Analysis: To have ‘fighting chance,’ P.R. needs to rebuild infrastructure, execute clear strategy
Although Puerto Rico appears to have lost its major corporate tax advantage following the approval of the U.S. Tax Reform, if it were to backfire and motivate companies to send jobs overseas and transfer revenues to other countries, Puerto Rico could have a chance to survive the predicted economic onslaught associated with the measure.
In an analysis, economic firm H. Calero Consulting predicts that to have a fighting chance, Puerto Rico urgently needs to rebuild its infrastructure and execute a clear strategy to improve its attractiveness for investment.
“Puerto Rico has only one economic model: attract massive investment to its infrastructure and to incentivize merchandise and services exports. A new year is a great new start,” H. Calero Consulting noted in the December edition of its “Economic Pulse” newsletter.
On Dec. 20, Congress approved the U.S. Tax Cuts and Jobs Act, which represented a major overhaul to the tax code that, among other things, will substantially cut corporate tax rates on a permanent basis and tax cuts to households that will expire over the next decade.
The reform threatens half of Puerto Rico’s GDP, 288,000 direct and indirect jobs, and 33 percent of the central government budget, as it puts at risk what remains of manufacturing on the island. The tax reform lowers the corporate tax rate from 35 percent to 21 percent for companies doing business stateside.
“The United States has one of the highest corporate tax rates in the world. It forces companies to move their operations and jobs overseas. But the effective tax rate is lower because corporations have tax attorneys who take advantage of deductions, lowering their effective rate. Almost half of corporations pay no taxes,” the firm noted.
Under the mandate, Puerto Rico was defined as a foreign jurisdiction, where the effective tax rate went to 12.5 percent from the 2 percent in effect prior to the reform’s approval.
“A production line or a distribution center in Puerto Rico added much value to a company’s global operation because it reduced the company’s global tax rate,” H. Calero Consulting noted.
For example, a company with $300 million net taxable income distributed equally between the U.S. mainland, Puerto Rico, and other countries paid 35 percent in the U.S., approximately 2 percent in Puerto Rico, and 12.5 percent in other countries, for an average tax rate of 16.5 percent.
After the Tax Reform, the same company will pay 21 percent in the U.S., 12.5 percent in Puerto Rico and 12.5 percent in other countries, for an average 15.3 percent. While that may benefit companies, Puerto Rico is at risk of losing a chunk of revenue that it relies upon to run the government and provide tax breaks.
The majority of manufacturing companies that remain in Puerto Rico operate under the classification of a Controlled Foreign Corporation, or CFC, which is a corporation organized in a foreign country but owned by a U.S.-based shareholder.
CFC dividends to U.S. shareholders were normally subject to a 35 percent tax rate. However, the U.S. Internal Revenue Code allows the deferral of taxes on their income until it is repatriated as dividends to their U.S. shareholders. This allowed them to pay federal taxes only when they repatriated their income back to the U.S. as dividends paid to U.S. parent.
Meanwhile, effective this month, U.S. companies will benefit from reduced tax rates of 10.5 percent on global intangible low-taxed income (GILTI). Also in 2018, businesses with gross receipts of at least $500 million are required to pay a tax equal to the base erosion anti-abuse minimum tax (BEAAT) of 20 percent of amounts paid or incurred by a domestic CFC for the taxable year to avoid tax base erosion.
“All these provisions constitute a move to a territorial system so generally only income within U.S. mainland borders is taxed, and anti-abuse rules to prevent companies from shifting their income abroad. They impact many CFCs (owned by U.S. shareholders) operating in Puerto Rico, particularly manufacturing operations that generate royalties and intangible revenues,” H. Calero Consulting noted.
Manufacturing is P.R.s’ main economic driver
Manufacturing is Puerto Rico’s main economic driver with 1,730 establishments doing business. In Fiscal 2016, manufacturing represented 47 percent of GDP and in FY 2017 manufacturing had 72,000 direct jobs or 8 percent of total employment. In addition, the sector maintains 216,000 indirect jobs.
Manufacturing also paid $2.75 billion in fiscal revenues in Fiscal 2017, which accounted for one third of the Puerto Rico government’s General Fund revenues. CFCs in Puerto Rico are mostly in pharmaceuticals, medical devices, and electronics.
The growing concern among industry executives, including the Puerto Rico Manufacturers Association, economists and the government, is how many of these companies will decide to pack up and leave under these new circumstances. The last time Puerto Rico saw a max exodus of manufacturing companies was after Section 936 of the U.S. Internal Revenue Code was eliminated.
In 1979, PR had 672 “936” corporations, of which 65 were pharmaceutical companies and 112 were electronics. By 2015, there remained 219 CFCs in the island, with 36 in pharmaceutical and 27 in electronics.
“The 2017 U.S. Tax Reform was passed without considering its potential impacts on Puerto Rico. The efforts of Puerto Rico officials to include protections for the island carried a mixed message to Congress and in the end, were too little too late,” H. Calero Consulting further noted.
Despite the loss of tax advantages, Puerto Rico fulfills some of the global site selection criteria for CFC’s: Qualified human resources in Current Good Manufacturing Practices; location close to the U.S. market; and access to a cluster of manufacturing services. However, labor costs are slightly higher than other countries; Puerto Rico has an indirect tax in the form of a Sales and Use Tax, which is different from most developed countries with a Value-Added Tax; and, its regulatory environment is complicated due to federal regulations.