I constantly am asked about the tax implications for an Act 60 company owner who wants to spend the summer abroad with family while working remotely. This article will use a hypothetical case study to explore the considerations for Act 60 business owners working from abroad, highlighting the importance of careful planning to avoid significant tax and legal complications.
Background:
Joe, a U.S. citizen and bona fide resident of Puerto Rico, owns a Puerto Rican company (“PRCo”) that qualifies for tax benefits under Puerto Rico’s “Act 60.” PRCo is an LLC taxed as a corporation in both U.S. and Puerto Rican jurisdictions. Under Act 60, PRCo is taxed at a 4% income tax rate in Puerto Rico, and distributions from PRCo to Joe are exempt from Puerto Rican income tax.
PRCo provides services to clients outside Puerto Rico, and Joe, who is also an employee of PRCo, plays a critical role in its operations. The company generates annual gross revenue of $25 million, resulting in a $15 million profit after expenses. Each year, PRCo distributes $10 million in dividends to Joe.
Additional Employees: Joe has three other employees at PRCo, all also bona fide residents of Puerto Rico. According to a transfer pricing study, Joe’s efforts account for 90% of PRCo’s revenue. Until now, Joe and his team have worked entirely from Puerto Rico. However, Joe is now considering spending his summers in Italy while continuing his role at PRCo. When discussing his plans with his U.S. tax advisor, Joe is unpleasantly surprised to learn that working in Italy might activate a little-known rule, which could make a portion of PRCo’s dividends taxable in the U.S. at the qualified dividend rate, potentially reaching as high as 23.8%.
Source of Services Income Earned by PRCo
Personal services income is sourced to the location where the services are performed, regardless of the payor’s location, the taxpayer’s residence, the place of contracting, or the place of payment.
Until now, Joe and his employees have conducted all their work in Puerto Rico, meaning all of PRCo’s services have been performed there, and consequently, all of PRCo’s gross income has been considered Puerto Rican-source income.
Source of Joe’s Dividend Income from PRCo
There are two important dividend sourcing rules from the Internal Revenue Code that apply to Joe and PRCo:
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- The 861/862 Dividend Sourcing Rule, and
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- The 937 Dividend Sourcing Rule.
861/862 Dividend Sourcing Rule
This rule plays a key role in determining whether PRCo qualifies as a controlled foreign corporation (CFC). If PRCo’s dividends are classified as Puerto Rican-source income under the 861/862 rule, Joe is not considered a U.S. person, and PRCo would not be classified as a CFC.
Under Code §§861(a)(2) and 862(a)(2), dividends from a foreign corporation are treated entirely as foreign-source income if less than 25% of the corporation’s total gross income over the past three years is effectively connected with a U.S. trade or business (known as “effectively connected income” or ECI).
As mentioned, all of PRCo’s gross income has been from services, all of which are foreign-source (Puerto Rican-source). Since none of PRCo’s income has been earned from U.S. sources, none is classified as ECI. Therefore, because less than 25% of PRCo’s income is ECI, dividends from PRCo should be treated as Puerto Rican-source income under the 861/862 rule.
Thus, Joe has not been considered a U.S. person regarding whether PRCo is a CFC, meaning PRCo is not subject to Subpart F or GILTI rules. This will remain the case even if Joe starts spending part of the year in Italy, as all of PRCo’s income will still be foreign-source.
937 Dividend Sourcing Rule
The 937 Dividend Sourcing Rule is important for determining whether Joe can exclude the dividends he receives from PRCo from U.S. taxable income. According to this rule, dividends from PRCo are considered Puerto Rican-source income if PRCo passes both the “80% Test” and the “50% Test.” These tests are applied based on a three-year period, including the current year and the previous two years, known as the “testing period.” For a corporation in operation for less than three years, the tests are based on the period it has existed.
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- The 80% Test requires that at least 80% of the corporation’s gross income during the testing period comes from sources within Puerto Rico or is effectively connected with a trade or business in Puerto Rico.
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- The 50% Test requires that at least 50% of the corporation’s gross income during the testing period is derived from the active conduct of a trade or business within Puerto Rico.
If PRCo fails either test, the dividends it pays to Joe will only be treated as Puerto Rican-source income to the extent of the corporation’s “possessions source ratio,” which is the proportion of PRCo’s income from Puerto Rican sources relative to its total gross income.
Source of PRCo Dividends (Under Code §937) Until Now
Up until now, PRCo has generated only Puerto Rican-source income. Therefore, it has passed both the 80% and 50% tests, and all dividends paid to Joe have been excluded from his U.S. taxable income.
Source of PRCo Dividends (Under Code §937) After Spending Summers in Italy
When Joe starts spending part of the year in Italy, some of PRCo’s income will be earned outside Puerto Rico. If more than 20% of PRCo’s gross income during the three-year testing period comes from Joe’s activities in Italy, only a portion of the dividends can be excluded from Joe’s U.S. taxable income under Code §933.
