CRS REVIEWS POSSESSION TAX CREDIT.

CRS REPORT FOR CONGRESS

The U.S. tax code's possessions tax credit provides a substantial tax benefit for U.S. firms that operate in U.S. possessions. The credit is designed to promote economic growth and employment in the possessions by attracting investment by U.S. businesses. Some have questioned the cost-effectiveness of the credit, arguing that its impact on employment has been weak compared to its cost in terms of forgone tax collections. But the government of Puerto Rico maintains that the tax benefit is indeed effective in promoting economic growth and continues to rely on the credit as a key part of its economic development strategy.

                        by David L. Brumbaugh

The U.S. tax code's possessions tax credit provides a substantial tax benefit for U.S. firms that operate in the U.S. possessions. Under the credit's provisions (also known as the "section 936" provisions, after the relevant section of the Internal Revenue Code), income U.S. firms earn from business operations in the possessions is exempt from the Federal corporate income tax, along with income from certain types of financial investment. To complement the tax benefit provided at the Federal level, the governments of Puerto Rico, the Virgin Islands, and other possessions have enacted their own business tax reductions that are designed to attract businesses to the possessions. In combination, the possessions tax credit and the possessions' own tax incentives result in more favorable tax treatment of possessions-source income than is generally available for income U.S. firms earn either in the mainland United States or locations in foreign countries.

The purpose of the possessions tax credit is to stimulate economic growth in Puerto Rico, the Virgin Islands, and other possessions by attracting business investment from the mainland United States and alternative locations abroad. The reduction of unemployment in the possessions has been a particular concern of policymakers. Puerto Rico, for example, has registered unemployment rates that are substantially higher than those of the mainland United States.

As by far the largest economy that is directly affected by the possessions tax credit, Puerto Rico has been the focus of an ongoing controversy over the effectiveness of section 936 in actually promoting economic growth. On the one hand, the government of Puerto Rico and others have argued that the possessions tax credit has indeed attracted a large amount of investment to Puerto Rico -- investment that has been the foundation of economic growth, and which has created substantial new employment. ¹

Yet others have questioned the cost effectiveness of the possessions tax credit, arguing that its cost in terms of foregone tax collections by the U.S. Treasury has been high in comparison to the jobs it has created in the possessions. Such considerations led the U.S. Treasury to include the phasing-out of section 936 among the list of tax reform measures it set forth in 1984. For its part, Congress has addressed the cost-effectiveness of the possessions tax credit on several occasions, modifying the 936 provisions in an attempt to reduce the provisions' revenue cost and target them more closely to investment in the possessions. Most recently, Congress adopted rules to facilitate Puerto Rico's "twin-plant" initiative, which is designed to enhance the ability of 936 to attract employment-generating investment to Puerto Rico as well as other areas in the Caribbean.

The possessions tax credit thus presents policymakers with several issues. First, is it desirable to provide a tax incentive for businesses to invest in the possessions above and beyond that which is available on the U.S. mainland and in foreign developing countries? Second, if such a tax incentive is indeed desirable, are the current 936 provisions effective in providing it?

HOW THE POSSESSIONS TAX CREDIT WORKS

Section 936's tax benefit is technically in the form of a tax credit: an offset against Federal taxes. But since the tax code provides that the credit is always equal a firm's Federal tax liability on income earned in the possessions, the credit has the effect of a tax exemption.

To qualify for the credit, a firm must be incorporated in the United States and must meet two requirements designed to link the tax benefit to active business operations in the possessions: it must earn at least 80 percent of its income in a possession; and at least 75 percent of its income must be from the active conduct of a trade or business in the possessions.

If a corporation meets these requirements, any income from its active business operations in the possessions qualifies for the possessions tax credit and is thus tax-exempt. But the tax exemption applies to only a limited range of income from financial investment. Income from assets such as stocks, bonds, and other financial instruments qualifies for the credit only if the investments are made out of funds generated by business operations in the possessions, and only if the investment is made in the possessions.

