Dangerous Puerto Rico Resident CFC & PFIC Tax Planning Pitfalls

Puerto Rico Resident CFC and PFIC Tax Planning Pitfalls

Puerto Rico Resident CFC & PFIC Tax Planning

Can you just move to Puerto Rico and avoid all United States Tax and reporting of a CFC (Controlled Foreign Corporation) and/or PFIC (Passive Foreign Investment Company)? No, of course not — and when less experienced tax practitioners and attorneys try to get “too creative” in their Puerto Rico tax planning, it can spell disaster for US Taxpayers — even if they meet the Puerto Rico Bona-Fide Residence rule. Puerto Rico is a territory of the United States. Since it is not technically a state – some loopholes can exist to minimize tax and reporting. But, these loopholes can be closed at any time (see recent Malta Personal Retirement Scheme CAA) and especially with Puerto Rico and Incentives Code 60 (formerly Acts 20/22), the IRS and US Government are not fond of the offshore tax strategies used to circumvent the US tax rules. While there are some exceptions, limitations, and exclusions for Taxpayers who reside in Puerto Rico and are generating Puerto Rico sourced income — the interplay between US Tax Law, Puerto Rico Tax Law, and more complex international tax law such as GILTI, Subpart F, and CFCs can have a great impact. This is further compounded by the Foreign Trust interplay for Puerto Rico Residents. 

Puerto Rico Act 60 Can Shapeshift and Terminate

While Puerto Rico Incentives Code 60 is a great program for taxpayers to qualify — it is important to note that the Government in Puerto Rico can modify or discontinue the program at any time. Taxpayers have to go in with the understanding that if they are going to be operating a business based on certain aspects of the Act/Incentive code, Puerto Rico can change the rules at any time in the game — and the IRS can dispute the statute.

Avoiding CFC Status in Puerto Rico has Strict Requirements

From a baseline perspective, a corporation in Puerto Rico can be considered a CFC. But, the idea is that if a US person resides in Puerto Rico and qualifies under the residence rules, then they are not considered a US person relative to a Puerto Rico corporation — and the company would not be a CFC. In addition, if the income is not US sourced, then there may be no US tax implications — and Puerto Rico offers a reduced tax rate on certain business income. While this sounds great — there are very important tax aspects to consider. First, the Taxpayer must remain a resident of Puerto Rico under the very strict BFR rules. Next, the only income that is exempt is Puerto Rico sourced income, and depending on the specifics of the business, this could become a problem in the future as the company grows and expands.  While some planning techniques may involve the use of various flow-through businesses and disregarded entities or blockers to funnel non-Puerto Rico income through to Puerto Rico – so that it is “sourced” in Puerto Rico — if the United States believes the taxpayers earning income that is not sourced in Puerto Rico, it could be to both an individual tax implication and CFC reporting and tax implication.

Other CFCs are still subject to 5471, GILTI and Subpart F

With the globalization of the US economy, it is not uncommon for a US taxpayer to have several controlled foreign corporations in many different countries. Controlled Foreign Corporations outside of Puerto Rico would presumably still be considered controlled foreign corporations from a US tax perspective — and require extensive international information reporting (Forms 5471, 8865, etc.). Therefore depending on how much money is being generated from the Puerto Rico source income, the tax reward may not be as great as perceived.

Foreign Income is Still Taxable

For most taxpayers, when they want to relocate to Puerto Rico for business-related purposes, then Puerto Rico is not the only country in which they have income being sourced. Thus, the mere fact that a taxpayer qualifies for their Puerto Rico income to be exempt from US tax does not exempt the remaining of all their other foreign income and US income.

Puerto Rico Trust are Foreign (Even if Accounts and Assets are not)

Sometimes, when taxpayers try to get too creative, they may include in Puerto Rico type trust in order to protect their assets. The ambiguity comes from the fact that while a bank account or asset located in Puerto Rico is typically not reportable for FBAR or FATCA purposes – a foreign trust located in Puerto Rico is considered a foreign trust requiring the filing of form 3520/3520 – which may serve to expose the otherwise hidden assets. And, making an election for a Puerto Rico Trust to be treated as a Domestic Trust comes with its own share of headaches.

PFICs that are in Foreign Trusts are Probably Still PFIC

As was with controlled foreign corporation rules — and the potential CFC taint exception for US taxpayers who are qualified residents of Puerto Rico and have a PFIC within Puerto Rico — the same rules may apply to PFIC located in Puerto Rico and generated Puerto Rico sourced. But, this also comes with the same issues for Taxpayers who have PFICs outside of Puerto Rico and/or PFIC income from outside Puerto Rico in their Puerto PFIC. This would usually necessitate the filing of Form 8621 — and still require the taxpayer to pay tax on those excess distributions — unless an election for MTM or QEF election was made.

You Must Look at the Whole Picture

Simply relocating to Puerto Rico will not stop the tax bleeding for any income sources outside of Puerto Rico – and this is something taxpayers have to consider carefully when dreaming up tax planning strategies to avoid US tax.

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