This article discusses opportunities for traders in securities and commodities to dramatically decrease the U.S. federal income tax they owe on trading gains by relocating to Puerto Rico. As with all tax-reduction strategies, it assumes that traders will continue to generate gains from their activities. The article is written from the perspective of a U.S. citizen, but certain steps and conclusions also apply to U.S. resident aliens.
Capital Gains From Trading
The gains or losses from trading in securities and commodities are considered capital unless the trader makes a mark-to-market election under Sec. 475, which treats the gains and losses as ordinary income. Certain futures contracts under Sec. 1256 can receive special treatment. Generally, except for Sec. 1256 contracts, traders gain tax advantages by making the Sec. 475 election. However, traders who relocate to Puerto Rico should not make the mark-to-market election, thus treating all gains from their trading activity as capital.
Note that this discussion applies only to traders, not to dealers or investors. Traders are treated as carrying on a trade or business, but, unlike dealers, they do not have inventory or customers. Therefore, their gains and losses on the sales of securities are treated as capital gains and losses (except as noted above) and are reported on Schedule D, the same as an investor. Dealers, on the other hand, regularly purchase securities and sell them to customers in the ordinary course of their business, and the securities owned by a dealer for use in his or her business activity represent inventory held primarily for resale. At the other end of the scale, investors are not in the business of buying and selling securities but buy and sell on their own behalf.
Puerto Rico Tax Advantages
In January 2012, Puerto Rico passed Act No. 22 of 2012, 1 which offers incentives for individuals to relocate to Puerto Rico. The law provides a 100% tax exemption from Puerto Rico income taxes to new Puerto Rico bona fide residents on certain capital gains.
The new bona fide resident must not have been a resident of Puerto Rico at any time during the 15-year period preceding the effective date of Act 22 (i.e., between Jan. 16, 1997, and Jan. 16, 2012).
Act 22 provides that the grant of a tax exemption is a contract with the Puerto Rican government. The individual files an application for a Puerto Rico tax decree before relocation, the approval of which also serves as a contract guaranteeing the incentives through 2035 from any subsequent changes in local legislation. The reason for this is to afford certainty that the tax benefits under Act 22 will not be revoked by subsequent legislation. Since the Puerto Rico Constitution prohibits legislation impairing contractual obligations, it is expected that making the tax grant a contract will protect the tax benefits.
Other laws aimed at stimulating investment enacted in 2012 are:
- The Export Services Act (Act 20), 2 which provides for a 4% maximum tax rate on income related to services for export provided by new export services businesses in Puerto Rico. Qualifying business may also be subject to requirements relating to employment of Puerto Rico residents, income, investment, and other factors or conditions.
- The International Financial Center Regulatory Act (Act 273), 3 which aims to make Puerto Rico an international banking and financial center by providing tax incentives (mainly, a 4% income tax rate) for new banking and financial activity in Puerto Rico conducted for clients outside Puerto Rico.
Income Exclusion for Bona Fide Residents of Puerto Rico
In general, a U.S. citizen or resident remains subject to full federal income tax regardless of domicile. The Internal Revenue Code, however, provides special rules for an "individual who is a bona fide resident" of Puerto Rico. 4 Income derived from sources within Puerto Rico (except amounts received for services performed as an employee of the United States or any agency thereof) is not included in U.S. federal gross income and is exempt from U.S. federal taxation for individuals who are bona fide residents of Puerto Rico during the entire tax year.
According to Sec. 937(a) and Regs. Sec. 1.937-1, the term "bona fide resident" means a person who satisfies all three tests below.
Presence test: The taxpayer must be present for at least 183 days during the tax year in Puerto Rico, but the test can also be satisfied by any of the following:
- Was present in Puerto Rico for at least 549 days during the three-year period consisting of the tax year and the two immediately preceding tax years, provided that the taxpayer was also present in Puerto Rico for at least 60 days during each of these years;
- Was present in the United States for no more than 90 days during the tax year;
- Did not have more than $3,000 of earned income in the United States and was present in Puerto Rico for more days than in the United States; or
- Had no significant connection 5 to the United States during the tax year.
Tax home test: The taxpayer must not have a tax home outside Puerto Rico during the tax year. This test generally is satisfied if the taxpayer's regular or principal place of business is Puerto Rico. If the taxpayer does not carry on any trade or business, or does, but because of its nature, the trade or business has no regular or principal place, the test is satisfied if Puerto Rico is the taxpayer's "regular place of abode in a real and substantial sense." 6 The IRS uses the following factors to determine the taxpayer's tax home if he or she does not have a regular or main place of business or work: 7
- The individual performs part of his or her business in the area of his or her main home and uses that home for lodging while doing business in the area;
- The individual has living expenses at his or her main home that are duplicated because the business requires the individual to be away from that home; and/or
- The individual has not abandoned the area in which both his or her historical place of lodging and claimed main home are located; the individual has a family member or members living at the main home; or the individual often uses that home for lodging.
If an individual satisfies all three factors, the tax home is the home where he or she regularly lives. If he or she satisfies only two factors, the individual might have a tax home, depending on all the facts and circumstances. If the individual satisfies only one factor, he or she is an itinerant; the tax home is wherever he or she works.
Closer-connection test: The taxpayer must not have a closer connection to the United States or a foreign country than to Puerto Rico. The regulations require that the connections of the taxpayer with Puerto Rico, the United States, and any foreign country should be compared in the aggregate, considering facts and circumstances including the location of the taxpayer's: 8
- Permanent home;
- Personal belongings, such as automobiles, furniture, clothing, and jewelry;
- Social, political, cultural, or religious organizations with which the taxpayer has a current relationship;
- Personal banking activities;
- Business activities (other than those that constitute his or her tax home);
- Jurisdiction in which he or she holds a driver's license;
- Jurisdiction in which the taxpayer votes;
- Residence designated on forms and documents; and
- Official forms and documents filed by the taxpayer (e.g., forms filed with the IRS).