U.S. firms generally pay Federal taxes on income from operations on the mainland United States; section 936 clearly provides favorable tax treatment to operations in the possessions by comparison. But the possessions are often viewed as competing with developing countries for U.S. investment. It is thus important to note that section 936 also provides favorable tax treatment for the possessions compared to income U.S. firms earn in foreign countries.

A tax benefit known as the "deferral" principal is available in many cases to U.S. firms that invest in developing countries. Under deferral, income U.S. firms earn through foreign subsidiary corporations is exempt from Federal taxes as long as it remains in the hands of the subsidiary. However, when the foreign income is ultimately remitted to a U.S. parent corporation as dividends, it is taxed by the United States. The tax benefit deferral provides is thus ability to postpone the payment of U.S. taxes on foreign income.

Most U.S. firms that use the possessions tax credit do so by establishing subsidiary corporations that meet the section 936 requirements; it is the qualifying subsidiaries that earn tax-exempt possessions-source income. But unlike the deferral principle, the section 936 provisions permits possessions subsidiaries to remit their income to their U.S. parents, free of Federal taxes. The possessions tax credit thus provides a permanent tax exemption compared to the temporary tax exemption for foreign income under deferral.

If a firm keeps its foreign income overseas for an extended period of time, the difference between deferral and a permanent tax exemption such as the possessions tax credit diminishes. But section 936 can provide an additional tax advantage over deferral to some firms: in some situations, a firm can use the possessions tax credit to shelter income earned in the mainland from Federal taxes along with income from the possessions.

The opportunity for additional tax savings occurs when a U.S. firm develops an intangible asset (such as a copyright or patent) in the United States and then transfers ownership of the asset to its possessions subsidiary -- a transfer that can be effected free of Federal taxes. In such a situation, firms can attribute a least part of the profits the asset generates to its possessions operations, and obtain the section 936 tax exemption for the income. Because, in theory, income generated by an asset developed in the United States has its source in the United States the possessions tax credit thereby exempts U.S.-source income from taxation in these situations.

As described in the following sections of the report, the ability of firms to use section 936 to shield U.S. income from taxes was at least partly eliminated by Congress in 1982.

PUERTO RICO'S ECONOMY AND SECTION 936

The Federal tax benefit for income earned in the possessions has been a central part of Puerto Rico's long-range economic development strategy since World War II. In the years immediately following the War, Puerto Rico formulated a development strategy known as "Operation Bootstrap," which relied on the development of a manufacturing sector to spearhead growth in income and employment. The centerpiece of Operation Bootstrap was tax incentives; Puerto Rico enacted its own industrial tax incentives to attract manufacturing investment. Equally important, however, was the Federal tax exemption for income earned in the possessions.

By all accounts, Operation Bootstrap succeeded admirably for almost three decades. Manufacturing investment poured into Puerto Rico over the period 1948-74, transforming the island's economy from one based largely on agriculture to an economy led by manufacturing and services. The development of manufacturing was accompanied by prodigious growth in Puerto Rico's Gross National Product; real GNP grew at an average annual rate of 6.1 percent. By comparison, the growth rate for the United States was significantly slower over the same period, averaging 3.6 percent per year. A number of factors helped stimulate the influx of capital to Puerto Rico: labor was inexpensive compared to the United States; Puerto Rico was inside the tariff boundaries of the United States, giving Puerto Rican products easy access to mainland markets. But, clearly, the Federal and Commonwealth tax incentives combined to make Puerto Rico attractive for U.S. manufacturing firms.

Beginning in 1974, however, economic growth in Puerto Rico slowed. Over the period 1975-86, real GNP grew at an average annual rate of under 2 percent and the island's economy registered several years of negative growth. The unemployment rate, which was high even during the halcyon days of Operation Bootstrap, has been over the 20 percent mark since 1982.

There are a number of important reasons for the slowdown in Puerto Rico's growth that have nothing to do with taxes. The introduction of the Federal minimum wage rules, for example, reduced the cost advantage of Puerto Rico over the U.S. mainland. Also, in the 1960s the United States reduced its tariff barriers substantially, thus reducing the cost advantage of Puerto Rico over manufacturing locations in less developed countries.

