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January 27, 2014
Economic Analysis: The Treasury Bailout of Puerto Rico
by Martin A. Sullivan

Full Text Published by Tax Analysts®

By Martin A. Sullivan --

It may be off the radar of the public and media, but the fragile state of the economy and government finances in Puerto Rico is not being ignored by the White House.

Puerto Rico has experienced eight straight years of negative economic growth. According to the most recent data, the unemployment rate is 14.7 percent. Continuing the decline that began in 2002, Census Bureau data show that Puerto Rico's population fell by 36,000, or about 1 percent, between July 2012 and July 2013.

Meanwhile, investors in America's $3.7 trillion municipal bond market, already shocked by Detroit's bankruptcy, are jittery about $70 billion of outstanding Puerto Rican bonds. The commonwealth's bond rating is currently just one notch above junk status, and rating agencies are threatening a downgrade. The next time it issues new bonds, Puerto Rico may have to pay interest as high as 10 percent, more than double what financially secure municipal issuers pay. ("$2 Billion Deal in Works for Puerto Rico," The New York Times, Jan. 21, 2014.)

On October 30, 2009, President Obama signed Executive Order 13517, which expanded the responsibilities of the President's Task Force on Puerto Rico's Status to seeking recommendations on economic development. Founded by President Clinton in December 2000, its mission used to be to examine proposals for Puerto Rico's future as a commonwealth, state, or independent nation.

The task force that convened in December 2009 was composed of members from almost every Cabinet agency, including Treasury. The officials from Treasury were not from the Office of Tax Policy or the IRS. After two public hearings in San Juan and Washington, the task force issued a 122-page report on March 11, 2011. Its recommendations on economic policy were all favorable to Puerto Rico, but they were unlikely to have a measurable effect on the island's economy. They consisted mostly of streamlining access to existing federal programs, the formation of intragovernmental working groups, and a wish list of legislation that Congress is unlikely to pass.

However, Treasury officials were drafting a three-page document that would deliver billions of dollars of cash benefits to Puerto Rico. The action-forcing event was a request in November 2010 from the government of the island for a ruling on creditability against U.S. tax of a new tax on multinational manufacturers doing business in Puerto Rico that took effect on January 1, 2011.

In general, under special grants from the Puerto Rican government, these manufacturers otherwise pay very low tax to Puerto Rico. And under a special provision of U.S. law in place since 1921, they are considered foreign corporations whose income generally is not subject to tax unless repatriated back to the United States. The new tax was estimated to raise nearly $6 billion over five years.

Puerto Rico's economy is heavily dependent on its manufacturing sector, which accounted for 48.6 percent of GDP in 2011 (compared with 11.5 percent in the 50 states). The sector is dominated by affiliates of large U.S. multinationals, including those of most major U.S. pharmaceutical and medical device manufacturers, as shown in the table on the next page. Since the expiration of the Puerto Rican economic activity credit (which provided transition relief from the repeal of section 936 in 1996) at the end of 2005, these affiliates have mostly been operating as branches of controlled foreign corporations.

On March 30, 2011, the IRS released Notice 2011-29, 2011-16 IRB 663. It stated that the new tax was novel and that "determination of the creditability of the Excise Tax requires the resolution of a number of legal and factual issues." Until these issues are resolved, the IRS would not challenge taxpayers' claims that the tax was creditable. Further, if the IRS decided the credit was not creditable in the future, the new position would apply only prospectively. Thus, most -- but not all -- of the new tax burden imposed on multinationals doing business in Puerto Rico was completely eliminated by Treasury.

                               Table 1.
              Largest U.S. Public Companies in Puerto Rico
       (Ranked by Number of Full-Time Employees in Puerto Rico)

                                                    Full-Time Employees
 Company Name                                       in Puerto Rico

 Johnson & Johnson                                         4,090
 Pfizer                                                    4,000
 Medtronic                                                 3,050
 Abbott Laboratories Inc.                                  2,200
 Amgen                                                     2,200
 General Electric Co.                                      2,200
 Baxter International                                      2,080
 Eaton                                                     1,669
 Merck & Co.                                               1,350
 Fenwal International Inc.                                 1,332
 Coca-Cola                                                 1,300
 Stryker                                                   1,231
 Hewlett-Packard                                           1,100
 St. Jude Medical                                          1,033
 Pepsi-Cola Co.                                              899
 Becton, Dickenson & Co.                                     866
 Boston Scientific                                           600
 Bristol Myers Squibb                                        600
 Zimmer Holdings Inc.                                        582
 Hubbell                                                     513
 Procter & Gamble                                            500

 Sources: Caribbean Business; The Book of Lists 68 (2013).

On February 28, 2013, the government of Puerto Rico, citing the need for additional tax revenue because of continued poor economic conditions, expanded and extended the life of the excise tax to 2017 (Act 2-2013). Under the revised law, the tax rate will be 4 percent beginning on July 1, 2013, and through its new expiration date of December 31, 2017. The tax is now expected to raise $1.96 billion in fiscal 2014 (which began in July 2013). As shown in Figure 1, that is more than 20 percent of expected general fund revenue.

