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Highlights
- A decade ago, the IRS audited and brought cases against numerous taxpayers who claimed residency in the U.S. Virgin Islands to take advantage of a highly touted benefit whereby bona fide Virgin Islands residents could claim a 90 percent tax credit on Virgin Islands-sourced income.
- More recently, the IRS' focus has shifted to taxpayers who claimed the tax benefits afforded by the Puerto Rico Tax Incentives Code (Act 60).
- This Holland & Knight alert details the benefits of Act 60 and how to establish residency in Puerto Rico to claim the benefits thereunder.
A decade ago, the IRS audited and brought cases against numerous taxpayers who claimed residency in the U.S. Virgin Islands to take advantage of a highly touted benefit whereby bona fide Virgin Islands residents could claim a 90 percent tax credit on Virgin Islands-sourced income. The IRS targeted these taxpayers challenging them on residency and sourcing rules.
More recently, the IRS' focus has shifted to U.S. taxpayers who have claimed the tax benefits afforded by the Puerto Rico Tax Incentives Code (Act 60). In recent weeks, Bloomberg Tax and other tax publications have reported that a prominent law firm received subpoenas regarding its clients and their claims of Puerto Rico residency and Act 60.
Puerto Rico's Act 60
Act 60 represents Puerto Rico's effort to attract businesses and affluent individuals through a territorial tax incentives program. Enacted in 2019, Act 60 consolidated and streamlined several previous tax incentive programs – most notably Acts 20 and 22 – into a single, more cohesive framework. Act 60 maintains the core benefits of its predecessors while introducing refinements and compliance measures. For qualifying businesses, it offers a corporate tax rate of just 4 percent, compared to the 21 percent federal corporate rate. For individuals, the incentives are equally compelling: zero percent tax on capital gains accrued after establishing residency and a complete tax exemption on interest and dividends. The preferential tax rates are applied to income from sources within Puerto Rico. Eligibility hinges on bona fide residency1 – physical presence in Puerto Rico of at least 183 days and no tax home nor closer connection to the U.S. or foreign country.2
The preferential rates provided by the incentive program attract taxpayers who seek to claim the substantial tax benefits. Where tax benefits can arise, IRS scrutiny will follow shortly thereafter. Similar to the Virgin Islands cases, the most frequent challenge to Act 60 benefits relate to failing to satisfy the residency requirements in Puerto Rico. The IRS wants taxpayers to be "all in" when it comes to tax incentive programs. Because of the strict residency requirements, documentation is crucial. Taxpayers should maintain a residency file that is updated annually with detailed travel logs, flight records and passport stamps. Further, taxpayers should keep boarding passes, hotel receipts and other travel-related documentation, as well as utility bills, evidence of property ownership (or long-term lease), family ties, and social and community involvement.
Establishing Residency in Puerto Rico
Filing IRS Form 8898, Statement for Individuals Who Begin or End Bona Fide Residence in a U.S. Territory, and a tax return with a Puerto Rico address will not prevent the IRS from challenging a taxpayer's good faith assertion as to Puerto Rican residency.
A U.S. taxpayer must be prepared to demonstrate that he or she is a bona fide Puerto Rican resident and was present in Puerto Rico for at least 183 days during the taxable year. See Treas. Reg. § 1.937-1(c)(1).3 The determination of whether a taxpayer is a bona fide resident is analyzed via the following 11 factors:4
- intention of the taxpayer
- establishment of a temporary home in the foreign country for an indefinite period
- participation in social and cultural activities of a chosen community, identification with the daily lives of the people and, in general, assimilation into the foreign environment
- physical presence in the foreign country consistent with employment
- nature, extent and reasons for temporary absences from a temporary foreign home
- assumption of economic burdens and payment of taxes to the foreign country
- status of resident contrasted to that of transient or sojourner
- treatment accorded to income tax status by an employer
- marital status and residence of the family
- nature and duration of employment, such as whether an assignment abroad could be promptly accomplished within a definite or specified time
- good faith in making a trip abroad or whether for purpose of tax evasion
Section 937 was amended to provide greater clarity as to determining bona fide residence in U.S. possessions. Specifically, an individual is a bona fide resident of a U.S. possession if such person:
- is present in the possession5 for at least 183 days during the year
- does not have a tax home6 outside the possession during the year
- does not have a closer connection7 to the U.S. or a foreign country than to the possession
If the taxpayer does not meet these tests and has failed to file a federal income tax return with the IRS, the statute of limitations remains open under I.R.C. § 6501(c)(3), even if the taxpayer acted under a good faith belief as to being a Puerto Rican resident.
Conclusion
Navigating Puerto Rico's Act 60 can be complex. If you are seeking to strengthen your residency position, ensure compliance and mitigate the risk of IRS challenges, contact the authors for professional guidance.
Footnotes
1 I.R.C. § 933
2 I.R.C. § 937(a).
3 If the taxpayer is a non-resident alien, the individual must meet the 183-day test under 7701(b)(3)(A). See Treas. Reg. § 1.937-1(c)(2) and Lujan v. Comm'r, T.C. Memo. 2000-365.
4 See Sochurek v. Comm'r, 300 F.2d 34, 38 (7th Cir. 1962); Bergersen v. Comm'r, 109 F.3d 56, 62 (1st Cir. 1997). Other circuits group the 11 factors into the following four categories: 1) the taxpayer's intent to remain in the place of residency for "an indefinite or at least substantial period of time," 2) the taxpayer's physical presence, 3) the taxpayer's social, family and professional relationships, and 4) the taxpayer's own representations.
5 Guam, American Samoa, Northern Mariana Islands, Puerto Rico or U.S. Virgin Islands.
6 Determined under the principles of I.R.C. § 911(d)(3) (without regard to the second sentence thereof).
7 Determined under the principles of I.R.C. § 7701(b)(3)(B)(ii).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.