But the slowdown in Puerto Rico's economic growth also brought the section 936 Federal tax benefit under scrutiny, and divergent views developed of the provision's effectiveness. One view focuses on both the lack of growth in Puerto Rican employment and the cost of section 936 in terms of foregone Federal tax revenues and concludes that the possessions tax credit is not cost effective. This view of the possessions tax credit has appeared most prominently in the U.S. Treasury Department's 1984 tax reform proposal -- a program that advocated the repeal of section 936. ² In contrast, the government of Puerto Rico has argued that the possessions tax credit is still vital to Puerto Rico's economic future, and has maintained that the Treasury Department's estimates of the provision's cost are overstated. These views of section 936 are discussed in more detail in the next two sections of the report.

THE COST-EFFECTIVENESS OF THE POSSESSIONS TAX CREDIT

Since 1976, the U.S. Treasury has been required by law to submit annual reports to Congress on the operation and effects of the possessions tax credit. A focus of these reports has been the cost effectiveness of section 936. Each report has estimated the tax revenue cost of the possessions tax credit and the direct employment of possessions corporations, and has used these estimates to calculate the revenue loss of section 936 per employee. The Treasury calculations imply that the cost of section 936 is high compared to its benefits. For example, the revenue cost of section 936 was estimated to be more than $22,000 per employee in 1982. In comparison, average compensation of possessions corporations' employees was estimated to be only $14,210. ³

While such calculations are eye-catching and have been used to support arguments against the possessions tax credit, they may understate the benefits of section 936. Investment by possessions corporations creates jobs outside the possessions corporations themselves. For example, a factory that qualifies for the possessions tax credit may create employment in industries that supply inputs to the factory. Similarly, a possessions corporation may stimulate the development of other plants that use the possessions corporation's product as an input.

On the cost side, the Treasury Department's estimates assume that if section 936 did not exist, income of possessions corporations would be taxed like income of corporations operating in the United States. In actuality, if the possessions tax credit were to vanish, firms might seek to minimize their U.S. taxes by changing their legal form in order to take advantage of the deferral principle either in Puerto Rico or in a foreign country (see above, page 2). Thus, the cost side of the cost/benefit calculation may also be overstated.

But regardless of whether the cost-per-employee figure is strictly accurate, the Treasury Department reports pointed out a number of reasons to suspect that the revenue cost of section 936 was high compared to its impact on employment. First, as noted above, firms that develop intangible assets on the mainland United States may be able to shelter U.S.-source income with the possessions tax credit by transferring the intangibles to subsidiaries in the possessions. In cases such as this the employment impact of the possessions tax benefit is probably small compared to its revenue cost. Second, the possessions tax credit is an incentive to employ capital investment in the possessions and stimulates employment of labor only as a by-product of capital investment. Indeed, in recent years the bulk of the section 936 tax benefit has been claimed by capital-intensive, high-technology firms in industries such as pharmaceuticals and electronics rather than firms in labor-intensive industries such as textiles. ⁴

In 1982 Congress sought to contain the revenue cost of section 936 by restricting the use of the possessions tax credit to shelter U.S.-source income from intangibles. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA; Public Law 97-248) required possessions corporations that use intangible assets developed by U.S. parent firms to make payments to the parent firms for the use of the intangibles. The payments reduce the income of a possessions subsidiary and increase the income of its parent, thus reducing the amount of U.S.-source income that is tax-exempt under section 936.

THE WAGE CREDIT PROPOSAL

Another response to questions about the cost-effectiveness of section 936 came in 1984 when the U.S. Treasury published its broad program of tax reform. The Treasury asserted that the possessions tax benefit is "one of the most complex in the tax law, expensive, difficult to administer and yet has not been effective in creating jobs in the possessions." ⁵ Accordingly, its plan for general tax reform included a proposal to replace section 936 with a "wage credit" a tax credit linked to the wages a firm pays in the possessions. The initial Treasury proposal would have phased out the wage credit itself over a period of 11 years.

