By The STAR STAFF
Puerto Rico, which can draft its own tax policies, will be the first U.S. jurisdiction to be substantially affected by Pillar Two, the global tax agreement that seeks to establish a 15% minimum tax rate on corporate income, a recent report from the non-profit Tax Foundation said.
“Pillar Two is a significant threat to Puerto Rico’s development model, which has typically featured lower taxes. Puerto Rican lawmakers have begun to respond. However, no comprehensive tax reform addressing Pillar Two has thus far crossed the finish line and become law,” the report notes.
The threat to Puerto Rico’s development model is simple. Puerto Rico is a small open economy that has used low taxes to attract valuable global companies to its shores, especially in the pharmaceutical industry and in manufacturing functions. Pillar Two intends to effectively compel an increase in Puerto Rican tax rates.
“If Pillar Two goes into effect, and Puerto Rico retains its current tax laws, then other countries will tax income sourced in Puerto Rico. This scenario only offers downsides to Puerto Rico. Global corporate investment on the island will feel the effects of higher taxes, and the value of Puerto Rican tax incentives will be reduced or even fully canceled out, but the Puerto Rican government will not gain the revenues from those higher taxes,” the report said.
The island has often used a strategy of low corporate income taxes, which can be effective for a small open economy. Low corporate income taxes can make a location attractive for both real investment by global businesses and on-paper profit shifting of intangible investments.
While Puerto Rico has always used a low-tax strategy, the execution of that strategy has been varied and somewhat haphazard over the decades—in part, though not entirely, because of instability in the federal treatment of Puerto Rico, such as the repeal of Section 936 tax incentives.
Pillar Two involves a series of three taxes that backstop and reinforce each other to impose a 15 percent minimum rate on large global companies. The first, a qualified domestic minimum top-up tax (QDMTT), is assessed by jurisdictions on domestic activity and would require businesses that pay below a 15 percent rate to “top up” their taxes to that 15 percent minimum. The second, an income inclusion rule (IIR), would be a similar top-up tax assessed on a country-by-country basis by the jurisdiction in which a corporation is headquartered. The parent jurisdiction would thus ensure that operations in a jurisdiction without a QDMTT would still roughly be taxed as if there were a QDMTT. Finally, and most controversially, Pillar Two includes the undertaxed profits rule (UTPR). Under the UTPR, any jurisdiction in which a multinational group operates could attempt to collect the 15 percent minimum on income taxed below 15 percent, effectively stepping in for the jurisdictions that would normally tax the income through source-based taxes like the QDMTT or through residence-based taxes like the IIR, the report said.
“Puerto Rico will first feel the impact of Pillar Two through the income inclusion rule. The territory has attracted some manufacturing investment from global companies headquartered in Europe, and the European Union has adopted the income inclusion rule in EU Member States for fiscal years beginning on or after December 31, 2023. This is a problem for the island all by itself: the effective tax rate on investments in Puerto Rico is being raised, but Puerto Rico—which could use the revenue—does not receive the tax money. Of course, European countries are entitled to assess residence-based taxes if they so desire, but the economic results may be suboptimal from a Puerto Rican perspective,” the Tax Foundation said.
Later down the line, the problem will escalate substantially if countries attempt to assess UTPR on Puerto Rico, because it will spread to US-based companies. In addition to presenting an economic problem, this arguably presents a significant legal one: if Pillar Two countries assess UTPR on US companies’ operations in Puerto Rico, then they will be taxing according to neither source-based principles nor residence-based principles.
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