María de los A. Rivera, Tax Partner
Contacts: lmorales@kevane.com / mrivera@kevane.com
The American Jobs and Creation Act of 2004 that was signed by President Bush on October 22, 2004 contains some provisions that affect Puerto Rican residents. The incorporation of a new Section 937 to the United States Internal Revenue Code (USIRC) is bringing new rules in the determination of the residency in Puerto Rico and the Virgin Islands for US tax purposes.
Section 937 has three subsections. The first one, establishes the new rule to be used for taxable year 2005 and subsequent years thereto at the moment of determining whether an individual is a bona fide resident of Puerto Rico for any given tax year. The individual must meet three tests on an annual basis: (a) be present in Puerto Rico for at least 183 days during the taxable year (Presence Test), (b) not have a tax home outside PR (Tax Home Test), and (c) not show closer connections to the US or other foreign country than to PR (Closer Connection Test). These regulations generally apply to taxable years ending after October 22, 2004 (i.e. calendar year 2004). However, the Presence Test is effective for taxable years beginning after October 22, 2004 (i.e. calendar year 2005).
The second subsection establishes the sourcing rules to determine whether income is from US or PR source or effectively connected with the conduct of a trade or business in the US or PR. These rules apply to income earned after October 22, 2004. This subsection will be discussed in a subsequent article.
Thirdly, Section 937 states that an individual becoming a resident of PR or ceasing to be a bona fide resident of PR must notify the Secretary of the Treasury of the US by filing a notification form pending to be released by the IRS. This requirement is retroactive to tax year 2001 and subsequent years. Failure to notify conveys a penalty of $1,000.
Before the enactment of this new Section 937, an individual was considered a bona fide resident of Puerto Rico based on the facts and circumstances of that person and based on the length and nature of his stay in Puerto Rico. The list of facts and circumstances, among others, included the location of the jurisdiction in which the individual votes, the location where the individual conducts his routine personal banking activities, the number of days spent in Puerto Rico, the location of the personal belongings, the location of the individual’s family, etc. US lawmakers were concerned the standards (in the Virgin Islands and other possessions like Puerto Rico) were too easily manipulated, resulting in frivolous residency claims and tax evasion.
Once you meet the bona fide resident test explained above, there are some tax advantages. Section 933 of the USIRC allows the bona fide resident of Puerto Rico for a full taxable year to exclude from US taxation all his Puerto Rico source income. This rule does not apply to the federal government employees.
The Internal Revenue Service issued Temporary and Proposed Regulations to Section 937 providing rules to determine the residency in a US possession. As a general rule an individual is considered a bona fide resident of a possession if he or she complies with all the tests mentioned above (i.e. Presence Test, Tax Home Test, and Closer Connection Test).
Presence Test
The presence test is satisfied if during the taxable year an individual meets any of the following tests: (1) was present in the possession for at least 183 days; (2) was present in the US for no more than 90 days; (3) had no earned income in the US and was present for more days in the relevant possession than in the US; OR (4) had no permanent connection to the US. There are days of presence in the US that are not counted for purposes of these tests. For example, time spent in the US as part of an individual’s official duties as a government official or employee of a possession is not counted.
For the purposes of the Presence Test (tests (1) and (2)), an individual shall be treated as present in Puerto Rico “on any day if such individual is physically present in PR at any time during such day”. This definition is also applicable to other sections that affect residents of PR. For example, sections dealing with the determination of source of income of personal property (i.e. stock) and the definition of the controlled foreign corporation.
If an individual renders services in the US, then he or she must be present for more days in the relevant possession than in the US (test (3)). To meet test (4) the person should not have a permanent connection to the US. The term permanent connection is defined to include a permanent residence or a spouse or dependent with a principal place of abode in the US. An individual who lives in a possession but travels extensively to the US for business purposes or to receive medical treatment may satisfy the test for not having the permanent connection in the US.
Tax Home Test
An individual has a tax home in Puerto Rico for a taxable year if such individual did not have a tax home outside the relevant possession during any part of the taxable year. The individual’s tax home is considered to be located at the individual’s regular or principal place of business. If the individual has no regular or principal place of business, then the individual’s regular place of abode is considered. The regulations establish special rules for seafarers, students and government officials or employees, among others.
Closer Connection Test
The Closer Connection Test is similar to the old rules to determine the residency status. This test incorporates facts and circumstances that include, but are not limited to: the location of the individual’s permanent home; the location of the individual’s family; the location of the personal belongings, such as automobile, furniture, clothing, and jewelry owned by the individual and his or her family; the location of social, political, cultural and religious organizations with which the individual has a current relationship; the location of the jurisdiction in which the individual votes; the location of the jurisdiction in which the individual holds a driver’s license.
It is expected that the IRS will be looking more carefully at persons claiming to be residents of possessions. Those individuals claiming to be bona fide residents of PR but spending considerable time outside PR and having significant connections to places outside PR wherein second or vacation homes are located should consult their tax advisors to determine whether they are complying with the new rules.