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An Overview of the Special Tax Rules Related to Puerto Rico and an Analysis of the Tax and Economic Policy Implications of Recent Legislative Options

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An Overview of the Special Tax Rules Related to Puerto Rico and an Analysis of the Tax and Economic Policy Implications of Recent Legislative Options AN OVERVIEW OF THE SPECIAL TAX RULES RELATED TO PUERTO RICO AND AN ANALYSIS OF THE TAX AND ECONOMIC POLICY IMPLICATIONS OF RECENT LEGISLATIVE OPTIONS ____________ Prepared by the Staff of the JOINT COMMITTEE ON TAXATION June 23, 2006 JCX-24-06 Contents Page INTRODUCTION .......................................................................................................................... 1 I. EXECUTIVE SUMMARY............................................................................................. 2 A. Introduction................................................................................................................ 2 B. Overview of the U.S. Tax and Non-Tax Rules Related to U.S. Possessions............. 2 C. Special Tax Rules Related to Puerto Rico ................................................................. 3 D. Statehood, Commonwealth, and Independence Status .............................................. 5 E. Economic Analysis.................................................................................................... 5 F. Legislative Options.................................................................................................... 6 II. PRESENT LAW TAX PROVISIONS RELATED TO PUERTO RICO AND OTHER U.S. POSSESSIONS ....................................................................................... 13 A. Overview of U.S. Tax Provisions Relating to Puerto Rico...................................... 13 1. In general........................................................................................................... 13 2. Taxation of individuals...................................................................................... 13 3. Taxation of corporations.................................................................................... 17 4. Employment taxes.............................................................................................. 18 5. Excise taxes........................................................................................................ 19 6. Taxation of Puerto Rico obligations .................................................................. 20 7. Low-income housing credit ............................................................................... 20 8. Tax treaties......................................................................................................... 21 B. Overview of Puerto Rico Tax Law, Compiled by the Library of Congress ............ 22 1. Introduction........................................................................................................ 22 2. Domestic or resident corporations ..................................................................... 23 3. Nonresident foreign companies ......................................................................... 27 4. Taxation of individuals...................................................................................... 27 5. Revenues from income tax................................................................................. 29 6. Special rates of tax, deductions and credits ....................................................... 29 7. Puerto Rico excise and other taxes .................................................................... 32 C. Overview of U.S. Tax Provisions Relating to Other U.S. Possessions ................... 37 1. U.S. territories and commonwealths.................................................................. 37 2. U.S. Virgin Islands............................................................................................. 39 3. Guam.................................................................................................................. 41 4. Commonwealth of the Northern Mariana Islands.............................................. 42 5. American Samoa................................................................................................ 43 III. MECHANICS OF THE POSSESSION TAX CREDIT................................................ 45 A. The Possession Tax Credit in General..................................................................... 45 B. Qualification for the Credit...................................................................................... 47 C. Computation of the Credit ....................................................................................... 48 IV. LEGISLATIVE HISTORY OF THE POSSESSION TAX CREDIT AND GOVERNMENT REPORTS......................................................................................... 50 i Page V. OVERVIEW OF FEDERAL TAX POLICY ISSUES RELATING TO ECONOMIC DEVELOPMENT IN PUERTO RICO ................................................... 58 A. Overview of Economic Well Being in Puerto Rico in Comparison to the 50 States................................................................................................................... 58 B. Federal Tax Policy and Economic Development in Puerto Rico ............................ 60 VI. SUMMARY OF STATEHOOD, COMMONWEALTH, AND INDEPENDENCE STATUS ........................................................................................................................ 65 A. Description of Statehood Agenda ............................................................................ 65 B. Description of Commonwealth Agenda................................................................... 69 C. Description of Independence Agenda...................................................................... 70 VII. RECENT PROPOSALS REGARDING THE U.S. TAX TREATMENT OF PUERTO RICO ............................................................................................................. 72 A. Proposals Related to Individuals.............................................................................. 72 1. Extend earned income tax credit to residents of Puerto Rico ............................ 72 2. Extend refundable child credit to residents of Puerto Rico with fewer than three children.............................................................................................. 78 B. Proposals Related to Corporations........................................................................... 83 1. Extension of section 30A................................................................................... 83 2. Section 199 proposal.......................................................................................... 88 3. Section 956 proposal.......................................................................................... 93 4. Section 245 proposal........................................................................................ 102 C. Proposal Related to Revenue Transfers ................................................................. 111 1. Repeal limitation on cover over of rum excise tax to Puerto Rico .................. 111 APPENDIX................................................................................................................................. 117 i INTRODUCTION This pamphlet1, prepared by the staff of the Joint Committee on Taxation, provides an overview of the special tax rules related to Puerto Rico and an analysis of the tax and economic policy implications of recent legislative options. This pamphlet was prepared at the request of Senate Finance Chairman Charles Grassley and Ranking Member Max Baucus. A copy of their request can be found in the Appendix of this pamphlet. Part I of the document provides an executive summary of the pamphlet. Part II discusses the present law tax provisions related to Puerto Rico and other U.S. possessions. Part III covers the mechanics of the possession tax credit. Part IV traces the legislative history of the possession tax credit and summarizes the findings included in several government reports released over the last 20 years. Part V contains an economic analysis of U.S. Federal tax policy issues relating to economic development in Puerto Rico. Part VI is a description of the Puerto Rico statehood, commonwealth and independent party agendas. Part VII is an analysis of the tax and economic policy implications of recent proposals regarding the U.S. tax treatment of Puerto Rico. 1 This pamphlet may be cited as follows: Joint Committee on Taxation, An Overview of the Special Tax Rules Related to Puerto Rico and an Analysis of the Tax and Economic Policy Implications of Recent Legislative Options, (JCX-24-06), June 23, 2006. 1 I. EXECUTIVE SUMMARY A. Introduction In October 2003, Senate Finance Chairman Grassley and Ranking Member Baucus, requested that the staff of the Joint Committee on Taxation (the “Joint Committee staff”) prepare a report on legislative options concerning Puerto Rico. The request asked the Joint Committee staff to provide an analysis of the tax and economic policy implications of the legislative options, the revenue costs of such options, and a comparison of the options to present law relative to the States, the District of Columbia, and the other U.S. territories.2 At the same time, the Chairman and Ranking Member requested that the Government Accountability Office (“GAO”) report to the Finance Committee with respect to the Puerto Rico economy, the impact of U.S. Federal tax policy on Puerto Rico, and proposed U.S. tax legislation regarding Puerto Rico. The Chairman and Ranking Member requested that the Joint Committee staff complete its report following the completion of the GAO report. The GAO completed its report in May of 2006. While this pamphlet is an independent work-product of the Joint Committee staff, the
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