Home Local News US Senate eyes tax reform impact on PR
Issued : Wednesday, May 16, 2012 02:05 PM
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US Senate eyes tax reform impact on PR

By CB Online Staff

The U.S. Senate Finance Committee held a hearing Tuesday to examine the impact of tax reform on Native American tribes and the U.S. territories including Puerto Rico, the U.S. Virgin Islands, Guam, American Samoa and the Northern Mariana Islands.

“Indian governments and the territories are in some ways similar to state governments,” said committee chairman Sen. Max Baucus, D-Mont., in a statement. “Each provides hospitals, public schools and law enforcement. But U.S. policies do not recognize tribal governments or territories as states or fully sovereign nations. Instead, U.S. law is a patchwork of complicated rules for each territory. And for tribal governments, U.S. policies are inconsistent. Tax policy is a microcosm of this inconsistency.”

The ranking Republican on the panel, Sen. Orrin Hatch of Utah, also pointed to inconsistencies in the tax policies for the territories, signaling that more uniformity could be in order.

“In a nutshell, even though the people of the various possessions are United States citizens or nationals, most do not pay tax to the federal government, but rather to their possession’s government,” Hatch said.

Some U.S. possessions including the U.S. Virgin Islands have a mirror tax code, with tax laws essentially identical to the U.S. Internal Revenue Code, simply swapping the name of the possession wherever the Internal Revenue Code says United States. Yet others, like Puerto Rico, are given more autonomy to write their own tax laws as they see fit.

“In some ways, possessions are treated like foreign countries. In other ways, however, they are treated like states,” Hatch said.

For example, research and development in a territory is eligible for the R&D credit, just as if the R&D were performed in a U.S. state. However, income taxes paid to a possession’s government are generally eligible for a U.S. foreign tax credit, just as if paid to a foreign government. Of course, taxes paid to a state government are not creditable, and only sometimes deductible.

“I will be interested in understanding whether greater consistency in the tax treatment of possessions is desirable or feasible,” the veteran Utah senator said.

The hearing covered several issues of particular relevance to U.S. territories. That included tax-breaks that could mean losses of about $150 million for the Puerto Rico government and a combined $312 million for some U.S. manufacturers operating on the island over the next two years if Congress fails to pass “tax extender” legislation that provides these monetary benefits, according to estimates released by Congress.

The domestic manufacturing rebate lowers to 32% from 35% the tax rate that U.S.-based manufacturers operating on the island pay. The intent of this legislation is to keep Puerto Rico on a level playing field tax-wise with the rest of the U.S. for domestic manufacturers operating on the island.

If Congress chooses to broaden the base of both the individual and corporate income tax, they may choose to eliminate this special provision for entities with Puerto Rico-sourced income.

“The result may be some shifting of activity away from Puerto Rico, though the magnitude of this shift would seem minimal, especially in the short term, as much of the activity generating the income may not be easily or quickly shifted out of Puerto Rico,” testified Dr. Steven Maguire, a specialist in public finance at the Congressional Research Service

If Congress chooses additional structural reforms, such as lower overall rates, the value of the deduction to taxpayers would decline. If, for example, the top rate for the U.S. corporate income tax were to drop from 35% to 25%, the after deduction marginal tax rate would be 9% of a smaller number (a 3.15 percentage point reduction compared to a 2.25 percentage point reduction).

“The size of this change would seem unlikely to significantly influence capital flow to and from Puerto Rico,” Maguire said.

Even if Congress eventually acts and approves the tax extender legislation, which expired Dec. 31, 2011, most observers believe it won’t be until after November’s U.S. and congressional elections. That situation is likely to cause a big headache to government and company budget officers as they navigate spending plans around huge potential shortfalls.

The Congressional Joint Committee on Taxation said earlier this year the benefit would be worth $312 million through 2013 for the companies. The U.S. Treasury Department, however, estimates the benefit at just $160 million over that time period.

While many U.S.-based manufacturers have organized Puerto Rico operations as controlled foreign corporations (CFCs) to avoid a federal tax burden, there are still a number of domestic manufacturers here such as Coca-Cola. The loss of the tax break could ramp up the pressure on the manufacturers, which are already dealing with high power and labor costs as they strive to remain competitive against destinations both in the U.S. and across the region.

