March 15, 2013 7:00 AM
Puerto Rico: a Latin Liechtenstein?
By Patrick Brennan
The government of Puerto Rico has an interesting new economic-development strategy: Attract Americans who don’t want to pay capital-gains taxes. According to Bloomberg:
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.”
Already, 10 Americans have taken advantage of a year-old Puerto Rico law that lets them avoid local and U.S. capital gains taxes by signing agreements with the territory’s government. Paulson, a 57-year-old New York [hedge-fund billionaire], is considering such a move, according to four people who have spoken with him about it, Bloomberg reported March 11.
Puerto Rico wants to diversify its economy, which has lost some of its manufacturing base to low-wage countries such as the Dominican Republic and China, said Gabriel Hernandez, one of the framers of the Puerto Rican tax law and head of the tax division of BDO Puerto Rico PSC . . . who likened the effort to tax incentives used by states to lure businesses.
So how does it work? Puerto Rico passed a law about a year ago cutting its capital-gains tax rate to zero for investments made by new residents, effective through 2035 (and dramatically cutting the tax rate for businesses they start there, too, to 4 percent). The 0 percent rate will only apply to gains made after residents move to the island, but existing unrealized capital gains for commonwealth residents will be taxed at PR’s existing rate, which is just 10 percent, versus 23.8 percent in the U.S. (up from 15 percent last year). Residents of Puerto Rico are still subject to U.S. federal taxes on income earned within the United States — which would be the case whether they resided in the U.S., in a U.S. territory, or anywhere in the world, thanks to the U.S.’s uniquely onerous global tax regime. But otherwise, while residents pay payroll/FICA taxes to the U.S. federal government, they don’t have to pay federal income taxes on earnings in Puerto Rico, because the commonwealth has the right to run its own tax system. This puts Puerto Rican residents in the rare position, unlike U.S. citizens almost anywhere else, of being able to earn income in their place of residence and not owe U.S. federal income taxes on it — even the lucky-duck ex-pats in Andorra or the Caymans can’t do that.
Official Puerto Rican residency is more than just paperwork, as Bloomberg explains: Prospective tax refugees “must meet residency tests, including spending 183 days a year in Puerto Rico and having social and personal connections on the island” (though according to another Bloomberg story from earlier in the week, Paulson actually is looking at houses there).
But if Paulson does get that, he’d be in a pretty good spot, because he could earn a lot of his income technically on the island: A tax expert told Bloomberg that his firm, Paulson & Co., could probably set up a company in Puerto Rico for him to receive his management fees (his share of the 2 percent of assets the firm earns every year) at PR’s 4 percent business-tax rate for newcomers, and he could realize capital gains as a Puerto Rican taxpayer, not a normal American one, at the much lower rate (he has billions of dollars invested in his own firm’s funds and elsewhere). Paulson would be transferring investments with unrealized capital gains abroad, which normally incurs a fee equivalent to the taxes one would pay the U.S. government if they realized them before moving abroad. But doing so from New York State to Puerto Rico is currently legal and incurs no fee — the government’s new wealth-solicitation strategy might tempt Congress to change that. It is important, though, that Paulson probably wouldn’t be getting paid his share of Paulson & Co.’s carried interest (their commission on their investment funds’ profits, and how Mitt Romney earned his income in recent years from Bain) at the preferential Puerto Rican rate, because he would either receive that from his firm’s U.S.-based funds or their offshore parallels — only Puerto Rico–based income is exempt from federal income tax.
While I shudder to return to the topic of Mitt Romney’s taxes . . . this story reminds us of some ways in which the ultra-wealthy can manage to avoid U.S. income taxes — but how the Republican presidential candidate wasn’t doing so. Romney’s wealth and income sources were related to a lot of offshore corporations in low-tax jurisdictions, which existed for the sake of investors in other places to invest in U.S. funds without having to pay U.S. taxes, only owing investment taxes in their country of residency. But Romney, as a U.S. citizen and resident, owed and paid U.S. federal taxes on all his income (except for those in tax-deferred retirement accounts) — as would almost any U.S. citizen, in fact (after receiving credit for foreign taxes paid). Paulson’s move would be basically one of the very few ways to remain a U.S. citizen, report one’s individual income to the U.S. government, and avoid the full brunt of U.S. income tax, now made much more attractive by Puerto Rico’s exceptionally low rate.
You can imagine, then, why at least a few billionaires might start to think “I think I go back to San Juan,” and why, sooner or later, congressional finance committees might soon start thinking, “For a small fee in America.”
But so far, according to Bloomberg, only ten wealthy Americans have done so, and you can imagine why — one can secure serious tax savings by doing so, but even if one did want to spend half the year in San Juan, it’s not exactly a kind of place where a very rich person should move, as it’s more corrupt, more dangerous, and, broadly speaking, much more insecure than the U.S. itself.
In fact, ultimately, this is probably a pretty lame attempt to raise easy revenue on the part of the Puerto Rican government, recently won back by the Popular Democratic Party from former governor Luis Fortuño’s more fiscally conservative New Progressive Party. Puerto Rico’s government, which saw its bond yields shoot up before and after that election, faces huge unfunded pension liabilities and an increasingly uncompetitive industrial sector; this is hardly a serious way to go about fixing those real problems.