It has been two years and 10 months since Notice 2011-29 was issued, but the IRS and Treasury still have not reached a final decision about the creditability of the tax. The law firm of Steptoe & Johnson LLP, which in the employ of the government of Puerto Rico helped design the tax, issued an 84-page opinion letter stating that the tax is a creditable tax and that it does not violate the commerce clause or the due process clause of the Constitution. However, five out of five tax attorneys contacted by Tax Analysts had serious doubts that the tax was constitutional.

The Financial Information and Operating Data Report of the Commonwealth of Puerto Rico, issued on October 18, 2013, states:

    Act 154 has not been challenged in court; consequently, no court has passed on the constitutionality of Act 154. There can be no assurance that its constitutionality will not be challenged and that, if challenged, the courts will uphold Act 154. To the extent a court determines that the imposition of the excise tax or the expansion of the income tax or both are unconstitutional, the Commonwealth's revenues may be materially adversely affected.

Given the vital importance of the tax to Puerto Rico's financial standing and of the creditability of the tax to U.S. companies, it is unclear why Treasury and the IRS have not finalized the ruling if the technical tax experts consider it to be creditable. Providing finality to a favorable ruling would remove uncertainty that is damaging to the investment decisions of U.S. multinationals operating in Puerto Rico and to the investors in Puerto Rican bonds that are nervous about the commonwealth's finances.

Given the lack of any other logical explanation, it cannot be ruled out that Treasury has not issued a final ruling because there is serious concern that the tax is not creditable and that it is under political pressure to let the interim status remain intact until the tax expires (originally in 2016, now in 2017). Those applying pressure include the taxpaying companies themselves, the Puerto Rican government, and municipal bond investors. It also cannot be ignored that the White House and its task force have a strong commitment to strengthening the economy of Puerto Rico and the finances of its government. If Treasury or the IRS ruled that the tax is not creditable, it would be adverse to the administration's goal of maximizing assistance to Puerto Rico's flagging economy.

Financial Crisis

Since 1898 Puerto Rico has been part of the United States, and since 1917 Puerto Ricans have been U.S. citizens. Puerto Rico has a nonvoting representative in Congress, and Puerto Ricans cannot vote in presidential elections. The island is the size of Connecticut, but with approximately 3.5 million residents, it is more populous than 22 states. Section 933 provides that income derived from sources within Puerto Rico by a resident of Puerto Rico generally is exempt from U.S. taxation.

Puerto Rican Gov. Luis Fortuño took office on January 2, 2009. Besides being a member of the pro-statehood New Progressive Party (PNP), he is a Republican in the mold of Ronald Reagan. Puerto Rico's economy was severely depressed, and its bonds were close to achieving junk status. With an already declining population, high unemployment, and shrinking manufacturing sector, the economy had generally been considered to be in recession since 2006. So when the Great Recession hit in 2008, it had a more devastating effect on Puerto Rico than on the mainland. Six months after Fortuño's inauguration, the unemployment rate in Puerto Rico was 16 percent and rising. Citing Puerto Rico's bloated public sector, Wall Street Journal columnist Mary Anastasia O'Grady in February 2012 called the government Fortuño inherited "a welfare-state basket case."

Figure 1. Puerto Rican General Fund Revenues

(in billions)

Source: Commonwealth of Puerto Rico, "Financial Information and Operating Data Report," Oct. 18, 2013.

Fortuño's approach to the crisis was a bold program of regulatory reforms and massive downsizing of the government workforce. Eventually he would eliminate 15,000 public service jobs. He also implemented large tax cuts. His plan, called the "Strategic Model for a New Economy," included a "comprehensive tax reform that takes into account the Commonwealth's current financial situation." In February 2010 the governor formed a commission to review the island's tax system and propose reform. It consisted of a former Treasury secretary, the current Treasury secretary, the president of the Government Development Bank, the economic development secretary, the governor's chief of staff, and the chairs of the Puerto Rican Senate and House Treasury committees. Steptoe & Johnson was hired to advise it.

A theme often repeated in discussions of tax reform was that foreign corporations operating in Puerto Rico should share a large portion of the tax burden currently borne by individuals and domestic business. But at the same time, the government wished to safeguard tax incentives and avoid harming business.

On January 19, 2010, Senate President Thomas Rivera Schatz of the PNP introduced legislation that would impose a 10 percent tax on the net taxable income of all corporations with gross receipts greater than $10 million that had entered into tax exemption grant agreements with the government of Puerto Rico. The preamble to the bill reads: "It is essential that all economic sectors contribute, especially those that receive more benefits from the island's economic activities." On March 5 a group of 11 members of the PNP filed identical legislation in the lower chamber of the Legislative Assembly. In an April 2010 opinion piece in Caribbean Business, former Gov. Carlos Antonio Romero Barceló voiced his strong support for the bill but noted that "the opposition of the vested interests, that is, the 'tax-exempt' companies and their lawyers, lobbyists, and the financial, commercial and manufacturing organizations," had already mounted an effort to defeat it and were threatening to leave the island.