But the Treasury's tax reform plan was not the final program that the President submitted to Congress; the plan the Administration proposed in 1985 differed from the Treasury's program in numerous ways. With regard to the possessions tax credit, the Administration stated that it:

recognizes its special obligations toward, and supports the goal of encouraging increased employment and economic growth in, the possessions. The Administration also recognizes a special interest in the economic health of the Caribbean region. ⁶

In accord with this view, the Administration proposed replacing the current possessions tax credit with a wage credit that would be permanent rather than one that would be phased out. In proposing its wage credit, the Administration noted that the current tax exemption is based on the income a possessions corporation earns rather than directly on employment. The wage credit was intended to provide a direct incentive for firms to increase employment in the possessions.

The proposed wage credit was not included in the version of the Tax Reform Act of 1986 that Congress enacted. Instead, Congress slightly increased the payments possessions corporations must make for the use of intangibles and modified the types of income that qualify for the possessions credit so as to facilitate the operation of Puerto Rico's own "twin plant" initiative.

THE TAX REFORM ACT OF 1986 AND THE "TWIN PLANT" INITIATIVE

The government of Puerto Rico objected to both the Treasury Department's assessment of section 936's cost effectiveness and to the wage credit as a policy for economic development. It views the current possessions tax credit as effective in creating employment in the possessions and considers it a vital part of its long-term development plans.

The Puerto Rican government has argued that the Treasury Department estimates of section 936's effectiveness overstate the provision's cost and understate its benefits. With respect to costs, for example, it argues that the Treasury Department calculations do not take into account TEFRA's changes to section 936, which were aimed at reducing the revenue loss associated with the provision (see above, p. 5). With respect to benefits, the government of Puerto Rico has used multipliers to arrive at estimates of section 936's benefits that take into account income generated above and beyond the direct wage payments to possessions corporations' employees. After these adjustments, the government of Puerto Rico estimates that in 1982, the cost of section 936 was $14,960 per employee and that the provision generated $28,204 of additional income in Puerto Rico for each employee of a possessions corporation.

The opposition of Puerto Rican officials to the Reagan Administration's proposed wage credit was partly based on their evaluation of the credit's impact on overall employment. The government of Puerto Rico pointed out that the firms most attracted to the credit would be labor intensive ones. It asserted that even the proposed wage credit would not reduce labor costs enough for Puerto Rico to compete with developing foreign countries for labor- intensive investment. Accordingly, the Puerto Rican government argued that employment generated by the wage credit would not be sufficient to offset employment loss from repeal of section 936. ⁸

In more general terms, the government of Puerto Rico views the high-technology, capital-intensive investment promoted by section 936 as fitting its development strategy better than the labor-intensive investment that would be attracted by a wage credit. A report by the Economic Development Administration of Puerto Rico stated:

Section 936 has allowed Puerto Rico to attract a growing high technology sector which positions it for leadership and growth in high-tech production and economic development in the Caribbean. ⁹

As an alternative to the Administration's wage credit proposal, the Puerto Rican government proposed its "twin plant" initiative. The plan is designed to enhance section 936's effectiveness as an incentive to invest in Puerto Rico and to extend part of the 936 tax incentive to investment in other Caribbean areas. While the Administration's wage credit proposal was not included in the Tax Reform Act of 1986 (Public Law 99-514), the Act did contain provisions designed to facilitate the twin plant initiative.

The initiative works as follows. As noted above, income from investment that is strictly financial can qualify for the possessions tax credit as long as the investment is made out of funds derived from business operations in the possessions. Prior to 1986, the financial investment must also have been undertaken in the possessions. U.S. Treasury and Puerto Rican government regulations were implemented to ensure that once a firm deposited investment funds in a Puerto Rican financial institution, the funds remained in Puerto Rico and were not immediately invested outside the Commonwealth.

