Analysis: P.R. will feel economic blow of Federal Tax Cuts and Jobs Act in ’19

Written by  //  December 28, 2017  //  Economy  //  1 Comment

Economist José Joaquín Villamil heads Estudios Técnicos Inc. (Credit: © Mauricio Pascual)

The recently passed Federal Tax Cuts and Jobs Act will have implications for Puerto Rico’s economic that will start to become more noticeable after fiscal year 2019, local research firm Estudios Técnicos Inc. predicted in an analysis released this week.

The law, considered the most comprehensive change to the 1986 U.S. Internal Revenue Code since its inception, will directly impact those U.S. companies with operations in Puerto Rico, and thus, its economy, the analysis released by the firm presided by Economist José Joaquín Villamil, noted.

The mandate maintains the treatment of Puerto Rico as a “foreign tax jurisdiction” for federal tax purposes, but there are significant modifications to the tax arrangements under which U.S. corporations, known as “Controlled Foreign Corporations” (CFC) will operate in Puerto Rico.

One is related to their current deferred offshore profits, which include those generated or maintained in the island.

The new tax regime moves from a global system of taxation to a territorial system, with anti-abuse rules and a base erosion anti-abuse tax (BEAT). While the states where international companies have a tax liability will benefit from the repatriation clause. Puerto Rico will not benefit as it is considered a “foreign tax jurisdiction.”

Although the changes extend beyond 2027, its first decade, by that year the distribution of the federal tax burden would look different, and many of the provisions of the bill would expire on Dec. 31, 2025.For one, the bill includes temporary provisions, such as expensing of certain capital investments by businesses for five years. The majority of tax changes have a sunset clause.

“Puerto Rico will be competing for business investment through enhanced statutory credits or incentive programs with other jurisdictions in the U.S.,” the analysis stated.

“Changes to Puerto Rico’s corporate income tax code will have to be made to conform to the law, and that could impact local revenues in coming years. Thus, an increase in corporate taxes would make little sense given that they are being lowered in the mainland,” the Estudios Técnicos study further noted.

In the analyses of the impact of tax laws, too much emphasis has been paid to the statutory or nominal rate, and not the effective rate, which is more relevant as it is the one actually paid by the businesses.

“In the U.S. the top federal statutory corporate income tax rate [the rate set by law that applies to the highest corporate income tax bracket] has been 35 percent since 1993. Most corporate income is taxed at that rate. Adding state taxes, the top statutory rate is higher, on average a combined rate was 39.1 percent in 2012,” Estudios Técnicos pointed out.

While the federal statutory tax rate currently stands at 35 percent, very few companies actually pay that amount. Through the use of various deductions, credits, and income deferral mechanisms in the tax laws, companies end up paying a lower tax rate.

This lower rate is the effective tax rate (ETR), that differs by industry. That is, companies in the pharmaceutical sector, for instance, have a rate different from those in the construction, retail trade, or utilities sectors.

The law, besides reducing the statutory corporate tax rate from 35 percent in 2017 to 21 percent in 2018, will have the effect of reducing the average (all industries) ETR from the statutory rate of 21 percent to 9 percent in 2018.

Potential impacts on Puerto Rico
Two of the biggest concerns are the impacts on manufacturing employment (and the indirect employment generated through it), in particular in the pharmaceutical and medical equipment and supplies sectors.

The impact on fiscal revenues is also a major concern as the CFCs provide more than one-third of the Commonwealth’s fiscal revenues from Law 154 payments and other taxes.

Employment (nonfarm salaried) in manufacturing has been declining for several years. Between 2007 and 2016 it decreased at an annual average of 4 percent, translating into a loss of almost 33,000 jobs in the period.

Pharmaceuticals, computer and electronic equipment, and the medical equipment and supplies sectors represent 42 percent of the total employment in manufacturing. Employment in these sectors also declined, with the job losses in the pharmaceutical and drugs sector accounting for 29.4 percent of the total losses in manufacturing. Thus, any incremental losses in employment as a result of the law would accelerate the existing trend, Estudios Técnicos noted.

What measures in the law impact Puerto Rico?
Most of the attention on possible impacts has been on the12.5 percent on profits from intangibles that will impact sectors such as pharmaceuticals, IT and medical equipment.

