By Anthony Diosdi
U.S. shareholders of controlled foreign corporations (“CFCs”) or passive foreign investment company stock or (“PFICs”) stocks use various planning options to reduce or defer U.S. taxation on foreign source income. Few of these investors understand that they can relocate to a tax haven to avoid the taxes associated with being a CFC or PFIC shareholder. So, just where is this tax haven? The tax haven is Puerto Rico.
Puerto Rico is an unincorporated U.S. territory. Since Puerto Rico is an unincorporated U.S. territory, Internal Revenue Code Section 933(1) excludes U.S. federal income tax income derived from sources within Puerto Rico. After enduring economic hardship, Puerto Rico enacted Act 60 which provides some U.S. citizens a 100 percent exclusion from Puerto Rican income tax for all interest, dividends, and capital gains. These benefits are available to bona fide residents of Puerto Rico, even though they remain U.S. taxpayers for all other purposes. Furthermore, Puerto Rican corporations are only subject to a four percent corporate income tax on both export services income and income from other types of activities under Act 60.
Additional benefits are available to bona fide residents of Puerto Rico who own shares of corporations organized in Puerto Rico. These benefits include a complete exemption from the CFC and PFIC federal tax rules with respect to their ownership of Puerto Rican corporations.
The Definition of a Bona Fide Resident of Puerto Rico
The tax benefits under Act 60 are very attractive for those U.S. citizens willing to become a bona fide resident of Puerto Rico. A U.S. individual who is a bona fide resident of Puerto Rico for an entire taxable year is able to exclude from U.S. federal income tax under Section 933(1) Puerto Rican source interest and dividends, and potentially worldwide taxable gains. A person will be considered a bona fide resident of Puerto Rico for a particular taxable year only if such an individual:
1) Is physically present in Puerto Rico for at least 183 days during the taxable year;
2) Does not have a tax home outside of Puerto Rico during the taxable year; and
3) Does not have a closer connection to the United States or a foreign country than to Puerto Rico.
The physical presence test is satisfied for a tax year if an individual meets one of the following conditions:
1. The individual was present in Puerto Rico for at least 183 days during the tax year;
2. The individual was present in Puerto Rico for at least 549 days during the three-year period that includes the current tax year and the two immediately preceding tax years. During each year of the three-year period, the individual must be present in Puerto Rico for at least 60 days.
3. The individual was present in the United States for no more than 90 days during the year;
4. The individual had earned income in the United States of no more than a total of $3,000 and was present for more days in Puerto Rico than in the United States during the tax year; and
5. The individual had no significant connection to the United States during the tax year.
Let’s take a closer look at condition number one of the bona fide residence test, which requires physical presence of at least 183 days within Puerto Rico during the tax year in question. Generally, an individual is treated as being present in Puerto Rico on any day that he or she is physically present in that location at any time during the day. Internal Revenue Service (“IRS”) Publication No. 570 provides certain exceptions to the “physically present” requirement in cases where the individual is outside of the relevant possession:
1. On business or personal travel for up to 30 days;
2. To receive, or to accompany a qualified family member to receive, qualifying medical treatment;
3. Or has left or is unable to return to Puerto Rico during a 14 day period within which a major disaster occurs in Puerto Rico for which a Federal Emergency Management Agency’s (“FEMA”) notice of a federal declaration of a major disaster is issued in the Federal Register, or any period for which a mandatory evacuation order is in effect for the geographic area in Puerto Rico.
The term “tax home” discussed in number two of bona fide residence test is defined by reference to Internal Revenue Code Section 162(a)(2) and thus is located at the individual’s regular or principal place of business, or if none (because of the nature of the business or absence of such business), then at the “regular place of abode in a real and substantial sense.”
The “closer connection” outlined in number three of the bona fide residence test can be satisfied if an individual has a closer connection to Puerto Rico than the United States. The “closer connection” test takes into considered the location of the individual’s permanent home; location of the individual’s family and personal belongings (such as automobiles, furniture, clothing, and jewelry); the location of social, political, cultural or religious organizations in which the individual is currently involved; the location where the individual holds a driver’s license; the location of the jurisdiction in which the individual votes; and the area of residence designated by the individual on forms and documents.
As indicated above, the Section 933 exclusion applies only if an individual is a bona fide resident of Puerto Rico for the entire taxable year. Thus, residency must be 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 that entire taxable year only if 1) for each of the three taxable years immediately preceding the taxable year of the change of residence the individual is not a 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.
Impact of Foreign Source Income from a U.S. tax Standpoint.
Assuming the individual becomes a bona fide resident of Puerto Rico pursuant to the 933 test discussed above, how does becoming a bona fide resident of Puerto Rico help an individual with GILTI and Subpart F federal tax inclusions? Let’s assume that a U.S. person becomes a bona fide resident of Puerto Rico and establishes a CFC with a Puerto Rican subsidiary. Under Internal Revenue Code Section 957(c): 1) a bona fide resident of Puerto Rico is not treated as a U.S. person (as defined in Internal Revenue Code Section 7701(a)(30)) and thus is not subject to GILTI or Subpart F inclusions. Instead, at worst, the foreign source income will qualify for a preferential four percent Puerto Rican tax. This is far more favorable than the U.S. federal rates assessed on distributions received from CFCs.
Similar favorable provisions also apply to bona fide residents of Puerto Rico who are shareholders of Passive Foreign Investment Company or PFICs. Typically, a U.S. taxpayer that owns shares of a PFIC will be subject to harsh U.S. federal income tax consequences when they receive distributions from a PFIC and/or sell their PFIC shares. However, in certain cases, proposed regulations provide an exception to the PFIC rules for a bona fide resident of Puerto Rico.
U.S. persons that establish a bona fide residence in Puerto Rico are not subject to repatriation or exit tax imposed by Internal Revenue Code Section 877A. Consequently, a U.S. citizen can potentially obtain an exemption from PFIC, GILTI, and Subpart F income tax regimes without the need to give up U.S. citizenship and pay an exit tax under Section 877A of the Internal Revenue Code.
Conclusion
Puerto Rico has enacted very favorable tax legislation to attract high net worth individuals. If a U.S. citizen is willing to establish a bona fide residency in Puerto Rico, he or she can potentially avoid the PFIC, GILTI, and Subpart F tax on foreign dividends and foreign source income.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony Diosdi focuses a part of his practice on criminal tax enforcement, broad-based civil tax compliance and white collar matters generally. He also advises clients on the IRS voluntary disclosure program, with particular focus on disclosure related to offshore banking accounts.
Anthony Diosdi is a frequent speaker at international tax seminars. Anthony Diosdi is admitted to the California and Florida bars.
Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.