Tax Analysts Blog

There Is a Bailout: Obscure Treasury Ruling Provides $8 Billion to Puerto Rico

Posted on Jul 6, 2015

“There’s no one in the administration or in D.C. that's contemplating a federal bailout of Puerto Rico,” White House press secretary Josh Earnest told reporters on June 29. That statement is simply false. It may be true that the Treasury is not contemplating cash subsidies or loan guarantees for Puerto Rico, but it already is providing something just as good: tax credits for U.S. companies operating in Puerto Rico on a Puerto Rican tax designed to give those companies U.S. tax credits.

Sound complicated? Yep. That’s why nobody is paying attention. Think about it this way: Puerto Rico imposes a tax that the federal government pays. U.S. companies operating there are just the middlemen.

Here are the details.

Since 2011, approximately 20 percent of Puerto Rico's total revenue collections have come from a temporary excise tax on certain products manufactured in Puerto Rico (see figure below). When it was first signed into law by then-Gov. Luis Fortuño on October 25, 2010, the tax rate was scheduled to be 4 percent for calendar year 2011; 3.75 percent in 2012; 2.75 percent in 2013; 2.5 percent in 2014; 2.25 percent in 2015; and 1 percent in 2016. In February 2013, although he opposed the tax during the 2012 campaign, Puerto Rican Gov. Alejandro Garcia Padilla signed new legislation that increased the tax rate to 4 percent for all purchases after June 30, 2013, and extended the expiration date for one year, to the end of 2017. During fiscal 2013, the excise tax was paid by 27 groups of affiliated taxpayers, of which six accounted for approximately three-quarters of collections.

Now here’s the financial magic. On March 30, 2011, the IRS released Notice 2011-2 ruling that this new excise tax was a foreign tax creditable against U.S. taxes. The notice 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 were 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 of the new tax burden imposed on multinationals doing business in Puerto Rico was eliminated by Treasury.

So what's wrong with this ruling? There are two big legal and policy problems that make you wonder why technicians at Treasury would ever approve it in the first place -- and why they have not since withdrawn it.

Most affiliates of U.S.-headquartered multinationals have entered into industrial tax exemption agreements with Puerto Rico. These agreements provide a low flat rate of tax on Puerto Rican-source income. Because the new excise tax is not imposed on entities operating in Puerto Rico, it does not violate the agreements the island has made with these manufacturers. But the imposition of tax on purchasers raises questions about the constitutionality of the tax. According to the U.S. Supreme Court, to avoid violating the commerce clause, a nonfederal tax must be applied to an activity with substantial nexus to the taxing jurisdiction. So the question arises whether the purchase of products by affiliates with no physical presence on the island establishes sufficient nexus for Puerto Rico to tax those affiliates. The Puerto Rican government has obtained an opinion letter from a prominent U.S. law firm stating that there is sufficient nexus, but there are strong counterarguments for the opposite view.

A bigger policy issue than the constitutionality of the tax is whether it is proper for the tax to be credited. The foreign tax credit exists so U.S. multinational corporations are provided relief from foreign taxes that would otherwise result in double taxation on their foreign profits. Left unchecked, however, the availability of foreign tax credits invites abuse by foreign governments that 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. 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.

If the Treasury Department and IRS believed the tax was creditable, they could do a great deal to improve investor confidence and the overall fiscal situation in Puerto Rico by making the tax's creditability status permanent, as the Puerto Rican government has requested. Because it is the stated policy of the Obama administration to maximize assistance available to Puerto Rico under current law, a logical conclusion is that either the Treasury Office of Tax Policy or the IRS or both have serious objections to deeming the tax creditable.

It has been four years since Treasury issued Notice 2011-29. This look-the-other-way approach to the creditability of the tax raises serious questions of procedure and tax policy at Treasury. But from the perspective of the Treasury Office of Domestic Finance, which is apprehensive about financial collapse in Puerto Rico and the possible need in the future for explicit credit assistance, this approach is far superior to a ruling declaring the tax not creditable that by itself would probably trigger default of Puerto Rico's bonds.

So don’t believe everything the White House tells you about Puerto Rico. Without an appropriation of funds from Congress, without public scrutiny, with scant press attention, administration officials have been bailing out Puerto Rico for years. They were just hoping you wouldn’t notice.

Read Comments (2)

edmund dantesJul 6, 2015

Excellent article. Another glaring example of the politicization of the IRS by
the Obama administration. They achieved by executive action an objective that
they couldn't possible reach through the legislative process.

One wonders why the Republicans haven't raised the issue. On the one hand,
they may be in the pockets of the multinationals. On the other, they may just
be afraid of being called racists, and don't want to pick this particular fight.

When one wonders how Puerto Rico acquired such a massive amount of debt, one
key element is this pipeline into the US Treasury for the debt service.

John AnthonyJul 10, 2015

The nexus issue is clear. There's a transaction between a U.S. company and a
Puerto Rican (PR) company, which is typically controlled by the U.S. company.
The transaction is the subject to the tax. A buyer could certainly challenge
nexus if title passes outside of Puerto Rico, but, if there's a B2B contract,
then there's definitely contractual nexus, which has been settled by the U.S.
Supreme Court. See McGee v. International Life Insurance Co., 355 U.S. 220

The question here is whether a government can compel another person to assume
the liability for another person's income tax. A person is allowed to
voluntarily assume the income tax liability of another. Treas. Reg. §
1.901-2(f)(1). Therefore, if another person can legally assume liability, can a
government legally shift liability? That's the question.

Transfers between related parties have always been considered a recognition
event. However, the recognition event is for the seller; not the buyer. The
buyer has no income. So does a foreign government have the right to make
someone else liable against their will?

Treasury is right; this is novel. However, when in doubt, challenge! The role
of the Treasury is to preserve the nation's revenue. Turning a blind eye to
this is hardly being protective of our revenue.

A company compelled to make this payment should file suit in federal court. If
a court determines they are not legally liable under U.S. law, the tax will not
be creditable. For now, the Obama Administration has discretion on how to
execute laws. It can turn a blind eye if it wants. It's called "prosecutorial
discretion" and is a well settled power of any Executive. I hate to sound like
a wingnut Fox News pundit, but this does look like wealth redistribution on a
global scale.

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