The Fortuño administration on October 22 introduced the plan it had been developing for months as a substitute for the Rivera Schatz minimum tax. Neither the general idea nor the details of the plan had been previously released. Nevertheless, revised HB 2526 was approved by the legislature on October 23 in an unusual Saturday session. On the same day, members of the tax commission and Steptoe & Johnson partner Philip R. West, former Treasury international tax counsel, briefed a group of tax practitioners on the new statute. The practitioners were told of continued efforts to convince Treasury and the IRS that the tax was creditable. According to one participant at the meeting, West said that ongoing discussions with the IRS "have been favorable but are at a critical point in the discussion." (See "Offshore Firms Subject to Permanent Taxation Under New 'Source Rule,'" Caribbean Business, Nov. 4, 2010.) West is widely credited with developing the new law. (See "The Architect of the Excise Tax and Change in the 'Source Rule,'" Caribbean Business, Nov. 4, 2010.)

On October 25, three days after its introduction, Fortuño signed the bill that became Act 154. On the same day, Steptoe & Johnson provided the Puerto Rican government an opinion letter asserting that the new excise tax should be creditable against U.S. federal income tax as an "'in lieu of' tax under section 903 of the Internal Revenue Code."

The purpose of Act 154 was to offset the cost of Fortuño's soon-to-be-enacted cut in individual and corporate taxes, which was estimated to reduce revenue by an average of $1.2 billion annually for six years. Under the Fortuño plan, individual income taxes would be cut by 50 percent, including a doubling of the earned income tax credit. Corporate taxes would be reduced by 30 percent, including a reduction in the top corporate tax rate from 39 percent to 30 percent.

As a general rule, nonlocal manufacturers (mostly affiliates of U.S.-headquartered multinationals operating as branches of controlled foreign corporations) have entered into industrial tax exemption agreements with the government of Puerto Rico. These agreements provide, in addition to substantial relief from property and excise taxes, a low flat rate of tax on Puerto Rican-source income.

Act 154 does not impose tax on entities operating in Puerto Rico. Thus, it does not violate the agreements Puerto Rico has made with nonlocal manufacturers. Instead, it imposes tax on the affiliates that purchase goods and services from the Puerto Rican manufacturers. The law has two parts: a permanent expansion of the source rules that would greatly increase the amount of multinationals' profit subject to Puerto Rican income tax, and for foreign corporations with a Puerto Rican affiliate with gross receipts in excess of $75 million for any of the three preceding years, a temporary excise tax on purchases from Puerto Rico that is paid in lieu of payment of income tax under the expanded source rule.

In its opinion letter, Steptoe & Johnson revealed that the tax reform commission considered as a revenue-raising measure the implementation of combined reporting and formulary apportionment used by many states. Under this approach, all income of corporations in a unitary business is considered a single taxable entity, and profits are allocated across jurisdictions based on an apportionment formula. If that were adopted by the island, the Puerto Rican manufacturers and non-Puerto Rican affiliates purchasing from them would be considered a single business subject to Puerto Rican income tax. Concerned about the administrative difficulties of this approach -- in particular, the difficulty in obtaining the companywide information needed to apply formulary apportionment effectively -- Puerto Rico decided to tax income of non-Puerto Rican affiliates of Puerto Rican companies doing business in Puerto Rico when those affiliates make substantial purchases from Puerto Rican companies.

Specifically, with the adoption of Act 154 Puerto Rico established a permanent expansion of the source rule for Puerto Rican income tax as an alternative to combined reporting and formulary apportionment. Further, because the tax reform commission was concerned that the source rule might pose significant administrative difficulties, Puerto Rico imposed as an alternative to the expanded source rule an excise tax on purchases by non-Puerto Rican companies from manufacturing affiliates with more than $75 million in gross receipts.

For the source rule to apply to income of a non-Puerto Rican affiliate, its purchases from a related Puerto Rican manufacturer must be at least 10 percent of the non-Puerto Rican affiliate's purchases or 10 percent of the Puerto Rican manufacturer's sales. Effectively connected income is calculated by one of two methods. The first is an equal-weighted four-factor formula (with purchases, sales, property, and payroll serving as factors). The second method, for taxpayers unwilling or unable to provide adequate documentation necessary to apply the four-factor formula, treats as Puerto Rican-source income 50 percent of the income from sales of property manufactured in Puerto Rico.

The excise tax imposed on purchasers is collected and remitted by the Puerto Rican manufacturers. Under Act 154, the tax rate was 4 percent for calendar year 2011, 3.75 percent in 2012, and 2.75 percent in 2013, and will be 2.5 percent in 2014, 2.25 percent in 2015, and 1 percent in 2015. (As discussed below, in February 2013 the tax rate was increased to 4 percent for all purchases after June 30, 2013, and the expiration date was extended one year, to the end of 2017.)

Various news reports place the number of firms paying the excise tax at between 30 and 50. Most of them are U.S. pharmaceutical, medical device, and electronics manufacturers.


The government of Puerto Rico repeatedly asserted that the new tax would be minimally burdensome because, based on the opinion letter from Steptoe & Johnson, it would be creditable against U.S. income tax. Despite this, manufacturers in Puerto Rico, their parent companies, and business groups were incensed. They were angry over the lack of consultation, the precedent set for other jurisdictions, and significant uncertainty about creditability. Even if the IRS did agree that the new tax was creditable, manufacturers with foreign parent companies often would be unable to credit it.

