Puerto Rico: Vacation Spot or Tax Haven? – April 06, 2016 by Ray Polantz

The United States is one of the few countries in the world that retains the right to tax its citizens on worldwide income. For example, if a U.S. citizen lives in Canada and has no “U.S.-source income” (income derived from the U.S.), he will still be subject to U.S. tax on his Canadian-based income simply because of his status as a U.S. citizen.

With recent tax rate increases and the implementation of the Medicare surcharge, some U.S. taxpayers living in other countries have joked that they wish to expatriate to avoid paying U.S. tax on their worldwide income.

While some may joke, others have taken action! Facebook co-founder Eduardo Saverin famously dropped his American citizenship in May 2012, reportedly to avoid taxes on IPO profits. Other famous Americans who have renounced U.S. citizenship include recluse chess champion, Bobby Fisher, and pop icon Tina Turner. (Even All-American comic strip hero Superman reportedly renounced his U.S. citizenship in the 900th issue of Action Comics.)

Under the current rules, U.S. citizens who formally renounce their citizenship could be subject to an exit tax. An individual who expatriates is treated as having sold his worldwide assets for fair market value, and must pay tax on the deemed sale to the extent the gain exceeds $600,000 (adjusted annually for cost of living).

As an alternative to expatriating, U.S. citizens who become bona fide residents of Puerto Rico are able to retain their U.S. citizenship and still eliminate U.S. federal income tax on income derived from Puerto Rican sources, such as interest and dividends. In addition, by becoming a resident of Puerto Rico, U.S. citizens will no longer be required to pay U.S. federal tax on capital gains (even if from a U.S. source).

Until fairly recently, the benefits of this provision were limited, because even though exempt from U.S. tax, this income continued to be subject to local Puerto Rican income taxes. Changes to the Puerto Rican tax laws present a unique opportunity for certain U.S. taxpayers. On January 17, 2012, Puerto Rico enacted the Act to Promote the Relocation of Individual Investors to Puerto Rico, which generally eliminates the local tax for new residents who have certain long-term capital gains, as well as interest and dividends from Puerto Rican sources.

The income tax exemption is only available to long-term capital gains attributable to the increase in value accruing after the date that the individual establishes Puerto Rico domicile. Interest and dividends from corporations organized in the United States and elsewhere outside Puerto Rico will be exempt from Puerto Rico tax but still subject to U.S. tax.

A U.S. citizen can take advantage of these rules by becoming a bona fide resident of Puerto Rico (as long as they were not a resident of Puerto Rico at any time during the 15-year period ending on January 17, 2012). The term bona fide resident means a person who is present for at least 183 days during the taxable year in Puerto Rico, does not have a tax home outside of Puerto Rico during the taxable year, and does not have a closer connection to the U.S. (or another foreign country). The closer connection test will consider a number of different factors, including the location of the individual’s family, location of his personal belongings and location where the individual conducts business activities, among others.

Who can benefit most? Individuals who might find this opportunity most appealing would likely be high-net-worth individuals who have significant gains from stocks and securities and no continuing U.S business interests. With U.S. tax rates at a near-20-year high, the imposition of the 3.8% Medicare surcharge tax on net investment income (and the allure of year-round warm weather), U.S. citizens may now have all the incentive they need to relocate to Puerto Rico.

We want to hear from you! We encourage you to comment below on this blog post, share it on social media or contact Ray Polantz at rpolantz@cohencpa.com or a member of your service team for further discussion.

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.