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IRS campaign to focus on Puerto Rico Act 22

On Jan. 27, 2021, the Internal Revenue Service (IRS) announced a new compliance campaign focusing on the Puerto Rico Act 22 (now Act 60). Act 60 consolidated various tax decrees, incentives, subsidies and benefits, including Acts 20 and 22. Acts 20 and 22 were intended to incentivize investment in Puerto Rico, promote the exportation of services from companies and individuals providing such services and attract high net-worth individuals to Puerto Rico.

Those taxpayers that meet the requirements of Act 60 are eligible to receive significant tax savings. For example, Act 60 offers a corporate tax rate of 4% to Puerto Rico domiciled companies that export services performed in the territory to people or companies outside of the territory. Similarly, high net-worth individuals may qualify for a total exemption from Puerto Rico income taxes on all interest and dividends realized after the individual becomes a bona fide resident of Puerto Rico.

The Commonwealth of Puerto Rico is a U.S. territory (and generally subject to all U.S. federal laws). However, for federal tax purposes, Puerto Rico is treated as a “foreign country.” The Internal Revenue Code states that U.S. citizens and resident aliens are taxed on worldwide income[1]. However, section 933[2] provides an exception to this general rule. Residents of Puerto Rico receive special tax treatment for Puerto Rico sourced income.

The IRS’s new campaign addresses taxpayers who have claimed benefits through Puerto Rico Act 60, without meeting the requirements of section 937, Residence and Source Rules Involving Possessions. Consequently, the IRS has identified vulnerabilities with certain individuals who may be excluding income subject to U.S. tax on a filed U.S. income tax return or failing to file and report income subject to U.S. tax. As such, this campaign will also address those individuals who have met the requirements of section 937 but may be erroneously reporting U.S. source income as Puerto Rico source income in order to avoid U.S. taxation.

In an effort to enhance voluntary compliance with the tax laws, the IRS partners with foreign jurisdictions, federal, state and municipal governmental agencies. These partnerships often involve some type of formal agreement such as a memorandum of understanding or Tax Coordination Agreement (TCA) that allows for the exchange of taxpayer data. Article four of the TCA between the U.S. and the Commonwealth of Puerto Rico allows for the exchange of information to administer and enforce the tax laws of the respective jurisdiction.

The objective of this campaign is to address those taxpayers that abuse or look to circumvent the tax laws. The IRS will utilize various methods to address the noncompliance including examinations, outreach and soft letters. Consequently, it is reasonable to assume the IRS has started identifying those individuals who may fall under the scope of this audit campaign.

Taxpayers should review their reporting positions and, if appropriate, consider correcting past non-compliance now. Baker Tilly US has experience advising clients through a variety of IRS controversy matters including voluntary disclosures, civil audits and criminal investigations. Similarly, Baker Tilly is well versed in evaluating Puerto Rico-specific tax issues.

[1]  IRC section 61 defines gross income as all income from whatever source derived, including (but not limited to) the following items: compensation for services, including fees, commissions, fringe benefits and similar items; gross income derived from business; gains derived from dealings in property; interest; rents; royalties; dividends; annuities; income from life insurance and endowment contracts; pensions; income from discharge of indebtedness; distributive share of partnership gross income; income in respect of a decedent and income from an interest in an estate or trust.

[2] IRC section 933, provides an exception with respect to Puerto Rico residents. Individuals who are bona fide residents of Puerto Rico for the entire taxable year, other than federal employees, can exclude from gross income for federal income tax purposes, and these bona fide residents are therefore exempt from federal income taxes on, income from sources within Puerto Rico. In order to qualify for the exclusion for a taxable year, (1) the individual must qualify as a bona fide resident of Puerto Rico for the entire taxable year for purposes of the Internal Revenue Code (bona fide resident test can be found in IRC section 937(a)) and (2) the income must constitute Puerto Rico source income.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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