"Puerto Rico has historically proven itself to be a center of excellence in attracting foreign investment and venture capital from innovative bioscience companies and investors," said Jim Greenwood, president and CEO of the Biotechnology Industry Organization, in an October 27, 2010, statement. But "this new tax increase will profoundly affect the decision-making of foreign corporations as they consider whether to continue to do business and deploy their capital in Puerto Rico."

In an October 27, 2010, statement, former Michigan Gov. John Engler, now CEO of the National Association of Manufacturers, decried the new levy:

    We are alarmed by the actions taken by the Puerto Rican government to impose a new excise tax on multinational manufacturers. [Multinational manufacturers] represent approximately 80 percent of all the manufacturing jobs in Puerto Rico and nearly 26 percent of Puerto Rico's GDP. The imposition of the tax could jeopardize the jobs of over 100,000 people and could damage business relationships that have taken years to develop between the affected companies and the government of Puerto Rico.

Similar statements were issued by the U.S. Chamber of Commerce, the Advanced Medical Technology Association, and the Pharmaceutical Research and Manufacturers of America.

Carlos Bonilla, chair of the Puerto Rico Manufacturers Association Tax Committee, said: "If they allow Puerto Rico to get away with this, then it may become a threat to the multinational model. Then the Irish, Singapore and Spain may try to emulate Puerto Rico. Puerto Rico is saying it has the right to impose a tax on a foreign company that has never been in Puerto Rico. This is something totally new." (See Caribbean Business, Nov. 3, 2010.)

The leading rival political party to the PNP, the pro-Commonwealth Popular Democratic Party (PDP), strongly criticized the plan. "If this is the right alternative, why was it approved in the middle of the night and in record time," Sen. Eduardo Bhatia Gautier of the PDP said (Reuters, "Puerto Rico Slaps New Tax on Offshore Business," Oct. 24, 2010). During the campaign leading up to the 2012 gubernatorial election, PDP candidate Alejandro García Padilla blasted the tax and said he would overturn it if he were elected.

According to Caribbean Business, Fortuño personally contacted executives of the largest firms affected by the tax "to both justify the move and try to do everything possible to blunt the negative impact the laws might have on company operations" and to discuss "how the new tax will impact a particular firm, and what additional help the local government may provide." Subsequently, the Fortuño administration mitigated the burden of the tax when the Puerto Rican Treasury Department on December 29, 2010, issued Excise Tax Regulation Number 7970 that established a maximum annual tax and introduced seven different credits that could be used to reduce the excise tax.

'A Great Victory'

On March 30, 2011, the IRS released the notice on the tax, which said:

    The IRS and the Treasury Department are evaluating the Excise Tax. The provisions of the Excise Tax are novel. The determination of the creditability of the Excise Tax requires the resolution of a number of legal and factual issues. Pending the resolution of these issues, the IRS will not challenge a taxpayer's position that the Excise Tax is a tax in lieu of an income tax under section 903. This notice is effective for Excise Tax paid or accrued on or after January 1, 2011. Any change in the foreign tax credit treatment of the Excise Tax after resolution of the pending issues will be prospective, and will apply to Excise Tax paid or accrued after the date that further guidance is issued.

So although the IRS and Treasury made no determination about the creditability of the tax, businesses could claim credits for excise tax liability incurred to date and all future liability until further notice.

For the many Puerto Rican manufacturers and for the government, the notice provided a welcome relief. Government Development Bank Chair Carlos Garcia, who was a member of the governor's tax reform commission, said, "I believe that this determination of the IRS, which puts an end to challenges made by some sectors, is a great victory for Puerto Rico because we all win." (See "IRS Confirms 4% Excise Tax Can Be Written Off Federal Return," News Is My Business, Mar. 31, 2011.) Shortly thereafter, Fortuño stated:

    As confirmed by the IRS just a couple of weeks ago, the companies will be able to credit that excise tax against their federal income tax liability. In short, these companies will now be able to contribute to Puerto Rico's fiscal and economic reconstruction in a way that does not affect their bottom line, therefore protecting the operations and jobs they have on the island.

The immediate effect of Notice 2011-29 for multinationals with operations in Puerto Rico was that they could include the full benefit of the foreign tax credit in their first-quarter results for 2011. As Abbott Laboratories wrote in response to an inquiry from the SEC:

    Based on the stated guidance in the IRS notice, the opinion of Abbott's outside legal counsel, and discussions with our IRS auditors as part of the Compliance Assurance Program (CAP), we have concluded that the tax is creditable from a U.S. foreign tax credit perspective and that no amount of the credit relating to the excise tax paid by entities comprising Abbott's consolidated U.S. Federal income tax return should be included in our unrecognized tax benefits. [Letter to James Rosenberg of the SEC from Thomas C. Freyman, CFO of Abbott, May 2, 2012.]

In at least one case, the new ruling plus the accounting treatment of the excise tax resulted in earnings greater than if the excise tax did not exist at all. The excise tax is accounted for as a manufacturing cost that is capitalized in inventory. Costs are only recognized when the products are sold. Foreign tax credits generated by the tax are recognized when the tax is paid. This difference in the timing improved Amgen Inc.'s financial results for the first quarter of 2011. (See Amgen press release, "Amgen's First Quarter 2011 Revenue Increased 3 Percent to $3.7 Billion," Apr. 20, 2011.)