“The reason is that these are highly dependent on patents developed in the United States. Since Puerto Rico is considered a foreign tax jurisdiction, CFCs in Puerto Rico will be subject to the tax,” the analysis pointed out.

“Since most of their production depends on patents resulting from R&D in the mainland, and most of their production is exported to the U.S., the 12.5 percent can almost be considered an income tax,” the analysis showed

“This will probably not lead to an immediate and massive exodus of firms from Puerto Rico, but it will impact future promotions and generate a slow erosion in their presence, similar to what happened when Section 936 was repealed, perhaps faster since there is no 10-year transition as with 936,” the firm further noted.

“In the various analyses made on the potential impact of the law, a frequently overlooked aspect is the fact that taxes are being added to these firms in Puerto Rico while they are being reduced in the mainland,” the firm noted.

With the new legislation, federal effective tax rates for manufacturing fall to a little higher than 10 percent, while in Puerto Rico an effective tax rate of 4 percent for exempt firms now becomes much higher, even excluding the 4 percent now paid under Law 154, that generates $2.1 billion in local fiscal income.

A perhaps oversimplified analysis indicates that the gap between the previous tax legislation’s effective tax rate, 16.8 percent, and Puerto Rico’s effective tax rate of 4 percent, plus the Law 154 tax, was sufficient to make Puerto Rico an attractive investment venue and compensate for the risk factor attached to investing in the island.

“In the new situation, this is no longer true. The gap has narrowed significantly and the risk factor has become a major concern,” Estudios Técnicos noted.

The U.S. Food and Drug Administration will almost certainly place a great deal of pressure on pharmaceuticals and medical equipment manufacturers to avoid concentrating their production in Puerto Rico.

“This is so to avoid the recurrence of the problem created in the mainland when production of certain products stopped due to the hurricane. This risk factor will now be a more important component of site selection criteria,” the study showed.

Indirect consequence
An indirect consequence of the law will be the almost certain reduction in allocations to a number of federal programs including, but not limited to, those related to health services.

“This will place additional pressures on state and local governments. In Puerto Rico’s case its fiscal situation is such that this will have more serious consequences than in states in better fiscal condition,” the firm noted.

In addition, the “immense” tax savings for the manufacturing sector between 2018 and 2017, in excess of $260 billion, will support the policy objective of the Trump Administration of strengthening manufacturing production in the U.S. mainland.

“This could hurt Puerto Rico in view of its treatment as a foreign tax jurisdiction. Likewise, the fact that R&D investment can be recovered in five years in the U.S. and 15 years elsewhere — including Puerto Rico — acts as a disincentive for R&D in the island,” the firm noted.

In short, the law, in an initial reading, points to impacts on three fronts: the direct consequences of the 12.5 percent on CFCs, the indirect consequence of lowering the corporate rate in the U.S. and the potential impacts that a reduction in federal allocations to social programs will have.

“The result most likely will be that the manufacturing sector will experience a gradual erosion in the existing number of plants, but will also mean that new manufacturing promotions will have to be very different in terms of target industries,” Estudios Técnicos added.

A detailed analysis of the law will probably result in additional impacts on Puerto Rico, mostly indirectly. So, housing programs, some of which were left untouched, will almost certainly suffer changes in the coming years according to housing analysts.

“The law will suffer amendments since it was put together rather quickly and has been severely criticized by economists and accountants, as well as sector organizations,” the firm predicted.

With respect to Puerto Rico there is a possibility of amendments to the mandate and other legislation that could partially mitigate its negative points.

“The Opportunity Zones frequently mentioned as a positive initiative will have minimal impact in Puerto Rico’s economic recovery due precisely to its structure and requirements,” Estudios Técnicos noted.

Locally, the challenge is to make certain that reconstruction funds are used in such a manner that they support economic development.

“This requires careful planning and collaboration between the government and the private sector. In addition, the new context created by the law will mean that Puerto Rico’s promotional strategy, basically unchanged since the 1960’s, will have to move away from the tax-driven approach that has characterized it. The Rosselló administration is well-aware of this and is moving in this direction,” the firm concluded in its analysis.

One Comment on "Analysis: P.R. will feel economic blow of Federal Tax Cuts and Jobs Act in ’19"

  1. Kenneth McClintock December 28, 2017 at 5:39 AM · Reply

    The last two sentences are the most important. Secretary Laboy, a pragmatist, was already moving away from terminally ill tax incentives anyway since he cane into office.

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