According to the law in the US, all US citizens are supposed to be taxable on their worldwide income.
However, this is not the case in all territories, as the Internal Revenue Code (IRC) §933 has excluded Puerto Rico’s source income from the US federal tax.
The Puerto Rico government on its part has duly taken advantage of this exclusion to modify the tax rate in Puerto Rico.
The Act 20/22 are two extant incentivizing enactments aimed at attracting investors and companies into the country, to boost the economy.
Consequently, a category of people in Puerto Rico enjoys as much as a 0% tax rate.
Though, as with every incredible benefit, some conditions are attached. In this article, you’ll find out the rates on different taxes, learn about Act 20/22 and how it has affected the tax rate in Puerto Rico.
Taxation in Puerto Rico
Taxation in Puerto Rico includes taxes paid both to the United States federal government and to the Government of the Commonwealth of Puerto Rico.
Payment of taxes to the federal government is through the federal Internal Revenue Service (IRS), both personal and corporate.
That of the Commonwealth government is paid through the Puerto Rico Department of Treasury (Departamento de Hacienda).
Puerto Rico is an unincorporated territory of the United States.
Puerto Ricans are US citizens, but Puerto Rico is not a US state, but an insular area of the US. Consequently, while all Puerto Rico residents pay federal taxes, many residents do not pay federal income taxes.
Other U.S. federal taxes aside from income tax are federal commodity taxes, and federal payroll taxes (Social Security, Medicare, and Unemployment taxes), customs taxes.
Not all Puerto Rican employees and companies pay federal income taxes. Federal law requires payment of federal income tax from the following residents and corporations only:
- Federal government employees in Puerto Rico,
- Residents who are members of the United States military,
- Those with income sources outside of Puerto Rico,
- Those individuals or corporations who do business with the federal government, and
- Those Puerto Rico-based corporations intend to send funds to the United States.
Different Taxes in Puerto Rico and Their Rates
These are the taxes in Puerto Rico and the percentages at which they are rated.
Corporate Tax: Resident & Foreign Companies
Residents companies are companies created and managed or engaged in trade in Puerto Rico. Resident companies in Puerto Rico are taxed based on their worldwide income.
For foreign companies engaged in business in Puerto Rico, they are taxed based on income generated at the standard corporate rate on income generated in the country.
Income generated in the country is considered an effectively connected income.
Incomes not effectively generated, determinable or fixed, periodical or annual, generated from Puerto Rican sources by non-resident foreign companies and partnerships are taxed at a 29% rate.
Main Allowance Deductions and Tax Credits
Credits and deductions are available to some services like
- Investment and infrastructure.
- Research and development.
- Purchase of locally manufactured products.
- Exports services.
- Machinery and equipment.
- Charitable contributions (capped at 10% for net income).
Start-up expenses, operational losses, and bad debts, depreciations are deducted in the tax year in which business commences or ratably amortized over 5 years.
The interest rate is deductible. A 29% withholding at source is applied if paid to a non-Puerto Rican-related party.
The rent for the property used in the business is also deductible, traveling expenses at 50%, meals, and entertainment at 75%.
Taxes, apart from corporate income tax, are also deductible.
It is also possible to bring forward net operating losses, for 10 taxable years.
If losses are generated from taxable years beginning before December 31, 2012, then it is for taxable 12 years.
However, a corporation is not allowed to claim the same deductions it claimed for income tax purposes if it is subject to the alternative minimum tax.
- Federal unemployment tax (FUTA, 6.0% on the first $7,000 of wages paid during the calendar year of each employee).
- Property tax (In general, from 8/93% to 11.83% of the 1958 market value of the real property).
- Federal insurance contribution tax (7.65%, that is 6.5% of social security and 1.45% of medical tax).
- Special tax, a municipal tax on licenses (0.5 on the gross receipt of business).
- Disability insurance (0.3% of the first $9000 of the total wage paid in the year by the employer).
- State employment tax (SUTA, paid on the first $7,000 of wages paid during the calendar year of each employee, plus a special tax equal to 1% of the wages subject to unemployment tax).
Capital Gains Taxation
Instead of the standard corporate rate, capital gains are taxed at a rate of 20%
Individual Tax: Allowable Deductions and Tax Credit
Puerto Rico residents and non-resident US citizens can have access to personal deductions. These include
- Education expenses, medical expenses ( exceeding 6% gross income).
- Certain charitable contributions (subject to 50% of adjusted gross income).
- Mortgage interests (30% adjusted gross income).