This is not the first time the IRS has issued a notice on the creditability of a foreign tax that had a similar interim-certain/future-uncertain structure. On December 10, 2007, the IRS published Notice 2008-3, 2008-2 IRB 253, regarding the creditability of a new alternative minimum tax called the flat rate business contribution, enacted by the Mexican government in 2007. Similar to Notice 2011-29's treatment of the Puerto Rican excise tax, Notice 2008-03 announced that pending the completion of further study, the IRS would not challenge a taxpayer's position that the flat tax is an income tax eligible for a credit and that any change would be prospective. Noting that the IRS never issued any subsequent ruling on the flat tax, PricewaterhouseCoopers LLP wrote in 2011, "This could be indicative of the IRS's intent and priority-setting with respect to the [Puerto Rican] excise tax as well, giving taxpayers comfort they may be able to credit the excise tax for some time to come." (See Pharma and Life Sciences Tax News, Vol. 10, No. 3.) Mexico repealed the tax in 2013.


Section 901 allows taxpayers to claim a credit for "the amount of any income, war profits, and excess profits taxes paid or accrued . . . to any foreign country." The tax must be compulsory and not in exchange for a service, subsidy, or rebate provided by the taxing government.

Section 903 allows foreign taxes that are not income taxes to qualify for credits if it is determined that the tax is levied "in lieu of" an income tax. A creditable tax under section 903 must operate "as a tax imposed in substitution for, and not in addition to, an income tax or a series of income taxes otherwise generally imposed." Also, a credit is not available for a "soak-up tax," which is a tax that would not be imposed absent the availability of foreign tax credits. The Act 154 excise tax was expressly designed to meet all the requirements of the regulations. It is imposed in lieu of the expanded source rule for determining Puerto Rican income tax and, if the tax is legal, there is no readily apparent reason to believe the requirements of section 903 are not met.

The potential sticking point is the constitutionality of the excise tax. In its 2010 opinion letter, Steptoe & Johnson has a 38-page analysis of constitutional issues. It concludes that it is more likely than not that both the new expanded source rule and the new excise tax satisfy the requirements of the due process and commerce clauses.

The commerce clause is the tougher standard. In Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977), the Supreme Court delineated a four-part test for a tax to be valid under the commerce clause: (1) the tax must be applied to an activity with substantial nexus with the taxing state; (2) the tax must be fairly apportioned; (3) the tax must not discriminate against interstate commerce; and (4) the tax must be fairly related to services provided by the state. Of the four components, the test for substantial nexus is the most critical for determining the constitutionality of the excise tax.

In National Bellas Hess v. Illinois, 386 U.S. 753 (1967), the Supreme Court held that physical presence is required to establish nexus. The Court confirmed the validity of the physical presence requirement in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). Both cases addressed whether a mail-order business with no physical presence in a state could be taxed by a state whose residents purchased the business's merchandise. While Quill clearly established that in order to establish nexus for sales and use taxes, physical presence in the taxing jurisdiction is required, there is a great deal of controversy as to whether the physical presence test is also required to establish nexus for other sales and use taxes.

Without acknowledging the conflicting opinions of various state courts, the Steptoe & Johnson opinion letter adopts the view that the physical presence test applies only to sales and use taxes. Accordingly, it argues that constitutional application of an income tax to non-Puerto Rican affiliates under the expanded source rule does not require any physical presence in Puerto Rico. All that is required is a substantial presence. The substantial presence exists because the non-Puerto Rican affiliate makes substantial purchases of products manufactured in Puerto Rico, and these products are produced by related parties under common control in a unified business.

The reasoning is analogous to decisions in cases in which sellers (such as mail-order businesses) are deemed to have nexus in a state where they sell but have no physical presence. The difference here is that Puerto Rico is taxing as if substantial nexus is established by purchases rather than by sales. "While sales and marketing . . . may create such an economic presence, it is more likely than not that other activities, including production, would similarly establish such presence." Moreover, the opinion letter points out that the expanded source rule is a substitute for unitary reporting and that unitary reporting has been deemed constitutional.

Regarding the excise tax, the opinion letter argues that the tax is not a sales or use tax, so the physical presence standard does not apply. It compares the new excise tax to the Illinois telecommunications tax that the Supreme Court upheld in Goldberg v. Sweet, 488 U.S. 252 (1989). In that decision, the Court held that Illinois had nexus substantial enough to tax a consumer's purchase of an interstate telephone call if it originated or terminated the call and the service or billing address was in the state.

The Steptoe & Johnson opinion letter interprets this to mean that "no more than origination plus some additional presence or connection to the state is sufficient to impose the tax." It argues that the Puerto Rican excise tax more than likely meets this standard because it applies to transactions that originate in Puerto Rico and additional presence is established as a result of the manufacturing activities by the Puerto Rican sellers and of the oversight activities in Puerto Rico by the non-Puerto Rican affiliates.

Constitutional Questions

Tax Analysts contacted five tax attorneys and inquired about the constitutionality of the Puerto Rican excise tax. All five of them expressed the view that the tax was unconstitutional or that its constitutionality was seriously in doubt.

