.

The Section 933 exclusion applies only if the taxpayer is a bona fide resident of Puerto Rico for the entire taxable year. In other words, the exclusion applies only if the residence is established on the first day of the year. If the individual relocates to Puerto Rico during the taxable year, the individual will be treated as a bona fide resident for the entire year only 1) for each year of the three taxable years immediately preceding the taxable year of the change of residence, the individual is not bona fide resident of Puerto Rico; 2) for each of the last 183 days of the taxable year of the change of residence, the individual does not have a tax home outside of Puerto Rico or a closer connection to the U.S. or a foreign country than to Puerto Rico; and 3) for each of the three taxable years immediately following the taxable year of the change of residence, the individual is a bona fide resident of Puerto Rico.

Special Rules Applicable to CFC Provisions of the Internal Revenue Code for U.S. Shareholders that Become Puerto Rican Residents

The U.S. generally taxes U.S. citizens on their worldwide income regardless of their place of residence. This general worldwide income tax also applies to U.S. citizens who are bona fide residents of Puerto Rico. However, under Section 933, those individuals can generally exclude Puerto Rican source income from their U.S. individual income tax return when determining their U.S. income tax liability.

How do these rules apply to the Subpart F and GILTI tax regimes? To be subject to these tax regimes, a person must be a U.S. shareholder of a CFC. Generally, a U.S. shareholder is defined to include U.S. persons who own directly, indirectly, or constructively 10% or more of the vote or value of the CFC. Interestingly, however, under Section 957(c)(1) a bona fide resident of Puerto Rico is not treated as a U.S. person (as defined in Section 7701(a)(30)) and thus is not subject to Subpart F and GILTI inclusions associated with ownership of stock in a Puerto Rican subsidiary (provided dividends received by that individual would be considered Puerto Rican-source). If a U.S. citizen is classified as a bona fide resident of Puerto Rico, a Puerto Rican corporation will not be classified as a CFC as long as less than 25 percent of the Puerto Rican corporation’s gross income is comprised of income effectively connected with a U.S. trade or business. Thus, as long as a Puerto Rican corporation receives less than 25 percent of its gross income from U.S. sources, the corporation can conduct business and generate income outside of the United States and Puerto Rico without it being classified as a CFC for U.S.income tax purposes or subject to the Subpart F and GILTI tax regimes.

U.S. citizens that become a bona fide resident of Puerto Rico under the tests discussed above will not be treated as a “U.S. shareholder” for the purpose of determining whether a Puerto Rican corporation is a CFC. However, in order for U.S. citizens who are bona fide residents of Puerto Rico not to be treated as a “U.S. Shareholder” for purposes of determining whether a corporation is a CFC, the dividend received by such an individual from the corporation in question must be Puerto Rican source income. Under Section 933(1), a dividend will be treated as Puerto Rican source if it satisfies the “possession source ratio” test. Under this test, a dividend will be treated as Puerto Rican source if 1) 80 percent or more of the gross income of the corporation during the prior three years was derived from sources within Puerto Rico; and 2) 50 percent or more of the gross income during the prior three years was derived from the active conduct of a trade or business within Puerto Rico.

Conclusion

It should be understood by anyone considering establishing Puerto Rican residency that the IRS has challenged and is increasing scrutiny of U.S. taxpayers who establish residency in Puerto Rico for favorable tax positions. Consequently, any U.S. citizen that intends to claim Puerto Rican bona fide residency and claim transactions producing Puerto Rican source income with respect to Section 933 benefits should expect enhanced scrutiny from the IRS. Given that transactions with respect to Section 933 face enhanced IRS scrutiny and potential IRS audits, it is important that anyone considering utilizing Puerto Rican residency to mitigate or avoid U.S. federal income taxes consult with a qualified tax attorney. We have significant experience advising U.S. citizens that have utilized Puerto Rican residency to obtain Section 933 benefits.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.