About a fifth of Puerto Rico’s general fund revenue is at risk.
The future of the 4% excise tax on foreign manufacturers hinges on political gales in Washington, D.C., as well as uncertainty at home. In FY14, the commonwealth raised USD 1.9bn through the tax, or 20.3% of its general fund revenue.
Known as Law 154, the excise passed as a temporary measure in FY11 under the administration of former Governor Luis Fortuno, and was designed to fall each year until it reached 1% in 2016.
But in 2013, as the tax began to fade out and Puerto Rico’s financial situation deteriorated, the commonwealth changed course. Governor Alejandro Garcia Padilla successfully backed a measure that returned the tax to 4% until 2017, at which point the method for calculating the tax changes.
The risks to the tax are two-fold. The federal government, which has allowed companies that pay the tax to fully write it off against their federal returns, could stop permitting the write-off, said Treasury Secretary Juan Zaragoza and House Finance Committee Chairman Rafael “Tatito” Hernandez. Even if it remains creditable, because of the change in the way the tax is calculated, it will be difficult to predict how much revenue it will generate in 2017, said Zaragoza.
“There’s so much uncertainty as to the yield of that methodology,” Zaragoza said. “We are meeting constantly with officials at Treasury [to discuss the future of the tax].”
From crisis to crisis
The change to the excise tax in 2017 isn’t the commonwealth’s most immediate crisis.
The Government Development Bank for Puerto Rico warned lawmakers last month that a government shutdown in the next three months was “very probable” unless the government balanced its FY16 budget, completed a five year fiscal adjustment plan and passed a tax overhaul that moved toward a value added tax and away from a sales and use tax. The House subsequently voted down the tax overhaul leaving the commonwealth’s financial plans up in the air.
Even if Puerto Rico fixes its more immediate fiscal crises with tax reform, the commonwealth will have “three big black clouds” left to address, Economic Secretary Alberto Baco said. Those issues are pension systems that are woefully underfunded, a healthcare system that is expected to run out of money in 2018, and the changes to the excise tax.
“Those are the three other [challenges] that we have to solve,” Baco said.
But, he added, as soon as the commonwealth addressed its immediate financial problems, outside stakeholders, including the federal government, will be more willing to help find solutions.
“That’s something that the federal government has been reasonable in the past and will be again if they see we are able to solve our basic issues,” Baco said.
Looking the other way….for now
So far, the federal government has allowed companies to credit the tax against their federal liability, effectively allowing a transfer of federal money to Puerto Rico. In a 2011 notice the Internal Revenue Service (IRS) said it was evaluating the “novel” tax, and that it would be creditable until they decided otherwise.
“I call it the ‘gentlemen’s agreement’ between Puerto Rico and the [IRS], about the treatment of that tax,” said Senator Ramon Luis Nieves, a member of the governing Popular Democratic Party.
By not making a final decision, the IRS gave itself the option to limit the amount of money transferred to Puerto Rico, if, for instance, the commonwealth increased the tax rate or made it permanent. And Puerto Rico has already taken steps to change the original law, scrapping the five-year reduction in rates and extending the date of the methodology change to 2017 from 2016.
The creditability of the tax may rest on who wins the presidential election in 2016, said Hernandez.
“It’s an issue of what happens if Jeb Bush wins, is he going to support that or not?” Hernandez said. “We don’t know.”
However, he noted that while Republicans “never like” the island, manufacturers are likely to push their own – likely successful – effort at maintaining creditability.
Technical, but relevant
The change is technical and it applies to relatively few companies. In FY13, 27 companies – primarily pharmaceuticals and medical device manufacturers – paid the tax. Six companies paid 75% of the revenue collected, according to the annual financial report. The tax, which is now “pretty simple,” is about to become much more complex, Zaragoza said.
Under the current law, Puerto Rico affiliates of pharmaceuticals or other manufacturers that sell drugs or other goods to their parent company pay 4% of the internal sales to the commonwealth, said Sergio Marxuach, public policy director for the Center for the New Economy.
In 2017, this will change to a so-called “source rule,” where, through a complex set of calculations, the tax liability will be based on the value of the total sales of the products made in Puerto Rico, which is less susceptible to companies’ internal “financial shenanigans,” Marxuach said.
The tax liability under the source rule is calculated by averaging four fractions: looking at each of the purchases, sales, property and payroll in Puerto Rico and dividing it by the companies total purchases, sales, property and payroll, respectively, according to a 2010 opinion by Steptoe & Johnson on the creditability of the law.
“The problem is that implementing those rules is very complicated,” Marxuach said.
Not only is it complicated, but the Treasury Department lacks the information it would need to determine the tax liability, Zaragoza said.
“In order for me to determine [the tax liability], I will need access to [pharmaceutical companies] worldwide income and I don’t have access to that,” Zaragoza said.
There’s also a constitutional question. If challenged, Puerto Rico must show that the income is closely enough tied to Puerto Rico – that there’s a sufficient nexus – for Puerto Rico to tax the income.
“There can be no assurance that [the tax’s] constitutionality will not be challenged and that, if challenged, the courts will uphold [the tax],” the commonwealth said in its first-quarter financial statement.
A taxing ‘nightmare’
Companies have accepted that, in one form or another, the excise tax will remain, said Puerto Rico Industrial Development Company Executive Director Antonio Medina.
“We’ve already informed the companies that it’s not going to go away,” Medina said. “The companies have already told us that as long as it’s creditable they’re okay with it.”
Under the source rule, the excise tax “should achieve [federal tax] creditability in the long term,” he said.
Still, he said, companies would prefer a simpler, more predictable tax, like the excise tax.
“The question is how can we change that law into something that’s simpler to implement than the sourcing of income and maintain creditability in the long term?” he said. “[As is] it’s going to be a nightmare to audit this tax.”
A USD 3.5bn tranche of Puerto Rico 2014 8% general obligation bonds due in 2035 last traded in round lots today at 78.5, yielding 10.602%, according to Electronic Municipal Markets Access. Standard & Poor’s last rated Puerto Rico’s general obligation bonds CCC+/negative on 24 April. Fitch Ratings gave them a B/negative on 26 March. Moody’s Investors Service’s last rating was Caa1/negative on 19 February.