By Damon M. Lyon, David G. Noren, Lowell D. Yoder, Rachel E. Aaronson, Robert A. Clary II A temporary excise tax recently enacted in Puerto Rico will have a
significant impact on U.S.-based multinational groups conducting, or
considering conducting, manufacturing activities in Puerto Rico.
Companies should consider the creditability of the excise tax for U.S.
purposes and, even if the excise tax is creditable, whether their
current organizational structure allows them to fully utilize the
foreign tax credit.
On October 25, 2010, Puerto Rico enacted a temporary excise tax on
related party purchases of products manufactured in Puerto Rico or
services performed in Puerto Rico. The tax is imposed on the value of the products or services purchased.
The rate of the tax will decrease during the years of its existence
from 4 percent in 2011, to 3 percent in 2012, to 2.75 percent in 2013,
to 2.5 percent in 2014, to 2.25 percent in 2015 and down to 1 percent in
2016, when it will expire on December 31. The tax will
have a significant impact on U.S.-based multinational groups that engage
in manufacturing activities in Puerto Rico.
Currently, many U.S. companies manufacture products in Puerto Rico
that are subsequently sold throughout the world by affiliates.
By way of example, assume a U.S. corporation (USP) owns the stock of a
Dutch company (BV) that constitutes a controlled foreign corporation. Through a branch in Puerto Rico (PR Branch), BV engages in the manufacture of Product A. PR Branch sells Product A to an affiliate of USP (Purchaser), that in turn sells Product A to customers throughout the world.
Under current Puerto Rican law, the profit derived by PR Branch on
the sale of Product A to USP's worldwide affiliates is subject to tax in
Puerto Rico. However, under Puerto Rican tax incentives
legislation, the Puerto Rican government often grants industrial tax
exemptions to encourage manufacturing activity in Puerto Rico. These exemption grants entitle the manufacturer to pay little Puerto Rican tax on its income. Purchaser's income is often not subject to Puerto Rican tax because it is not Puerto Rican source. The exemption grants generally also provide relief from other Puerto Rican taxes, including an earlier excise tax.
Along with the enactment of the excise tax, Puerto Rico amended its
rules for determining when income is considered as from Puerto Rican
sources (the source rule). Specifically, new Section
1123(f) of the Puerto Rico Internal Revenue Code (PR-IRC) expands the
source rule to treat a nonresident individual or a foreign corporation
or partnership as having an office or fixed place of business in Puerto
Rico as a result of certain regular transactions between such person and
a related party performing activities in Puerto Rico.
When this threshold is satisfied, the amendments to the source rule
treat a portion of the income of the nonresident individual, foreign
corporation or partnership as from Puerto Rican sources, based on a
four-factor apportionment formula that includes purchases as a factor. Thus, under the example above, a portion of Purchaser's income could be characterized as Puerto Rican source.
Puerto Rico enacted the excise tax as a substitute for the newly expanded source rule. The tax is imposed on Purchaser, but PR Branch is required to collect and deposit the tax with Puerto Rican tax authorities.
Using a combination of the source rule and the excise tax, Puerto Rico
intends to tax the value of the products or services purchased, rather
than Purchaser's net income, using a tax that may qualify as an "in lieu
of" tax for purposes of the U.S. foreign tax credit regime.
The Excise Tax
PR-IRC Section 2101 will impose the excise tax on "the acquisition
after December 31, 2010 of personal property and services by a
nonresident alien individual or foreign corporation or partnership that
has, or is treated as having, office or other fixed place of business in
Puerto Rico ... equal to the value applicable percentage of the value of
such personal property and services."
For purposes of determining whether the nonresident alien individual
or foreign corporation or partnership has an "office or other fixed
place of business in Puerto Rico," PR-IRC Section 2101 refers to the
expansion of that concept as reflected in new PR-IRC Section 1123(f),
the source rule.