That the excise tax is not a sales tax defies the plain English meaning of a sales tax. The excise tax is a tax on purchases by affiliates outside Puerto Rico, which are by definition sales by affiliates in Puerto Rico. The Steptoe & Johnson opinion letter's arguments that the excise tax is not a sales tax because the transactions are between related parties and that the excise tax is separate and distinct from Puerto Rico's generally applicable sales tax are unconvincing.

Even if the excise tax is not considered a sales and use tax, which all authorities agree would require physical presence to establish nexus, it is not at all clear that the excise tax would escape the physical presence requirement. It is true that many state courts supporting the views of state tax authorities have held that physical presence is not required for taxes other than sales and use taxes. For example, in Tax Commissioner v. MBNA America, N.A. (W.V. Sup. Ct. of App. 2006), the West Virginia Supreme Court of Appeals stated that the physical presence test "applies only to state sales and use taxes and not to state business franchise and corporation net income taxes."

However, other state courts have concluded the opposite. For example, in J.C. Penney National Bank v. Johnson (Tenn. Ct. App. 1999), the district court stated that "while it is true that the Bellas Hess and Quill decisions focused on use taxes, we find no basis for concluding that the analysis should be different in the present case. In fact, the Commissioner is unable to provide any authority as to why the analysis should be different for franchise and excise taxes."

In their textbook on state tax law, John C. Healy and Michael S. Schadewald summarize the debate this way:

    Many commentators have argued there is no reason to believe that the Commerce Clause would impose a different standard for income taxes than for sales and use taxes. Therefore, the same physical presence test should apply. Nevertheless, until the Supreme Court rules on the issue, it will be uncertain. [ Multistate Corporate Tax Course, 2009 Edition, CCH, 2008.]

So even if the excise tax is not considered a sales and use tax, the issue of its constitutionality is unresolved.

Good Policy?

Notwithstanding the resolution of the uncertainty about the constitutionality of the Puerto Rican excise tax, it is important to step back and examine the creditability of the tax from a policy perspective. No matter how well the Puerto Rican government and its advisers have navigated the technical issues, the result they achieved raises serious concerns.

The foreign tax credit exists so our multinational corporations are provided relief from foreign taxes that would otherwise result in double taxation on their foreign profits. But as professor Daniel N. Shaviro has repeatedly pointed out, dollar-for-dollar compensation by Treasury for foreign taxes paid creates huge incentives for mischief. Shaviro emphasized that the availability of foreign tax credits creates the large incentive to engage in aggressive tax planning. For example, foreign tax credits can cause businesses to try to claim that otherwise deductible expenses, particularly fees paid for government services, are creditable foreign taxes. (See Shaviro, Fixing U.S. International Taxation, Oxford University Press, 2014.)

The availability of foreign tax credits invites abuse by foreign governments that, left unchecked, will use U.S. multinationals as conduits to tap into the U.S. treasury. Potential abuse by taxpayers and governments (and by taxpayers colluding with governments) makes it necessary for the law to limit the types and the amount of foreign taxes that can be credited.

When foreign governments impose income tax because a foreign tax credit is available, the credit does not provide double income tax relief to multinationals. If a foreign government imposes a tax only because it is creditable, the multinational would not pay any tax if the credit did not exist. The multinational pays tax and generates offsetting credits, but the credit is not helping the multinational because in the absence of the credit, there would be no tax. In this situation, the foreign tax credit is not achieving its policy objective. It is only transferring funds from the U.S. treasury to the foreign government, with the multinational acting as intermediary.

Clearly, unless it is the objective of the U.S. government to provide aid to a foreign government, this situation is highly objectionable and rules are needed to prevent it. The prohibition against creditability of soak-up taxes takes care of the easy case. With a soak-up tax, the amount of tax is explicitly linked to the availability of the credit. But more generally, how can we distinguish taxes that truly burden multinationals from those that only appear to do so?

Ideally, to prevent abuse we would have to know what the foreign government would do in the absence of the credit. As already noted, if the foreign government levies the tax because of the credit, the credit is benefiting the foreign government, not the multinational. If the government would have levied the tax anyway, the credit is providing relief to the multinational.

Unfortunately, we cannot know with any certainty what a foreign government would have done. There are, however, reasonable indicators of when a tax is levied because of the foreign tax credit. As a reasonable precaution against abuse, the U.S. government should not allow taxes to be creditable when these indicators are present.

One indicator is the net after-credit burden of a tax on the taxpaying population. This incentive effect can be quantified by the ratio of the amount of tax creditable to the total amount of revenue collected. The ratio is close to 1 when the credit is narrowly targeted on multinationals that can credit the tax. The ratio is close to zero when a tax is broadly imposed on the local population and multinationals that can credit that tax pay a small fraction of the tax. When the ratio is large, it is likely the tax is imposed because of the credit. When the ratio is small, it is likely the tax has little to do with creditability.