Failure of the 80% Test Triggers Form 5471 Filing Requirement
If PRCo fails the 80% Test or the 50% Test, Joe will be required to file Form 5471. This form is needed if Joe qualifies as a “category of filer” under Code §§6046 and 6038. Specifically, he may be required to file as a Category 2, 3, or 4 filer.
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- Category 2 and 3 filers need to file Form 5471 only in certain years.
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- Category 4 filers are required to file annually.
If PRCo fails either test, Joe will need to file Form 5471 annually as a Category 4 filer. A failure to file Form 5471 can result in a penalty of $10,000. Additionally, the statute of limitations for IRS audits or tax collection does not begin until this form is filed.Top of Form
Puerto Rico Tax Consequences
In the previous example, the first two summers that Joe spends working from Italy do not cause him to fail the 80/50 Tests. Joe is excited and believes he has found a way to legally avoid U.S. taxes on the dividends from PRCo. He plans to spend less time working in Italy during his third year to ensure he continues to pass the 80/50 Tests. However, Joe overlooks an important detail: while he may have found a way to legally avoid U.S. taxes on PRCo’s dividends, the income attributable to his services performed in Italy for PRCo likely does not qualify as “export services income” under Puerto Rican tax law.
According to the Puerto Rico Incentive Regulations, “working outside of Puerto Rico” can qualify as an eligible export service, but only if specific requirements are met.
Joe’s decision to spend his summers working in Italy does not meet these requirements. There does not appear to be a legitimate business reason for him to work outside of Puerto Rico, nor do his services performed in Italy seem to be incidental to PRCo’s main Eligible Activity.
The 4% tax rate under Act 60 only applies to eligible export activities. If Joe performs services outside of Puerto Rico that do not qualify as eligible export activities, the income generated from those activities may be subject to the full Puerto Rican corporate tax rates, which are among the highest in the world, reaching a top marginal rate of 37.5%.
If Joe spends 25% of his time working in Italy, 25% of the $13.5 million in income PRCo earns annually may be subject to the full Puerto Rico corporate tax rates. This could result in a Puerto Rico corporate tax liability of up to $1,212,000, or approximately $13,466 in Puerto Rican tax for every day Joe works from Italy.
Potential U.S. Criminal Implications of Failing to Pay Tax to a Foreign Jurisdiction (i.e., Puerto Rico)
In addition to the potential tax liability from Joe’s work during his summer in Italy, he should consider whether he is exposing himself to potential criminal liabilities due to his tax position. While we are not attorneys, and this article does not constitute legal advice, it raises an important question: Is Joe properly reporting and calculating PRCo’s Puerto Rico corporate tax liability due to his remote work in Italy? Or is he gambling on the possibility that the Puerto Rican tax authorities will never select his company for an audit?
If Joe and his tax preparer are signing a Puerto Rico tax return under penalties of perjury, claiming that all income generated for the year qualifies for the reduced 4% Puerto Rico tax rate when the facts do not support this position, are they at risk of criminal prosecution by the U.S. government if they knowingly made a false tax report? This is a critical question. Some advisors may mistakenly suggest that the IRS and U.S. Department of Justice aren’t interested in non-U.S. tax liabilities. However, U.S. courts have historically shown a different stance.
Though we are not legal experts and do not give legal advice, based on this case, Joe should consult with a licensed attorney and CPA familiar with the tax implications of his situation to ensure proper tax calculation and reporting. It is essential for taxpayers like Joe and PRCo to pay close attention to the specific requirements of their circumstances and seek professional advice tailored to their situation. As illustrated above, seemingly unrelated decisions—like living abroad and working remotely—can have far-reaching consequences. Guidance from trusted tax and legal experts is crucial to maintaining compliance with U.S., Puerto Rican, and foreign laws. In some cases, requesting clarification or an interpretation of the Puerto Rico Incentive Regulations in relation to the taxpayer’s unique situation may be advisable.
Planning Opportunities
Before Joe finalizes his plans in Italy, it’s essential that he consults with his tax advisors to assess his specific situation. Along with reviewing the nature and volume of work he plans to carry out while abroad, Joe should also explore whether he can request an amendment to his Act 60 Export Services grant from DDEC. This amendment could allow the work done outside of Puerto Rico to be classified as an eligible activity, which would make it subject to the reduced 4% Puerto Rico tax rate.
Joe should ask his Puerto Rico tax advisor if it’s possible to amend the terms of his tax grant to include a defined number of remote workdays that would be considered incidental to the primary Eligible Activity. This could offer a potential solution to better align his tax treatment with his international work, helping to avoid unforeseen tax obligations.