Rum rebate cover over remains in limbo

The U.S. Senate Finance Committee hearing on Tuesday also took up the issue of the rum rebate cover-over for Puerto Rico and the U.S. Virgin Islands that expired at the end of 2011 and hasn’t been renewed by Congress.

Permanent law provides $10.50 of the $13.50 per proof gallon tax on rum distilled in each territory and in foreign countries, but since the administration of former President Bill Clinton, temporary law, which expires each year and requires recurring congressional approval, provides an additional $2.75 per proof gallon, pushing up the take for Puerto Rico and the USVI to $13.25 per proof gallon.

“Allowing the higher payment to expire permanently as part of tax reform would have a direct impact on the governments of Puerto Rico and the USVI,” said Maguire.

In the near term, the reduced payments from the U.S. could adversely impact economic development projects that are tied to the anticipated revenue streams, said Maguire.

He cited debt issued by the USVI secured by future cover-over revenue to finance the construction of rum producing facilities. Over the longer term, however, the USVI would incorporate the reduction from $13.25 to $10.50, into future economic development plans, he said.

“An even more substantial reform, such as repealing the cover over for rum not produced in Puerto Rico or USVI (or termination of the cover over completely) would be significantly more disruptive to the island economies,” Maguire said.

To the extent the covered over revenues are used to subsidize rum producers in Puerto Rico and the USVI, the current subsidy may: reduce the price of Puerto Rico and USVI produced rum relative to other countries’ production of rum and distilled spirits; increase the rate of return of capital invested in the subsidized producers; and increase worker earnings in the subsidized production facilities.

The relatively competitive market in the United States for distilled spirits and existing labor market characteristics of Puerto Rico and USVI could lead one to conclude that the subsidy is largely realized in an increased rate of return to capital for investors in the subsidized producers, he said.

“From an economic efficiency perspective, this analysis implies that subsidy-receiving rum producers are earning a higher rate of return than would be the case absent the cover over and related government subsidy,” Maguire said. “Some observers have suggested that this outcome may be at odds with the intent of the cover-over program. However, Congress has indicated that the use of the cover-over revenue is best left to the territorial government.”

The Congressional Budget Office said earlier this year the proposed extension would mean a total $222 million over the next two years for both Puerto Rico and the U.S. Virgin Islands.

While Puerto Rico has historically gotten about 80% of all rebate revenue, its share is declining to roughly 60% with the move of Diageo’s Captain Morgan rum to St. Croix from Puerto Rico this year, industry sources said.

That puts Puerto Rico’s expected take over the next two years at about $150 million, according to a CARIBBEAN BUSINESS analysis of rum sales.

Failure to approve the rum rebate cover over would be particularly painful because the Captain Morgan move will cost the island an estimated $140 million annually. Moreover, since the departure of Captain Morgan, the commonwealth government has been forced to sweeten incentive deals for local rum makers so they can stay competitive with those in the neighboring USVI. Puerto Rico is now offering rum manufacturers incentives worth up to 46% of the rum-rebate revenue generated from rum sales. The aim of the incentives is to match the offer by the neighboring jurisdiction.

Congress has let tax extender deadlines pass before, only to retroactively approve them, but it may be tougher given the current climate. The rationale behind the so-called “tax extenders” legislation, which contains dozens of tax incentives requiring congressional authorization each year, is that Congress hasn’t decided whether to approve the incentives permanently, so instead it extends them on an annual basis. The new members of Congress, elected by conservative Tea Party groups, are particularly hostile to such measures.

While President Barack Obama has funded the extension of both measures in this proposed budget, there is no guarantee the budget will be approved. The U.S. House of Representatives is at work on another spending plan, which is expected to be markedly different. Political observers predict that “gridlock” between Democrats and Republicans may keep a budget from getting approved until after the election, which would force the government to live off of smaller appropriations bills in order to continue operating.

There are also concerns among top Puerto Rico government officials that the rum-rebate program has become endangered by the generous incentives the USVI began to grant its rum makers last year.

If Congress moves to kill the entire program, however, it wouldn’t likely happen until it approves a more sweeping federal tax reform, which nobody expects to happen until next year at the earliest.

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