Most of the large manufacturers affected by Act 154 are U.S.-headquartered multinationals. Among Puerto Rico's largest pharmaceutical manufacturers, all but one out of 33 manufacturing facilities are owned by U.S. multinationals, and all but 300 out of 17,000 workers are employed by U.S. multinationals. Among the listed medical device manufacturers, all but two out of 21 manufacturing facilities are owned by U.S. multinationals, and all but 1,100 out of 12,400 workers are employed by U.S. multinationals. (See The Book of Lists, 2013 edition, p. 177 and p. 180.) Because the ratio of tax relief provided by the United States to tax burden imposed by Puerto Rico is high, the incentive for the Puerto Rican government to levy the tax is large. Therefore, there is good reason to believe the tax would not exist (or would be significantly reduced) if it were not for the credit, and so the benefit of the credit accrues entirely (or significantly) to the government of Puerto Rico.

As a policy matter, because it is likely that the U.S. government is merely providing a subsidy to a foreign government rather than relieving U.S. taxpayers, the U.S. government should deny foreign tax credits for taxes like the Act 154 excise tax.

Crisis Continues

In the November 6, 2012, gubernatorial election, Fortuño fell short of securing reelection by a margin of 11,000 votes out of about 1.8 million cast. On January 2, 2013, he was succeeded by Padilla, who became the 11th elected governor of Puerto Rico. Later in January, after receiving clearance from Puerto Rico's Government Ethics Office, Fortuño became a partner in the Washington office of Steptoe & Johnson.

Despite Fortuño's efforts at downsizing the government and stimulating growth, the Padilla administration had a mess on its hands almost as bad as in 2009. Between January 2010 and January 2013, the Puerto Rican economy shed 46,000 jobs -- a decline of 4.4 percent during a period when employment in the 50 states increased by 4.2 percent. And with a budget deficit of $2.2 billion, the government still had an unacceptably large amount of red ink. Unless there were fiscal reforms, the bond rating agencies were threatening to downgrade Puerto Rico's already low credit rating even further.

To address the crisis, the Padilla administration promptly enacted a large tax increase, including new taxes as well as an increase in individual and corporate rates. All together, these measures were estimated to raise $1.4 billion in fiscal 2014. And despite Padilla's opposition to the tax before the election, the new revenue in his plan included an increase in and extension of the excise tax under Act 154. Under the legislation unanimously approved by the Puerto Rican House of Representatives and enacted in February 2013, the excise tax rate was increased from 2.75 percent to 4 percent for the rest of calendar year 2013. And instead of the rate declining to 1 percent in 2016 and the entire tax expiring at the end of that year, the rate was frozen at 4 percent and the life of the tax extended to the end of 2017.

Both Puerto Rican political parties agreed on the excise tax. In February Rep. José Aponte Hernández of the PNP introduced legislation to make the tax permanent and increase the rate to 10 percent. In a recent letter otherwise highly critical of the current administration, Commissioner Pedro R. Pierluisi, Puerto Rico's representative in Congress, wrote: "On a positive note, I credit the governing party for keeping in place the excise tax. . . . Whatever changes may be made to the structure or level of that tax, I believe it is critical that revenue raised from the tax be specifically targeted to address Puerto Rico's most pressing needs."

Unfortunately, after showing some signs of stabilization, the economy of Puerto Rico has deteriorated since midsummer. The unemployment rate rose from 13.2 percent in June to 14.7 percent in November. And the commonwealth's credit standing has only further deteriorated. All three bond rating agencies now give Puerto Rico a rating just above junk bond status. As shown in Figure 2, Puerto Rican bonds have plummeted in value since midsummer.

On November 6, 2013, Mary Miller, the U.S. Treasury Department's undersecretary for domestic finance, said, "We can be helpful in making sure that every federal dollar that Puerto Rico is entitled to is being spent effectively and efficiently." Miller added that "there are many conversations that are taking place between the island and Washington more broadly, but I don't want to convey that that translates into a direct ask for federal direct assistance, because that is not contemplated at this time." (See Bloomberg, "Miller Says Puerto Rico to Get Management Advice Without Aid.") On November 7 former Treasury Secretary Lawrence Summers said that "there are profoundly serious financial issues facing Puerto Rico right now" and that its bonds were trading as the "junkiest of the junk." (See Bloomberg, "Summers Sees Low Market Confidence in Puerto Rico Bonds.")

On November 21, 2013, David Agnew, co-chair of the president's task force, announced that a team of experts from the administration would begin partnering with Puerto Rico's government officials to marshal existing federal resources and help Puerto Rico build its capacity for addressing economic issues. Agnew wrote in a White House blog post:

    The interagency team will offer strategic advice to assist Puerto Rico in promoting its economic development and maximizing the impact of existing federal funds flowing to the Island. These efforts are not a federal intervention. Rather, these policy experts will share their expertise with the Puerto Rican officials leading the Commonwealth's economic efforts.
Figure 2. The Value of Puerto Rican Bonds Versus
Other Municipal Bonds Since January 1, 2013

Source: S&P Dow Jones Indices.

Upon formation of the new interagency team, Pierluisi stated:

    In meetings and other communications, I have been urging the Administration to move beyond monitoring the situation in Puerto Rico, asking them to take specific and concrete steps to help the Governor and his economic advisors formulate sound fiscal policies that will spur economic growth and enable the territory to maintain access to capital markets.

