When nations go broke, they’re forced to reengineer their thinking.
Smarter governments realize that raising taxes doesn’t actually mean raising revenue. Instead it just scares away productive people, capital, and businesses, and results in less income over the long run.
A few years ago the government of Puerto Rico found itself in this situation and realized it needed to be creative to attract capital to its shores.
As a territory of the United States, it had a special advantage, which it made full use of to create the most appealing offshore tax haven around for U.S. citizens.
For those moving to Puerto Rico, it offers zero capital gains taxes, zero taxes on your dividend income, and if you set up a corporation, only a 4 percent corporate income tax.
While anyone in the world can come to take advantage of this, it is attractive for U.S. citizens in particular.
You see, being a U.S. territory, Americans can become a resident of Puerto Rico as easily as they would in any other state of the union.
However, unlike residents of any of the 50 states, residents of Puerto Rico are not required to file taxes with the U.S. government each year (see section 734 of Title 48 of the US Code).
That is a big deal, as due to the U.S. system of global taxation the only other way out of filing is by renouncing your citizenship entirely.
Puerto Rico isn’t the only place where Americans can do this, with other U.S. possessions such as Guam, Palau, the U.S. Virgin Islands, and American Samoa also on the list.
Nonetheless, Puerto Rico is easily the most attractive option for two main reason.
First of all, it is the nearest option to the U.S. mainland, requiring just a short flight to get to many major U.S. cities. During daylight savings time, it’s even on the same time zone as the east coast.
Secondly, it is not just some small island with nothing to do.
With about 2.5 million people living in the San Juan metropolitan area, one can find a vibrant culture, nightlife, shows, restaurants, and many of the niceties and big box retailers that one is accustomed to seeing on the mainland.
Thus, if you are American, you can lower your tax liability far more by moving to Puerto Rico than you could moving even to tax-friendly states like Florida or Texas, all while living a lifestyle that is not altogether foreign.
According to the law, if you move to Puerto Rico and are approved for the special tax-resident status, the government will sign a contract with you to guarantee this special tax treatment until 2035.
The program is open to anyone who hasn’t lived in Puerto Rico within the last 15 years, and involves two main parts: Act 20 pertaining to business income and Act 22 to investment income.
Act 20 – The Export Services Act
Through Act 20, starting a Puerto Rican company or moving an existing company there puts the tax on corporate profits at just 4 percent.
The only requirement is that the income is ‘sourced’ in Puerto Rico, which according to the IRS, is where the services are performed.
So, as long as all the income your business receives is from services performed in Puerto Rico you will meet this requirement.
If the company has any connections or branches in the United States that perform part of the service, the income would be subject to U.S. tax.
So in order to qualify it is imperative that the company be fully engaged in Puerto Rico, while “exporting” services abroad.
This is primarily suitable for any company or individual that is able to offer services to their customers either online or over the telephone.
Where the customers are located does not affect the ‘source’ of the income. Thus the clients can be anywhere in the world, even in the United States.
If a Puerto Rican corporation meets the requirements for Act 20, resident shareholders also do not have to pay tax on the dividend income from the company.
This means for official residents of Puerto Rico with an approved business that “exports” services from the island, the total tax liability could be reduced to as low as 4 percent.
Act 22 – The Individual Investors Act
Act 22 is the second major incentive. It eliminates taxes on investment income that an individual generates after becoming a resident of Puerto Rico.
This applies to capital gains, dividends, and interest income, although the rule does not fully apply to existing investments that tax payers own prior to becoming a resident.
To help illustrate this, let’s assume an American buys shares of XYZ Corporation on the day after moving to Puerto Rico at $25/share.
Five years later, XYZ is trading for $75. The American can sell the stock and pocket the entire $50/share gain tax-free… no taxes owed to Puerto Rico or to the U.S. government.
However, if the shares are bought before the move, the transaction would still be subject to U.S. federal tax on the gains made as a resident of the U.S.
So if those same shares had been purchased at $10/share one year before the move to Puerto Rico, and the shares are worth $25/share a year later, U.S. taxes are still owed on the $15/share, which were accrued before becoming a resident of Puerto Rico.
