Economically, Puerto Rico has at least two things going on. First, there are ordinary hardworking people doing ordinary jobs, as in every state. Then there are people and corporations playing with tax tricks. Here are some examples.
Say you own a company that makes software. You set up shop in Puerto Rico, with at least one worker — but that worker could be the owner of the company, so you just open up a home office. You live in Puerto Rico for part of the year and have very few business expenses, so you don’t contribute much to the local economy. You make some local donations, but don’t spend much personally, since your main entertainment is travel. You create a video game. You say that your Puerto Rico division owns the video game.
You also have an office in New Mexico, and you have an office building there. You have 100 employees there, too, and lots of expenses which you can take off your taxes. You travel to New Mexico frequently from your official home in Puerto Rico, and you can deduct your travel and much of your entertainment as business expenses. You contribute quite a bit to the local economy, between your business and your personal expenditures.
Your Puerto Rico office charges the New Mexico office to license the new game. The New Mexico office pays $10,000 a month for the license, sending that money to The Puerto Rico office. This money comes from your company and goes to your company, so it doesn’t make any real difference to your bottom line. You don’t spend the money in Puerto Rico, especially since you don’t have a professional building or workers.
However, The Puerto Rico office counts it as income earned in Puerto Rico and pays almost nothing in taxes. The New Mexico office counts it as a cost of doing business and gets a tax deduction for it. Your expenses in New Mexico are tax deductible and your income in Puerto Rico is untaxed, so you count as many expenses as possible in New Mexico and count as much profit as possible in Puerto Rico.
That’s a very simple example of a transfer payment.
“The IRS is running out of patience with companies cutting their tax bills with transfer payments,” a recent article in Fierce Pharma claims. The IRS sent Amgen, a pharmaceutical company, a bill for $7.1 billion. They’re making an example of Amgen — and they’re not through. The IRS is still auditing the company.
But Amgen is just one example. The United States is bilked of billions in tax dollars every year by companies paying themselves in this way.
Transfer payments tend to be used most by large companies. However, a solo proprietor can set up a one-person home office in Puerto Rico and pay very little — in some cases nothing at all — in taxes. Act 60 is a law that simplified and streamlined a number of existing laws into one.
Under Act 60, someone moving to Puerto Rico and setting up a business there which serves people in the states can usually pay no taxes on their personal income, and 2-4% on their corporate income. This is true even if they have no employees apart from themselves.
This deal is not available to people from Puerto Rico.
The object of Act 60 is to create jobs in Puerto Rico, to stimulate the economy, and to encourage investment on the Island. However, it is extremely vulnerable to abuse by people who simply want to avoid paying taxes. The IRS is cracking down on this group, too.
Section 936 is no longer in force, but it was a very generous tax sheltering program in the 20th century. Pharmaceutical companies could expect to save $2.67 in taxes for every $1.00 they spent in their businesses in Puerto Rico. The government could have subsidized everyone employed under Section 936 and saved more than half of the cost of the program in tax dollars.
From 1976 to 2006, this tax incentive program saved corporations billions of dollars but brought relatively few jobs to Puerto Rico. On paper, Puerto Rico had an economy built on manufacturing, but the billions shown as profits from those manufacturing operations — as in the hypothetical example of the software company at the beginning of this post — did not stay in Puerto Rico.
Average incomes in Puerto Rico stayed far below those in the states. The Island’s infrastructure suffered. The territorial government went deeply into debt.
When Section 936 ended, it looked on paper as though Puerto Rico lost economically. In fact, rather than boom and bust it was just a bubble. The Senate Finance Committee said in a report they published on the subject, “Section 936 of the Internal Revenue Code was not an effective means to promote economic growth in Puerto Rico, and the emergence of the current and long-continuing recession cannot be attributed to the termination of 936.”
Statehood is the solution
States make most of their own tax decisions because of the 10th amendment to the U.S. Constitution. The 51st state of Puerto Rico will be able to have tax incentives just as states do.
However, Puerto Rico will be part of the overall U.S. economic system and will not have to rely on tax tricks for its prosperity. With equal treatment under federal programs and increased confidence from actual investors, the tax incentive bubbles will be less appealing.