The new team will consist of members of Padilla's administration and federal experts from the Department of Education, the Department of Health and Human Services, the Department of Housing and Urban Development, and the Environmental Protection Agency. It will be supported by experts at the Office of Management and Budget, the National Economic Council, the Council of Economic Advisers, and Treasury.

On December 1, 2013, Treasury officials Adam Chepenik and Lawrence Seale arrived in Puerto Rico for a week of meetings. They and other federal advisers are concentrating on three fronts: fiscal strategy, optimization of federal funding, and economic development.

There is no indication that the new interagency team will make any recommendation regarding Act 154. Nevertheless, many in Puerto Rico would welcome clarification from Treasury. In a 2013 interview, Juan Lara, chief economist at Advantage Business Consulting Inc. in San Juan, proposed that lobbyists for Puerto Rico focus their efforts on the IRS instead of Congress. "In my opinion, a final determination from the IRS regarding Act 154 is among the most important issues we should address," Lara said. "I would be pushing for the IRS to state finally that such a tax would be creditable for the next decade." He added that "it is easier for the IRS to render a ruling; it doesn't need legislation from Congress." (See "Lobbyists Called Upon to Address Ruling on Act 154," Caribbean Business, Feb. 14, 2013.)

In a recent editorial, Caribbean Business publisher Manuel A. Casiano, skeptical about the value of short visits by federal officials, suggested that the task force make clear that taxes levied by Puerto Rico through the Act 154 excise tax on multinational companies can be credited against the companies' U.S. tax burden. He wrote:

    Puerto Rico's fiscal situation has made the Act 154 excise tax more important than ever, and the Obama administration could strengthen this important tax-revenue source by making clear that the federal government will continue to grant the 4 percent tax credit to companies for the amount they pay Puerto Rico through the excise tax. In fact, the real big help would be to back increasing that tax credit to 6 percent to help Puerto Rico immediately even if it's for just three years until we finish getting our economic situation turned in the right direction. [ Caribbean Business, Dec. 13, 2013.]


There are serious doubts about the constitutionality of the new taxes on U.S. multinationals originally enacted in October 2010 and then increased and extended in February 2013 by the government of Puerto Rico. The tax's creditability against U.S. income tax is in question as well. Nevertheless, Treasury has allowed U.S. multinationals to credit the tax, and there is no indication that it will modify this policy in the future.

In response to inquiries from Tax Analysts, Treasury on January 6 provided a statement that largely repeated the message of Notice 2011-29:

    Treasury and the IRS continue to evaluate the legal and factual issues which will inform the determination of whether the Excise Tax is a creditable tax. The Notice provides interim guidance on the creditability of the Excise Tax and states that the IRS will not challenge a taxpayer's position that the Excise Tax is a tax in lieu of an income tax under section 903. Any change in the foreign tax credit treatment of the Excise Tax after resolution of the pending issues will be prospective and will not apply to prior Excise Tax paid or accrued before the date that further guidance is issued.

The 2013-2014 priority guidance plan, as updated on November 20, 2013, contains 329 projects that are priorities for allocation of the resources of the IRS and the Treasury Office of Tax Policy during the 12-month period from July 2013 through June 2014. It lists six foreign tax credit projects, but nowhere in it is there any indication of Treasury doing further analysis of the creditability of the Puerto Rican excise tax.

Even if the constitutionality of the tax is established and other technical requirements for its creditability are met, the creditability is objectionable on policy grounds because the primary beneficiary of the credit is the government of Puerto Rico and not multinationals. The provision of the credit is a subsidy by Treasury to the government of Puerto Rico.

This look-the-other-way approach to the creditability of the tax may be questionable procedure and policy, but it has furthered the Obama administration's goal of maximizing assistance to Puerto Rico under current law. It is unlikely in these times of extremely tight budgets that the administration could obtain congressional approval for financial benefits of similar magnitude.

On September 21, 2011, Pierluisi introduced H.R. 3020, the Puerto Rico Investment Promotion Act. The proposed legislation would allow businesses incorporated in Puerto Rico that earn at least 50 percent of their income to elect to operate as domestic U.S. companies whose Puerto Rican income is exempt from U.S. tax. So, unlike under current law, Puerto Rican income could be repatriated free of U.S. tax. But this legislation is going nowhere. Similarly, efforts to provide favorable treatment for Puerto Rico in international tax reform were rejected by House Ways and Means Committee Chair Dave Camp, R-Mich. (See "Congressional Chairman Rejects Puerto Rico Exemption Proposal," Caribbean Business, Sept. 19, 2013.)

Act 154 is obscure outside Puerto Rico. But its continuation is critical to Puerto Rico's financial future. Unless pressure from Congress or the public is brought to bear, it is likely that Treasury will continue to allow the tax to remain creditable, as it did in the case of the Mexican flat tax. Practitioners contacted by Tax Analysts expressed the view that taxpayers who do not receive the credit have not challenged the credit in court because they do not believe they could prevail in Puerto Rican courts and that the U.S. Supreme Court would likely not hear the case. The other interested parties are fine with the status quo. Those include both major political parties in the Puerto Rican government, the Obama administration, investors in Puerto Rico's municipal bonds, and U.S. multinationals that can credit the tax. The only ones on the short end of the stick are U.S. taxpayers, who are footing the bill.

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