Puerto Rico Manufacturing Group Submits Comments on Proposed FTC Regs

February 10th, 2021

Honorable Charles P. Rettig
Commissioner of Internal Revenue
Internal Revenue Service (I.R.S.)
CC:PA: LPD:PR (REG-101657-20)
Room 5203
Post Office Box 7604
Ben Franklin Station
Washington, D.C. 20044

RE: Comments on REG-101657-20: Guidance: Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income (REG–101657–20)

Dear Commissioner Rettig:

Thank you for this opportunity for the Puerto Rico Manufacturers Association (hereinafter, PRMA) to comment on REG-101657-20 (the “Proposed Regulations”) and its relation to the Puerto Rican economy. PRMA is a private, voluntary, non-profit organization established in 1928 with the purpose of uniting all Puerto Rico's manufacturers and service industries into a strong and effective body to further their mutual interests, as they relate to the private and public sectors of the Commonwealth of Puerto Rico.

Executive Summary

As we will explain below, it is the position of the PRMA that the proposed rules should not apply to the taxes imposed under the Puerto Rico Internal Revenue Code of 1994. The Income Tax Act of 1954 was modeled after the U.S. Internal Revenue Code of 1939 and included rules that substantially mirrored the source of income rules found in the U.S. Code placing Puerto Rico, a jurisdiction clearly not “foreign” in the general sense of the word, as a foreign jurisdiction with respect to taxation matters. The Tax Act of 1954 was substituted in 1994 by the Puerto Rico Internal Revenue Code of 1994, as amended (the “1994 PRIRC”). However, similar international taxation provisions from the 1954 were maintained.

It is the position of PRMA that Puerto Rico cannot be viewed in the same context as sovereign nations imposing “novel extraterritorial taxes without sufficient nexus between the foreign country and the taxpayer's activities or investment of capital or other assets that give rise to the income being taxed”. Therefore, the nexus standard in the Proposed Regulations should not be applied in the context of Puerto Rico taxation.

Additionally, Puerto Rico income taxation of U.S. companies, under the modified source of income rules and excise tax in lieu of Puerto Rico income taxes introduced to the Puerto Rico tax system by Act 154-2010, has been subject to specific analysis since the publication of Notice 2011-29, 2011-16 IRB 663, and therefore, should be addressed very specifically and not with the broad-brush approach used for all foreign jurisdictions. In light of the above, we can conclude that while Puerto Rico may not be a part of the United States within the revenue clauses of the Constitution, nexus between the jurisdictions and among taxpayers must be specifically addressed; not generalized.

Introduction

Manufacturing represents approximately 48% of Puerto Rico's GDP, with the highest paying jobs and generating indirect jobs in our economy. One in every 4 private jobs in Puerto Rico are dependent directly or indirectly on manufacturing. The majority of non-Puerto Rico manufacturers are part of U.S. based company groups and their contribution to the Puerto Rican economy cannot be understated. Moreover, manufacturing activity of these U.S. based company groups is directly responsible for the jobs of approximately 70,000 U.S. citizens that support their mainland U.S. and international operations. These are men and women, whose payroll is subject to FICA and FUTA, in the same manner as the payroll in any of the 50 states.

As stated before, it is the position of the PRMA that the proposed rules should not apply to the taxes imposed under the Puerto Rico Internal Revenue Code of 1994. Of specific concern to the Puerto Rico's manufacturing community is the potential impact of the Proposed Regulations on taxes (that include a modification on source of income rules and the imposition of an excise tax in lieu of Puerto Rico income taxes over income determined based on those modified source of income rules), that were introduced to the Puerto Rico tax system by Act 154-2010 and that are object of Notice 2011-29, 2011-16 IRB 663.

Foreign Tax Creditability

Section 901 allows taxpayers to claim a credit for "the amount of any income, war profits, and excess profits taxes paid or accrued . . . to any foreign country".

The tax must be compulsory and not in exchange for a service, subsidy, or rebate provided by the taxing government.

Section 903 allows foreign taxes that are not income taxes to qualify for credits, if it is determined that the tax is levied "in lieu of" an income tax. A creditable tax under section 903 must operate "as a tax imposed in substitution for, and not in addition to, an income tax or a series of income taxes otherwise generally imposed". Also, a credit is not available for a "soak-up tax," which is a tax that would not be imposed absent the availability of foreign tax credits.

The Proposed Regulations

The proposed regulations address many issues related to the provisions of Sections 901 and 903 of the USIRC. In terms of the issues that are related to the subject matter, the proposed regulations impose a jurisdictional requirement for purposes of determining whether a foreign tax is creditable under Section 901, by using a definition of a creditable foreign tax in Treas. Reg. §1.901-2, as one that has the predominant character of an income tax in the U.S. sense, but revise rules for making that determination.

Furthermore, the proposed regulations add a new “Jurisdictional Nexus” rule, which requires a sufficient nexus between the foreign country and the taxpayer's activities, a capital investment or other assets that give rise to the income being taxed.

The jurisdictional nexus requirement is the most fundamental change to the definition of creditable income tax, under Sections 901 and 903. The preamble of the proposed regulations state that the purpose of this standard is to “require that a foreign tax conform to traditional international norms of taxing jurisdiction as reflected in the Internal Revenue Code”. The preamble notes that this standard in large part is a reaction to novel extraterritorial taxes that “diverge in significant respects from traditional norms”. Specifically, in connection with the Jurisdictional nexus requirement, explanations to the Proposed Regulations indicate that:

“In recent years, several foreign countries have adopted or are considering adopting a variety of novel extraterritorial taxes that diverge in significant respects from traditional norms of international taxing jurisdiction as reflected in the Internal Revenue Code. The Treasury Department and the IRS have determined that in order to qualify as a creditable income tax, the foreign tax law must require a sufficient nexus between the foreign country and the taxpayer's activities or investment of capital or other assets that give rise to the income being taxed”.