Under this rule, a person may have a deemed office or fixed place of
business if it acquires personal property or services directly (or, it
appears, indirectly) from another member of the same controlled group,
or where a person provides distribution or facilitation services for or
on behalf of another member of the same controlled group, including
services on a commission or commissionaire basis, that account for:
(A) At least 10 percent of the total gross receipts of such other
member from the sale or personal property manufactured or produced, and
services performed, in Puerto Rico by such other member for the taxable
year or for any of the three preceding taxable years
(B) At least 10 percent, by cost, of the total amount of personal
property and services acquired by such person for the taxable year or
for any of the three preceding taxable years
(C) At least 10 percent of the total amount of commissions or other
fees earned by such person for the taxable year or for any of the three
preceding taxable years
(D) In the case of transactions facilitated by the nonresident alien
or foreign corporation or partnership, such transactions, together with
the activities in (A), (B) and (C) above, account for at least 10
percent of the total gross receipts of such other member or at least 10
percent of the total gross receipts of the nonresident alien or foreign
corporation or partnership from facilitation services for the taxable
year of for any of the three preceding taxable years
The terms "personal property" and "services" mean tangible property
manufactured or produced in whole or in part in Puerto Rico and services
performed in Puerto Rico in connection with the manufacture or
production of tangible property, acquired from any person that engages
in the manufacture or production of tangible property in Puerto Rico, or
performs services in Puerto Rico in connection with the manufacture or
production of tangible property, having gross receipts of $75,000,000
for any of the three preceding taxable years.
New PR-IRC Section 2101 also contains a broad anti-abuse rule disregarding any transaction, or series of transactions, one of the principal purposes of which is the avoidance of
PR-IRC Section 2101, including, but not limited to, the organization or
use of corporations, partnerships or other entities, the use of
commission or commissionaire arrangements (including facilitation
arrangements) or the use of any other plan or arrangement. Further, the use of non-arm's length charges for personal property or services is disregarded.
While the excise tax is levied on the purchaser, it is collected by the seller under new PR-IRC Section 2102.
The failure to accurately and timely collect and deposit the tax with
the Puerto Rican tax authorities will result in a penalty under the new
The excise tax is technically imposed on each related purchaser of the personal property or services. Thus, it may impose multiple levels of tax on a series of sales between related parties. The law provides for a credit intended to prevent multiple layers of taxation. However, as currently drafted, the law may not accomplish this goal in many cases.
The imposition of the new excise tax by Puerto Rico will affect many
U.S. companies currently conducting or considering conducting
manufacturing activities in Puerto Rico. Companies should consider the creditability of the excise tax for U.S. purposes.
The Puerto Rican government has obtained an opinion from counsel that
the excise tax should be creditable for U.S. tax purposes. Guidance from the U.S. Treasury and IRS on this point would be welcome.
Even if the excise tax is creditable, U.S. companies may still need to
consider whether their current organizational structure allows them to
fully utilize the foreign tax credit. Finally, companies should monitor potential reactions to the new excise tax on the part of the U.S. Congress.
Damon M. Lyon is a partner in the law firm of McDermott Will & Emery
LLP and is based in the Firm's Chicago office. Damon focuses his
practice on international planning for multinational companies.
David G. Noren is a partner in the law firm of McDermott Will &
Emery LLP and is based in the Firm's Washington, D.C. office. He
focuses his practice on international tax planning for multinational
David's work in this area covers a wide range of both "outbound" and
"inbound" issues, with particular focus on the "subpart F" anti-deferral
rules, the application of bilateral income tax treaties, and the
treatment of cross-border flows of services and intellectual property
rights under transfer pricing and other rules.
Lowell D. Yoder is a partner in the law firm of McDermott Will &
Emery LLP and is based in the Chicago office. He is head of the U.S.
& International Tax Practice Group.
Rachel E. Aaronson is an associate in the law firm of McDermott Will & Emery LLP and is based in the Firm's Chicago office.
Robert A. Clary II is an associate in the law firm of McDermott Will & Emery LLP and is based in the Firm's Chicago office.
The content of this article is
provided solely for informational
purposes: It is not intended as, and does not constitute, legal advice.
The Information contained herein should not be relied upon or used as a
substitute for consultation with legal, accounting, tax, career, and/or
other professional advisers. This article is provided "AS IS," and
McDermott Will & Emery makes no representation or warranty of any
kind with respect to its contents. McDermott Will & Emery expressly
disclaims all representations and warranties, whether express or
implied, including, but not limited to, warranties of merchantability,
fitness for a particular purpose, and non-infringement. In addition,
McDermott Will & Emery does not represent or warrant that the
content of this article is timely, accurate or complete.
This article is republished with
the permission of McDermott Will
& Emery LLP. Further duplication without the permission of McDermott
Will & Emery LLP is prohibited. All rights reserved.
Discover the features and benefits of LexisNexis® Tax Center
For quality Tax & Accounting research resources, visit the LexisNexis® Store