“Psst. How would you like to pay no taxes? Have I got a deal for you!”
At least, that’s how the dubious promotions usually go.
Nobody likes to pay taxes, even if we grudgingly accept their role in making civilization possible. Unfortunately, the desire to reduce one’s tax burden can lead people to ignore some basic facts when assessing offshore opportunities. Those facts are:
- If you are a U.S. citizen or permanent resident, you are liable for U.S. income taxes no matter where you live on the planet, with one exception.
- Many countries levy no or low income taxes, but residing there doesn’t affect your U.S. tax obligations in any way.
- Tax rules are subject to change, even abroad, especially when the U.S. government doesn’t like them.
Ignoring or misreading these facts can end up costing you … a lot.
The Puerto Rican Exception
One of the stranger facts of U.S. tax policy is that there is only one place on the planet where you can avoid paying U.S. federal income tax — and it’s part of the United States.
Puerto Rico became part of the U.S. in 1899 as a consequence of the Treaty of Paris, which ended the Spanish-American War. People born in Puerto Rico are natural-born U.S. citizens. The island is subject to the plenary jurisdiction of the United States, and the U.S. Congress has the power to annul local laws.
Bona fide residents of Puerto Rico — including those from the mainland — are exempt from paying U.S. taxes on all income earned in Puerto Rico. To be a bona fide resident, you must be physically present for at least six months each year. So any U.S. taxpayer can move to Puerto Rico, establish residence and get a job or start a business, and pay no federal income tax on that income.
But in 2012, Puerto Rico adopted Act 22, which gave residents 100% tax exemption from Puerto Rican income taxes on Puerto Rican dividends and interest — as well as on all capital gains from whatever source accrued after becoming a resident. That means a U.S. citizen could move to Puerto Rico, sell some stateside assets, set up shop, and theoretically pay no income tax at all.
This has led to much joy in some circles, as well as expensive online “how to” kits aimed at tax-avoiding prospective Puerto Ricans. Puerto Rico seems the ideal tax haven. But wiser heads say that the situation can’t last.
That includes Dr. Martin Sullivan, the influential chief economist for “Tax Analysts,” a former professor of economics at Rutgers and adviser to the congressional Joint Committee on Taxation. There are two reasons, he says. First, the island territory is nearly bankrupt and heavily dependent on the U.S. for subsidies of various types. Second, Act 22 has caught the attention of U.S. legislators, who are unhappy about the territory’s finances as well as Act 22’s impact on U.S. tax receipts.
As if on cue, last week Standard & Poor’s Ratings Services lowered its rating on the Commonwealth of Puerto Rico public bonds of all types to CCC+ from B. At the same time, S&P placed the government’s finances rating on “CreditWatch.”
S&P said that “the commonwealth’s market access prospects have further weakened and Puerto Rico’s ability to meet its financial commitments is increasingly tied to the business, financial, and economic conditions on the island. Absent improvement in those conditions, we believe debt and other financial commitments will be unsustainable.”
Translated: Puerto Rico can’t roll over its debts, and the economy isn’t strong enough to generate enough tax revenue to compensate. Insolvency looms.
Look Before You Leap
I predict Congress will annul Act 22. If it does, people who pulled up stakes and moved to the island to avoid taxation will be disappointed. They’ll be able to avoid federal tax on Puerto Rican income, but the island’s government is eventually going to have to hike taxes to pay off its debts.
Some time ago, I considered recommending the Act 22 tax play. But I didn’t … something just didn’t feel right. That’s because I want to give you the best advice possible … even if it means waiting to see how things turn out in the end.
Offshore and Asset Protection Editor