“Comments are requested on whether special rules are needed to address foreign transfer pricing rules that allocate profits to a resident on a formulary basis (rather than on the basis of arm's length prices), such as through the use of fixed margins in a manner that is not consistent with arm's length principles”.

“No inference is intended as to the application of existing §§1.901-2 and 1.903-1 to the treatment of novel extraterritorial foreign taxes such as digital services taxes, diverted profits taxes, or equalization levies. In addition, the proposed regulations, when finalized, would not affect the application of existing income tax treaties to which the United States is a party with respect to covered taxes (including any specifically identified taxes) that are creditable under the treaty. Comments are requested on the extent to which the new jurisdictional nexus requirement may impact the treatment of other types of foreign taxes, and on alternative approaches the Treasury Department and the IRS may consider to modify the rules to achieve the policy objectives described in this Part VI.A.2 of the Explanation of Provisions”.

Puerto Rico as a Tax Jurisdiction

According to the U.S. Supreme Court¹, Puerto Rico is "a territory appurtenant and belonging to the United States, but not a part of the United States within the revenue clauses of the Constitution". The Puerto Rico Federal Relations Act of 1950 (Pub. L. 81–600) several years later provided for “. . . taxes and assessments on property, income taxes, internal revenue, and license fees, and royalties for franchises, privileges, and concessions may be imposed for the purposes of the insular and municipal governments, respectively, as may be provided and defined by the Legislature of Puerto Rico”. Such authority was exercised by the Puerto Rico Legislative Assembly and, thus, the origins of Puerto Rico's current income tax system can be traced to the 'Puerto Rico Income Tax Act of 1954', as amended (the “Income Tax Act of 1954”). The Income Tax Act of 1954 was modeled after the U.S. Internal Revenue Code of 1939 and included rules that substantially mirrored the source of income rules found in the U.S. Code placing Puerto Rico, a jurisdiction clearly not “foreign” in the general sense of the word, as a foreign jurisdiction with respect to taxation matters.

Effective May 26, 1989, the Government of Puerto Rico and the Government of the United States of America, entered into a Tax Coordination Agreement intended to provide mutual assistance, exchange on information, prevention of avoidance or evasion of taxes and of double taxation. Under Article 2, in the case of Puerto Rico, the Agreement covers all taxes imposed by the Income Tax Act of 1954, as amended and also to any identical or substantially similar taxes imposed after the date of signature of the Agreement, in addition to or in place of the existing taxes.

The Tax Coordination Agreement covers all taxes imposed by the Income Tax Act of 1954, which was substituted in 1994 by the Puerto Rico Internal Revenue Code of 1994, as amended (the “1994 PRIRC”). However, similar international taxation provisions from the 1954 were maintained. Taxes under the 1994 PRIRC are considered covered taxes under the Tax Coordination Agreement. Act 154-2010 amended the 1994 PRIRC.

The Proposed Regulation Should Not Affect the United States – Puerto Rico Creditability of Taxes Imposed Under the 1994 PRIRC

As indicated above, Puerto Rico cannot be viewed in the same context as sovereign nations imposing “novel extraterritorial taxes without sufficient nexus between the foreign country and the taxpayer's activities or investment of capital or other assets that give rise to the income being taxed”. The nexus standard in the Proposed Regulations should not be applied in the context of Puerto Rico taxation.

Additionally, Puerto Rico income taxation of U.S. companies, under the modified source of income rules and excise tax in lieu of Puerto Rico income taxes introduced to the Puerto Rico tax system by Act 154-2010, has been subject to specific analysis since the publication of Notice 2011-29, 2011-16 IRB 663, and therefore, should be addressed very specifically and not with the broad-brush approach used for all foreign jurisdictions. Again, while Puerto Rico may not be a part of the United States within the revenue clauses of the Constitution, nexus between the jurisdictions and among taxpayers must be specifically addressed; not generalized.

Lastly, Puerto Rico and the United States have an adequate process to manage issues related to creditability of inconsistent taxes. Article 6 of the Tax Coordination Agreement states that whenever, by reason of inconsistent positions taken by the Contracting Governments, a taxpayer is or would be subject to inconsistent tax treatment by the two jurisdictions, the competent authorities of the Contracting Governments shall endeavor to agree upon the facts and circumstances necessary to achieve consistent application of the tax laws of the respective Governments. In particular, this covers:

The Tax Coordination Agreement serves the same purpose, as a tax treaty with respect to covered taxes that have been considered creditable, precisely to avoid double taxation. Consequently, the proposed rules should not apply to transactions involving covered taxes under the Tax Coordination Agreement.

PRMA greatly appreciates the opportunity to provide our feedback on REG-101657-20. At the same time, our organization strongly urges Treasury and the IRS to continue to work closely with the Puerto Rico's government, in the final review of these regulations and other relevant matters, and take into consideration our comments, in light of the legal framework set forth by the U.S. Supreme Court and Congress, and applicable local laws, as well as the Tax Coordination Agreement between the United States and Puerto Rico.

Respectfully submitted,

Mr. Carlos Rodriguez
President
Industriales Puerto Rico
San Juan PR