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 source of the income. This is the second article on this new Section 937, the first one dealt with the new rules on the determination of residency in Puerto Rico and other possessions.
The second subsection of Section 937 of the USIRC establishes the sourcing of income rules that must be followed in order to determine whether income is from US sources or effectively connected with the conduct of a trade or business in the US. Also, the same rules will be applied in determining whether the income is from PR or effectively connected with a trade or business within PR. In general, these rules apply to income earned after October 22, 2004.
In general, the regulations provide that the principles for determining whether income is US source income, and therefore subject to US taxation, are applicable for determining whether income is from any of the possessions. The regulations also provide that income from US sources is not considered income that is possession source or effectively connected with the conduct of a possession trade or business. Likewise, income that is effectively connected with the conduct of a US trade or business is not treated as possession source income or effectively connected with the conduct of a trade or business in a possession (the US income rule).
The regulations provide certain exceptions to the new rules including among others:
Dividends and interest income
The general rule is that income distributed by a corporation organized under the laws of Puerto Rico and received by a PR bona fide resident is treated as income from PR sources. These new rules will affect those bona fide residents of Puerto Rico that own, directly or indirectly, at least 10% of the voting stock of a Puerto Rico corporation that derives income from sources outside Puerto Rico. A Puerto Rico corporation could include a legal entity treated as a corporation for US income tax purposes (i.e. certain partnerships). As a result, if a PR corporation derives income from sources outside of PR, any dividends and interest received by a 10% owner may not be considered PR source income and will therefore be subject to US income taxes.
In the case of the interest it will be considered from PR sources to the extent that interest received is allocable to assets that generate, have generated, or could be reasonably expected to generate income from sources within PR or effectively connected with the conduct of a trade or business in PR.
The regulations establish that the total amount of dividends or interest received from PR corporations will be considered from PR sources if 80% or more of its gross income is derived from PR sources or was effectively connected with the conduct of a trade or business in PR and 50% or more of the gross income of the PR corporation was derived in the active conduct of a trade or business in PR. If the PR Corporation owns, directly or indirectly, at least 25% of the value of another corporation the proportion of the gross income of such corporation should be taken into consideration for these tests.
For PR purposes, the source of dividends and interest is where the payer is located; therefore, dividends and interest paid by a PR Corporation are PR source income. Thus, a PR resident will end up having an income that will be considered PR source income for PR purposes and US source income for US purposes. The same income will be subject to tax in PR and US with no chance of claiming any foreign tax credit on taxes paid to any of the jurisdictions.
In addition, the PR Corporation will be required to report the income considered from sources within the US in a separate informative form 1099-DIV or 1099-INT that will add an administrative burden to the entity.
Sale or disposition of personal property
Prior to the issuance of these regulations and for US taxation purposes, the source of the gain or loss derived in the disposition of certain personal property such as stock and other securities traded in the stock market was determined based on the residence of the individual. For PR purposes, the source of the gain or loss generated from the sale of personal property is determined based on where the title of the property is transferred to the buyer. Therefore, in the case of publicly traded stocks, for PR purposes the source of the gain or loss is US source. A resident of PR for a full year would be subject to taxation on this type of transactions only in PR because for US purposes is PR source income and therefore, excluded from US taxation.
The new rules establish that when the individual is a citizen (other than a bona fide resident of PR) or resident of the US, the appreciation of the personal property attributed to any of the preceding ten years before such individual became a bona fide resident of PR will be subject to US taxation. The new rules increase the recordkeeping of transactions involving appreciated property, and tax returns preparers should definitely get more details on this type of transactions in cases where an individual became resident of PR during the last ten years.
The Puerto Rico Internal Revenue Code of 1994 (PRIRC), as amended, allows a foreign tax credit for any taxes paid to foreign countries on foreign source income subject to PR taxation. Therefore, technically speaking this type of transactions should not trigger any adverse impact to the PR resident since the foreign tax credit will avoid the double taxation on the same income.
Conduit Arrangements
The new regulations provide that income derived pursuant to certain plan or arrangements will be considered as derived from sources in the US. Conduit arrangements are plans where the income is received in exchange for consideration provided to another person and such person (or another person) provides the same consideration (or of a like kind) to a third person in exchange for one or more payments constituting income from sources within the US.
Given the complexity of these new rules, we strongly recommend you to consult your tax advisor in order to determine whether you will be required to include additional income in your US return or even determine if you will be required to file a US return based on these new rules.