- Retirement plan (at least $5000/individual).
These deductions may not be available to non-resident foreign nationals.
Besides, personal deductions apply; $3500 for individuals, $7000 for taxpayers, married and living together $1500 for veterans, and $2500 for each dependent.
Special Expatriate Rate
Puerto Rican residents are taxed in Puerto Rico based on their worldwide income. Non-residents are only taxed on their Puerto Rico-sourced dividends.
For personal service done within the country, if the income is or less than $3000 or the individual is present in the country for 90 or fewer days, it is not considered Puerto Rico sourced.
Non-resident foreign nationals in the country may not access this deduction.
The Sales Tax applies to the sale of most products and services within Puerto Rico.
The standard rate for the sales tax is 11.5% (10.5% plus 1% municipal tax).
Prescription medicines, groceries, and business-to-business services are exempt from the commonwealth sales tax. Municipalities that collect a local sales tax, however, may collect up to a 1.5% tax on unprocessed foods and groceries.
Dissimilar to Value Added Tax (VAT), the Puerto Rico sales tax only pertains to end consumers of the product. Companies and individuals who are buying goods for resale, as raw materials, or for improvement can utilize a Puerto Rico Sales Tax Exemption Form to purchase these goods tax-free.
A Puerto Rico state tax sales exemption certificate is a necessity for individuals or companies who desire to make a qualifying purchase tax-free. This certificate can be acquired from the Puerto Rico Department of Revenue.
A completed Puerto Rico Sales Tax Exemption Form may be submitted to the vendor by the Exemption Certificate holders on making an exempt purchase instead of paying sales tax.
Sales tax exemption forms (as well as business sales tax id applications, sales tax returns, and the full Puerto Rico sales tax code).
Reduced Tax Rate
Specific goods and services are exempted from consumption tax, they include
- Funeral services.
- Prescribed medications.
- Food products.
- Advertisement services.
- Insurance and other professional services.
- Medical machinery and equipment.
- Health services.
- Services provided by traders of the volume of business less than $50,000.
Some professional and B2B services are taxed at a 4% SUT reduced rate. Prepared food is especially taxed, at 7%.
Other Consumption Taxes
Cigarettes, cement, fuel, diesel, and other petroleum products, vehicles, sugar, gains from horse racing, and plastic products attract excise duties levy.
The Act 20/22
Puerto Rico has a unique tax status. Even though it is a territory of the United States and should be controlled by all the US. federal laws, it is regulated as a “foreign country” for the US federal income tax.
This unique tax treatment also applies to its residents. It also gave room for Puerto Rico to enact tax incentives that are channeled towards promoting economic development in the territory.
Act 20 and Act 22 was enacted in 2012 as a major tax incentive to promote foreign investment. Both laws were targeted at providing incentives that will encourage investors to relocate to Puerto Rico.
For local services, it was intended to help them enhance their businesses to accommodate clients located outside Puerto Rico.
In all, the goal was to contribute to the economic growth of the Island. Since its enactment, these laws have become an integral part of the government’s economic development plan.
The Act 20/22 tax incentives promote the establishment of international banking operations, manufacturing operations, tourism activities, international insurance operations, and production of films in Puerto Rico, among others.
However, these incentives apply only to “bonafide residents” of Puerto Rico.
Even though U.S. citizens are subject to worldwide taxation, irrespective of source derived, Puerto Rico residents are exempted under IRC §933. The tax incentives of Act 20 and 22 are most favorable to U.S. citizens ready to become bonafide residents of Puerto Rico.
It allows bonafide residents of Puerto Rico to exclude their Puerto Rico source income from U.S. federal tax. Following IRS §937 and the regulations thereunder, a bona fide resident of Puerto Rico is an individual who:
- Is physically present in Puerto Rico for at least 183 days during the taxable year,
- Does not have a tax home outside of Puerto Rico during the taxable year, and
- Does not have a closer connection to the United States or a foreign country than to Puerto Rico.
Any US citizen who becomes a bonafide resident of Puerto Rico will have to move his(her) business to Puerto Rico. As such, the individual generates Puerto Rico sourced income and therefore stands to gain.
- 4% corporate tax/fixed income tax rate,
- a 100% exemption on property taxes, and
- a 100% exemption on dividends from export services.
However, It is important to note that income derived by a bonafide resident of Puerto Rico from sources without Puerto Rico will be subject to US federal income taxation. Individuals with a range of investments that generate income from sources without Puerto Rico should consider this factor.
