Analysts Fret Over Legality of Puerto Rico Tax
Feb 11, 2014
By Mike Cherney
In the wake of three credit-rating downgrades, there are more worries for Puerto Rico: Some analysts say they are concerned a tax that is a key revenue source for the fiscally troubled island may not even be legal.
The so-called excise tax is assessed when U.S. or foreign companies make purchases from their Puerto Rico affiliates, and is expected to bring in about $2 billion this fiscal year, more than 20% of Puerto Rico’s general fund revenue. The tax is structured so that U.S. companies can subtract whatever they pay in Puerto Rico excise taxes from their U.S. corporate income taxes.
That arrangement has never been tested in court, and the Internal Revenue Service and the U.S. Treasury have still not reached a final decision about whether the excise tax can be credited against U.S. taxes, said Martin Sullivan, chief economist at Tax Analysts, a nonprofit group that publishes tax research. Mr. Sullivan said it is unclear why the two agencies have not made a final decision, considering the tax was created by Puerto Rico in 2010. In the meantime, however, companies are allowed to credit the excise tax.
Mr. Sullivan, who published a report on the matter on Jan. 27, said he polled five tax lawyers and that all of them said the tax was unconstitutional or its constitutionality was in doubt. On Sunday, investment firm Cumberland Advisors weighed in, calling the tax an “indirect subsidy” from the federal government that is being given without congressional approval.
“If you have a fourth or a fifth of your general fund budget subject to an IRS ruling which is three years in the making and is not yet issued, do you have a funding risk? I would think the answer to that is yes,” David Kotok, chairman and chief investment officer of Cumberland, said in an interview. The firm oversees about $2 billion for individual investors and doesn’t own Puerto Rico bonds.
Puerto Rico debt is widely-owned by U.S. investors because of its generous tax benefits, but the bonds have tumbled in value over the last year. The island has been struggling with an economic downturn, high unemployment and persistent budget deficits. The year-old administration of Gov. Alejandro Garcia Padilla has raised taxes and cut some pension benefits, but that was not enough to stop Standard & Poor’s Ratings Services, Moody’s Investors Service and Fitch Ratings from recently downgrading its debt to junk status.
Puerto Rico finance officials declined to comment on the legality of its excise tax structure. However, officials did warn in an October finance report “there can be no assurance that its constitutionality will not be challenged and that, if challenged, the courts will uphold” the tax. If struck down, the island’s revenues “may be materially adversely affected,” the report said. Last year, Puerto Rico increased the tax rate and extended the tax to 2017, according to Mr. Sullivan’s report.
In a statement Monday, a U.S. Treasury spokesperson said it and the IRS “continue to evaluate the legal and factual issues which will inform the determination” of whether or not the excise tax can be credited against U.S. taxes.
Despite the concern over its legality, Mr. Sullivan said it was unlikely the tax would be challenged in court. U.S. companies have been given other concessions by Puerto Rico to locate operations there. And it’s not clear how the courts would ultimately rule on the issue, he said.
“If I were holding Puerto Rico bonds, I’d be worried about a lot of things, but this would not be the one I would be (most) worried about,” Mr. Sullivan said. “But it does linger there.”
On Tuesday, Puerto Rico said it expected it to sell a general-obligation bond soon and that it had hired a team of bankers to manage the deal.