Under the twin plant initiative (as implemented by the Tax Reform Act of 1986 and by changes in Puerto Rican regulations), investment can be undertaken in qualified Caribbean countries as well as the possessions and still qualify for the possessions tax credit. To qualify, the investment must be undertaken either through a qualified bank or through the Government Development Bank of Puerto Rico. The banks must then use the funds to invest in active business assets in a qualified Caribbean country. The projects thus funded are intended to be labor-intensive operations that will ship their partially-finished output to more capital-intensive operations in Puerto Rico for final assembly (hence the term "twin plant"). ¹⁰

To be a qualified location for investment under the twin plant initiative, a country must be a beneficiary country under the Caribbean Basin Initiative (CBI), and must have reached an exchange of tax information agreement with the United States. As of December 31, 1987, three countries had signed the required agreements: Barbados, Grenada, and Jamaica.

CONCLUSIONS

The most general issue posed by the possessions tax credit is whether or not Federal tax treatment of investment in the possessions should be more favorable than that provided to most investments in the mainland United States or to investment abroad. The issue is complex. In 1986 the U.S. Congress enacted a broad tax reform program that sought to improve the efficiency of the U.S. economy by eliminating other tax provisions that distorted investment decisions. These efficiency considerations and burgeoning Federal budget deficits made the possessions tax credit a candidate for close scrutiny by policymakers.

Yet whether elimination of the possessions tax credit would produce substantial gains in tax revenue is not clear; the affected corporations might simply move to other low-tax locations in foreign countries. Further, economic efficiency and cost may be only secondary considerations in evaluating section 936. At the very least, a flourishing Commonwealth of Puerto Rico is important to the United States as a demonstration of how a free market economy can develop and prosper.

The Treasury Department's proposed elimination of the possessions tax credit was not included in the Tax Reform Act of 1986; both the Reagan Administration and Congress ultimately supported a continuation of a tax benefit for operating in the possessions. However, the Administration's proposed modification of section 936 highlighted a second issue: are the current section 936 provisions the best way to stimulate growth and employment in the possessions? The Administration proposed replacing the current tax exemption for income with a wage credit: a tax incentive linked directly to employment.

The government of Puerto Rico, however, maintains that the current section 936 tax benefit and the high-technology firms it attracts are vital to Puerto Rico's future development. A part of Puerto Rico's development strategy is to rely on its high-technology manufacturing sector to lead economic development both in Puerto Rico and the Caribbean Basin in general. The this end, Puerto Rico has implemented a policy of encouraging the establishment of "twin plants" in Puerto Rico and neighboring Caribbean countries -- a policy that relies heavily on the possessions tax credit.

² U.S. Department of the Treasury. Tax Reform for Fairness, Simplicity, and Economic Growth: the Treasury Department Report to the President. Washington, 1984. Vol. 2, p. 327-9.

³ Ibid., p. 328.

⁴ U.S. Department of the Treasury. The Operation and Effect of the Possessions Corporation System of Taxation: Fifth Report. Washington. U.S. Govt. Print. Off., 1985. p. 47.

⁵ U.S. Department of the Treasury. Tax Reform for Fairness, Simplicity and Growth. Vol. 2, p. 328.

⁶ U.S. President. The President's Tax Proposals to the Congress for Fairness, Growth, and Simplicity. Washington, 1985. p. 311.

⁷ Economic Development Administration of Puerto Rico. An Analysis of the President's Tax Proposal to Repeal the Possessions Tax Credit in Section 936 of the U.S. Internal Revenue Code. In Testimony of the Hon. Rafael Hernandez Colon, Governor of Puerto Rico before the Committee on Ways and Means, July 11, 1985. p. 58.

⁸ Ibid. p. 74-86.

⁹ Ibid., p. ii-iii.

¹⁰ U.S. Congress. Joint Committee on Taxation. General Explanation of the Tax Reform Act of 1986. Joint Committee Print, 100th Cong., 1st sess. Washington, U.S. Govt. Print. Off., 1987. p. 1005.