Incomes derived by an individual with regards to the sale of securities within the duration of becoming a bonafide resident of Puerto Rico are specially regulated.
Puerto Rico’s government, on January 17, 2020, enacted Act No. 20 of 2012, otherwise known as the “Export Services Act”. This is to provide the essential elements; tax credits and tax exemptions to specific businesses in Puerto Rico to aid in creating a World Class Service Center.
This is to be achieved by diversifying the cores of economic growth through the local service providers. It targeted the expansion of local services to persons outside of Puerto Rico, thereby attracting new businesses to Puerto Rico.
The Export Services Act applies to businesses engaged in the exportation of services to non-resident individuals and/or foreign entities, with an office located in Puerto Rico. That means this incentive is only for “bonafide residents” of the territory.
The business must also provide “eligible service” not related to the conduct of a trade, business, or other activity in Puerto Rico. In other words, it offers incentives to companies exporting services from Puerto Rico.
Services that are eligible for these incentives include:
- Research and development.
- Advertising and public relations.
- Economic, environmental, technological, scientific, managerial, marketing, human resources, computer, and auditing consulting services.
- Advice on issues related to any trade or business.
- Creative Industries defined by law as those businesses with potential for creating jobs and wealth, mainly through the export of creative goods and services in the following sectors: design (graphic, industrial, fashion, and interior design); arts (music, visual arts, performing arts, and publishing); media (application, video games, online media, digital, and multimedia content development); creative services (architecture and creative education).
- Drafting of construction plans and engineering, architectural, and project management services.
- Professional services, such as legal, tax, and accounting services.
- Centralized management services.
- Electronic data processing centers.
- Computer program development.
- Voice and data telecommunications between persons located outside Puerto Rico.
- Call centers.
- Shared service centers that include, but are not limited to accounting, finance, tax, auditing, marketing, engineering, quality control, human resources, communications, electronic data processing, and other centralized management services.
- Storage and distribution centers of companies engaged in the business of transportation of items and products that belong to third parties, known as “hubs”.
- Hospitals and laboratory services.
- Investment banking and other financial services.
- Any other service that the Secretary, with the advice of the Secretary of the Treasury, determines that must be treated as eligible service for understanding that it is in the best interest and for the social and economic wellbeing of Puerto Rico.
Investment Banking and Financial Services Tax Benefits Under Act No. 20:
- 4% maximum tax rate on income related to the exportation of services.
- 100% exemption on the income tax rate on dividends or profit distributions.
- 60% exemption on municipal license taxes.
- 90% exemption of real and property taxes.
- 20-year tax decree, renewable for an additional 10-year period.
Act 22 is specifically designed to entice individual investors to move to Puerto Rico. It provides a complete exemption from Puerto Rico income taxes on all passive income accrued after they become bonafide residents of Puerto Rico.
That is to say, such individuals enjoy 100% tax exemption from Puerto Rico taxes on all dividend and interest income and long-term capital gains.
The relocation of such individuals should result in boosting the economy of Puerto Rico through new local investments. These investments can be in services and other consumer products, real estate, and capital injections to the banking sector.
Tax exemption conferred under Act 22 are valid through December 31, 2035:
Passive Income Exemptions:
- New Residents will enjoy a 100% tax exemption from Puerto Rico income taxes on all dividend and interest income.
- Interest and dividends that qualify as Puerto Rico source income will not be subject to federal income taxation under Section 933 of the IRS Tax Code.
Capital Gain Exemptions:
- All capital gains accrued after becoming a New Resident will be 100% exempt from Puerto Rico taxes. These gains will not be subject to federal taxes.
- All capital gains accrued and unrealized before becoming a New Resident will be subject to a tax:
At the prevailing tax rate (currently 10%), if such gain is recognized within 10 years of a new residence in Puerto Rico, and, 5%, if such gain is recognized after the said 10-year period.
The U.S. will not tax any prior unrealized gains if recognized after 10 years of residence in Puerto Rico.
Article 7 of Act 22 protects those trusts created by Act 22 grantees from the forced inheritance provisions of the Puerto Rico Civil Code.
The tax rate in Puerto Rico has become a major attraction for businesses to migrate to Puerto Rico.
Thanks to the law of the Internal Revenue Code(IRC) §933 and Act 20/22, Puerto Rico now seems a haven for some individual investors and corporations. Also, local businesses have been encouraged, leading to their expansion and growth.
So if you are looking at moving to Puerto Rico, you can consider the tax rates and the conditions attached to make that choice.