Bear in mind, U.S. citizens cannot escape all forms of capital gains tax in Puerto Rico, most notably those from U.S. real estate.
For example, a property purchase in Florida even after moving to Puerto Rico, would still be subject to U.S. capital gains taxes when the property is sold.
And as elaborated above, dividend income from a Puerto Rican corporation is also completely tax exempt.
A significant selling point for Puerto Rico is that you don’t have to completely uproot yourself and move there to take advantage of the incredible benefits.
Even spending no time on the island you can still take advantage of the 4 percent corporate tax rate, and spending as little as six months there you can take years of income and dividends completely tax free.
To qualify for corporate residency, 80 percent of the work, as measured by the payroll, has to be performed in Puerto Rico.
If you’re operating a business yourself, and you’re 100 percent of the payroll, that means that you would have to spend nearly 10 months on the island to qualify.
However, if you’d prefer to spend more of your time in the U.S., you can still make this requirement by hiring people to live and work for you in Puerto Rico, and by paying them enough to qualify.
Then, in order to keep your income and dividends tax-free all you have to do is let the profits accumulate in the company.
Once a significant amount has built up, then you can choose to make the move and establish residency on the island.
After becoming a resident you can either pay yourself the accumulated dividends or you can sell the company and take the profits from both completely tax-free.
Technically by the next year you could move right back home, taking all of your earnings with you.
This route, however, requires timing as well as confidence that the government will maintain the contract through 2035 as promised.
Governments in general don’t have a great track record of keeping their promises, so to stay on the safe side it might be worth establishing residency from the start.
This requires the sacrifice of spending six months of the year by beautiful, sunny beaches.
Qualifying for residency in Puerto Rico
According to the IRS, you qualify as a bona fide resident of Puerto Rico if you meet these three criteria:
- Physical presence test
- Do not have a tax home outside Puerto Rico
- Do not have a closer connection to the United States or to a foreign country than to Puerto Rico.
Physical presence test
In order to qualify as a resident of Puerto Rico for tax purposes, Section 937 of the Internal Revenue Code says that you must spend 183 days within a year in Puerto Rico.
Luckily the calculations are in your favor, as a day spent in both Puerto Rico and the US mainland counts as 1 day in Puerto Rico for residency. Thus, you can spend 1 hour of the day in Puerto Rico and 23 hours in the US, and that day would count as if you were in Puerto Rico the whole day.
Do not have a tax home outside Puerto Rico
According to the IRS, your tax home is the place where you are permanently or indefinitely engaged to work as an employee or self-employed individual.
In order to pass this test, you must establish Puerto Rico as your tax home and break any ties to any that you had before moving to Puerto Rico. Passing this test is simple in principle: live and work in Puerto Rico.
Be sure to let the IRS know, by filing form 8898 to notify them of your move.
Do not have a closer connection to the United States or to a foreign country than to Puerto Rico
To pass this test, you must be able to prove that you are indeed living and working in Puerto Rico and that you have more significant connections there than in mainland United States.
This is a subjective call, but from experience you can prove this by selling or renting out your previous home, writing on immigration forms that your place of residence is Puerto Rico, and by being able to show some level of involvement in the local community. Some examples of community involvement would be making an effort to learn Spanish, bringing your family with you, or joining a local gym, club, or other organization.
Put simply—don’t just move on paper. Move for real.
In general, it wouldn’t be the worst thing in the world to spend six months of the year on an island with beautiful beaches and sunshine. And now, by doing so in Puerto Rico you could come away not only with a tan, but with almost 100 percent of your income still in your pocket.
For those concerned by the fact that the Puerto Rican government has recently defaulted, just remember that the country’s tough financial situation is why these incentives came about to begin with.
That said, there is no guarantee that what Puerto Rico is currently offering will remain on the table for decades to come. Which is all the more reason to get on this as quickly as possible.
After all, even if the incentives are reduced or scrapped altogether, eliminating taxes for just one or two years could be enough to make all the effort worthwhile.