By adopting Incentives Code Act 60-2019, also known as Act 60, Puerto Rico has instituted several favorable tax incentives for resident taxpayers, including those who provide services to customers abroad. To avoid the IRS-imposed penalties for substantial valuation misstatement with respect to pricing of these export services, Puerto Rican taxpayers providing services to related parties outside the island must prepare documentation of their related-party transactions.
Export Services Under Act 60
As a US territory, Puerto Rico has a unique tax climate. Section 936 of the tax code, enacted in the mid-1970s, allowed US manufacturing companies to avoid corporate income taxes on profits made in Puerto Rico and other US territories.
This incentive prompted many US companies to set up manufacturing and other operations on the island. The Section 936 regime started to phase out in 1996, and many manufacturing jobs in Puerto Rico have been lost since. This dramatic loss of the tax base put Puerto Rican government finances in a precarious situation.
Recently, however, Puerto Rico has rolled out its own broad program of tax incentives available to both individuals and businesses in Act 60-19. The economic activities covered by the law run a gamut from manufacturing, tourism, and international banking to sales of products to foreign markets and export services.
If an export services business qualifies for the tax benefits under Chapter 3 of Act 60, the net income stemming from the business is subject to a low Puerto Rican corporate income tax (generally 2% to 4%, depending on revenue) and distributions from earnings and profits won’t be taxable. Other tax incentives are also available to Puerto Rican residents.
At the same time, Section 933 of the tax code provides that income derived from sources within Puerto Rico by an individual who is a bona fide Puerto Rican resident during the entire taxable year is exempt from US federal income taxation. This provision effectively protects the low-tax status of the export services performed from Puerto Rico.
Arm’s Length Standard
Given the potential for abuse of favorable Puerto Rican tax provisions in related-party settings, taxpayers should expect greater IRS scrutiny of transactions covered by Act 60. Therefore, it’s important for related parties to exchange pricing export services in a way that’s consistent with the arm’s length standard.
Under Section 482 of the US Treasury Regulations, taxpayers can establish whether a controlled transaction produces an arm’s length result by comparing the results of a controlled transaction to results realized by uncontrolled taxpayers engaged in comparable transactions under comparable circumstances. The arm’s length price of a controlled service transaction must be established under the rules of Treas. Reg. 1.482-9.
Transfer Pricing Documentation
Taxpayers may avoid IRS penalties for alleged mispricing of controlled transactions only if they have applied one of the methods in the Treasury Regulations in a reasonable manner and timely prepared the transfer pricing documentation to the requirements in Treas. Reg. 1.6662-6.
As a side benefit, the documents prepared for the US compliance purposes also should be presentable to the Puerto Rican tax authorities. Puerto Rican tax law establishes that transfer pricing documentation must be prepared following the US transfer pricing rules in the Section 482 and its related US Treasury Regulations.
The Benefit Test
The first step in pricing a service transaction between related parties is to establish whether the service activity by one of the controlled parties benefits the controlled recipient. An activity is considered to confer a benefit if an uncontrolled taxpayer, in circumstances comparable to those of the controlled recipient, would be willing to pay an uncontrolled party to perform the same or similar activity, or if the recipient otherwise would have performed for itself the same or a similar activity.
It follows that uncontrolled parties wouldn’t be willing to pay for activities that provide only remote or indirect benefits to the recipient and for duplicative activities that the recipient performs for itself. As such, fees for services with no detectible direct benefits and duplicative services can’t be charged between related parties.
Transfer Pricing Methods
US transfer pricing regulations specify as many as seven different methods can be used to price a controlled services transaction. The best method rule should guide taxpayers’ selection of the most appropriate one. All but one—the services cost method—expect a profit element to be included in the price of a controlled transaction.
The services cost method only can be used in limited circumstances. It applies only for services that a taxpayer concludes don’t contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the renderer, the recipient, or both.
If the first condition is satisfied, further conditions still apply. Activities in Revenue Procedure 2007-13 automatically will qualify. Treating of other activities under the services cost method is possible only if they pass the low margin test, in which the median profit markup on total service costs of independent companies performing comparable services is calculated at 7% or less.
The regulations exclude certain types of services from being eligible, such as construction, manufacturing, and reselling and distribution activities. Because Act 60 includes many of these activities as export services, it follows that many types of export services provided under Act 60 will have to carry an arm’s length profit markupdetermined using an economic analysis of comparable uncontrolled transactions.
A controlled service transaction may be of a hybrid type where the service is combined with other transfers, such as transfers of financial instruments (loans and leases) or intangible or tangible property. In such transactions between related parties, elements may be evaluated separately under other portions of the Section 482 regulations if such approach provides the most reliable measure of an arm’s length result.
Conclusion
Taxpayers who rely on provisions of Puerto Rico Act 60 should provide export services to related parties to prepare a Section 6662 documentation to describe pricing of their controlled transactions. Such timely prepared documents allow taxpayers to avoid penalties for misstatement of income from export services that may be imposed by the IRS.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Vladimir Starkov is an expert in transfer pricing, business valuation, and valuation of intangible assets at NERA Economic Consulting. He provides advice to attorneys and corporate clients from a wide range of industries.
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