Summer 2006-01 Tax reform legislation enacted
Tax reform legislation enacted
The governor of Puerto Rico has signed several new laws in an effort to balance the budget for Fiscal Year 2005-2006.
The legislation is the result of a budgetary crisis that forced the partial shutdown of government operations. This controversial legislation will surely be the discussion of taxpayers and practitioners in the forthcoming months. All these laws became effective immediately.
Act No. 88 of May 13, 2006-Royalties
Act No. 88 amends Section 6(k) of the Puerto Rico Tax Incentives Act of 1998 to impose a 15% tax on payments made by businesses enjoying tax exemption to nonresident corporations, partnerships and individuals for the use in Puerto Rico of patents, intellectual property, formulas, “know-how” and similar property. The Secretary of the Treasury can reduce the tax rate on royalties to not less than 2%. The exempt business making the payment is responsible for deducting, withholding and remitting the tax to Puerto Rico Treasury.
Act 89 of May 13, 2006-2.0% Bank Tax
On August 11, 2005, the governor had signed Act No. 41, amending the Puerto Rico Internal Revenue Code to impose an additional 2.5% tax on the income of corporations and partnerships with net taxable income of $20,000 or more. This law did not modify Code § 1016 (c), which left a maximum tax rate of 39%.
Act No. 89 corrects this oversight to reflect a maximum income tax rate of 41.5% for regular corporations and partnerships.
It also establishes a new tax of 2% applicable to corporations operating under the Puerto Rico Bank Act.
Its provisions apply to tax years commenced after December 31, 2005, and on or before December 31, 2006. Act 89 also provides that the rates will revert to the tax rates in effect prior to the enactment of Act No. 41 (maximum of 39%), by elimination of the 2.5% special tax and the 2% bank tax.
Act 98 of May 6, 2006-Extraordinary Tax
Of the laws signed by the governor, Act No. 98 is the most controversial for taxpayers and practitioners alike. It imposes a 5% “extraordinary” tax to corporations and partnerships with gross revenues in excess of $10,000,000. The 5% applies to the net income reported for taxable years ended on or before December 31, 2005. If an extension was filed for 2005, the extraordinary tax is determined on an estimate of the net taxable income for that year, and adjusted upon the filing of the return.
Act 98 does not apply to the following:
conduit tax entities, such as special partnerships and corporations of individuals,
exempt, registered investment companies, and
not-for-profit organizations, churches and labor unions.
Act 98 also applies to exempt businesses, although only to the taxable income derived from operations that are not covered by their tax grants.
The extraordinary tax can be claimed as a credit against the tax liability for tax years commencing after December 31, 2005. Unused credits can be used in equal parts in the four tax years following the year in which the extraordinary tax was paid. Although this credit is available to foreign taxpayers, in order to claim it the taxpayer must be able to show inability to use the credit, or deduct the extraordinary tax, in another jurisdiction. A foreign taxpayer that is eligible to claim the tax credit, but cannot claim it due to net operating losses, is permitted to extend the period, with certain limitations, until the credit is exhausted.
Act 87 of May 13, 2006-5% tax on IRAs
Act No. 87 amends Sections 1165 and 1169 of the Code, providing for a special tax rate of 5% applicable to distributions made from retirement plans and individual retirement accounts during the period of May 16, 2006, to November 15, 2006. It also provides for tax prepayment at the special rate, if made within said period.
Act 87 provides that any distribution made during the May-November period will be subject to a special tax rate of 5% in lieu of any tax imposed by Code § 1165(b)(I). The distributions made during this period, which can be of all or part of the accumulated benefits of the participant, will be considered amounts paid by reason of separation from service.
Act 87 also allows participants to prepay during the period-at the rate of 5%-the tax on all or part of their accumulated and undistributed amounts. The law authorizes distribution of the amounts necessary to pay the 5% tax. As a result, the participant’s tax basis will be increased by the amount prepaid. Thus, at distribution only the earning component related to the prepaid amount will be taxable at the capital gain tax rate applicable at the time of distribution (i.e., similar to the tax treatment granted to after-tax contributions).
Act 87 applies to participants of plans qualified in Puerto Rico, regardless of the location of the retirement trust. Although it does not limit its benefits to defined contribution plans, the law is silent as to its application to defined benefit plans. In addition, because the distribution used for the prepayment of the tax may not be considered a distributable event under federal law, it remains uncertain how dual qualified plans will be able to comply with these requirements.
Guidance from Treasury is expected shortly, specially on whether the special 5% tax will be applicable to distributions, other than a lump sum distribution, on account of separation from service (i.e., age over 59 ½, hardship, loan defaults, etc.).
Act 87 provides to IRA owners a special tax rate of 5% to be withheld at the source by the financial institution, for any distribution made during the May-November period. This special tax rate will apply in lieu of any other tax that can be imposed by the Code. These distributions may not exceed $50,000. Any amount distributed in excess of the $50,000 limit will be subject to tax at the regular rates. Act 87 waives the 10% penalty on these distributions. The 10% penalty is generally imposed on distributions made to individuals under the age of 60.
The new law allows the prepayment of a 5% tax on all or part of the participant’s accumulated and undistributed amounts in an IRA. The participant’s tax basis is increased by the prepaid amount, so that upon distribution only the additional earning component of such prepaid amounts will be subject to tax.
Act No. 92 of May 16, 2006-Catch-up
Act 92 amends the deferral limits imposed by the Code to all cash or deferred arrangements qualified in Puerto Rico for participants that at the close of the plan year have reached the age of 50. The catch-up contribution is not to exceed $500 for the taxable year commenced January 1, 2006, and $1,000 for tax years commenced after December 31, 2006.
In addition, the catch-up contributions:
will not affect a plan’s actual deferral percentage test;
can be matched by the employer; and
will not affect the $8,000 limit used for the acquisition of IRAs by plan participants.
© 2006 Goldman Antonetti & Cordóva, LLC