Year of the Move to PuertoRico
Bona Fide Treatment Qualification Exception
As mentioned above, an individual who is a bona fide resident of Puerto Rico during the entire tax year excludes from gross income for U.S. federal tax purposes the income derived from sources within Puerto Rico, except amounts received for services performed as an employee of the United States or any agency thereof. 9
Special rules apply to determine whether the tax home and the closer-connection tests are satisfied for the tax year in which the individual relocates to and becomes a bona fide resident of Puerto Rico (year-of-the-move exception). An individual is eligible to take advantage of the special rules if he or she meets three tests: 10
- The individual must not have been a bona fide resident of Puerto Rico during each of the three tax years preceding the year of the move;
- During the second half of the year of the move, the individual must not have had a tax home in, or closer connection to, the United States or a foreign country than to Puerto Rico; and
- The individual must be a bona fide resident of Puerto Rico for each of the three years following the year of the move to Puerto Rico.
If each of these tests is met, the individual will be considered to have satisfied the tax home and closer-connection requirements for the whole year of the relocation. As a result, the income related to the whole year of the relocation will constitute Puerto Rico-source income.
Ownership Period Cutoff Issues
The following examples illustrate some issues raised during the period when Puerto Rico residency is being established.
Example 1. Securities and commodities owned prior to becoming a bona fide resident of Puerto Rico: Taxpayer A acquired security XYZ on Nov. 1, 2012, moved from the United States to Puerto Rico on May 1, 2013, meeting all conditions for the year-of-the-move exception, and became a bona fide resident for 2013. A sold XYZ on Sept. 1, 2013. The gain or loss during the period Nov. 1, 2012, to April 30, 2013, is considered a U.S.-source gain. 11 The gain or loss attributable to the period May 1, 2013, to Sept. 1, 2013, can be treated as U.S.-source or Puerto Rico-source at the discretion of the taxpayer, as discussed below.
Regs. Sec. 1.937-2 provides guidance on several types of income from sources within a U.S. possession, including Puerto Rico. For traders in securities and commodities, the relevant guidance is in Regs. Sec. 1.937-2(f), which describes how gains from certain dispositions of property owned by former U.S. residents are treated for tax purposes. The type of property includes property:
- Of a kind described in Sec. 731(c)(3)(C)(i), which covers stocks, notes, commodities, derivative instruments, etc.;
- That was owned by the taxpayer before he or she became a bona fide resident of Puerto Rico.
Regs. Sec. 1.937-2 further clarifies that, for the property above, the gain from the sale of such property can either be all subject to U.S. federal tax, or the taxpayer can elect that the portion of the gain attributable to the Puerto Rico holding period can be subject to Puerto Rico tax. Regs. Sec. 1.937-2(f)(1)(vii)(B) defines the Puerto Rico holding period as commencing when the taxpayer did not have a tax home outside Puerto Rico—i.e., the date the taxpayer moved his or her place of business to Puerto Rico.
The gains and losses from the sale of securities for which there are no publicly available quotes should be allocated to U.S. and Puerto Rico holding periods based on the number of days in each period. 12
Example 2. Securities and commodities acquired during the year of the move to Puerto Rico: Assume that all conditions of Example 1 are the same, except that A acquired XYZ on Feb. 1, 2013—i.e., during the year of the move but before the date of physical relocation to Puerto Rico.
Based on Regs. Sec. 1.937-1(f), A is considered a bona fide resident of Puerto Rico for all of 2013. Consequently, XYZ was acquired after the taxpayer became a bona fide resident of Puerto Rico, and the security or commodity is not subject to the allocation in Regs. Sec. 1.937-2(f) of the gain or loss between the United States and Puerto Rico. Gains and losses on securities and commodities acquired during the entire year of the move should qualify as Puerto Rico-source income or loss.
Year-of-the-Move Exception Election
It appears widely assumed that the year-of-the-move exception would benefit the taxpayer because of the clear tax advantages provided through Act 22. This assumption is based on the premise that the taxpayer realizes gains from trading securities and commodities. However, where the taxpayer incurs losses during the year of the move to Puerto Rico, it would be advantageous to continue during that year to be subject to U.S. federal taxation and to potentially offset that loss against prior years' income.
The year-of-the-move exception is based on the three tests listed above, one of which pertains to future periods: The individual must be a bona fide resident of Puerto Rico for each of the three years following the year of the move to Puerto Rico. 13 Additionally, Part III, line 11, of IRS Form 8898, Statement for Individuals Who Begin or End Bona Fide Residence in a U.S. Possession , asks whether the taxpayer would be "using the year-of-the-move exception," given his or her meeting the closer-connection and the tax home tests. Based on this, it is arguably at the discretion of the taxpayer to decide whether to claim the year-of-the-move exception.
Puerto Rico-Source Income
U.S. citizens and residents generally have three types of income sources: U.S. income (or income effectively connected to the United States), U.S. possession-source income, and other-source income (from countries outside the United States and its possessions). Once an individual has become a bona fide resident of Puerto Rico, only the Puerto Rico-source income earned by that individual is not subject to U.S. federal income tax. The income from the United States and from sources outside the United States and its possessions continues to be subject to U.S. federal taxation. 14 The Treasury regulations provide detailed rules on when income is considered derived from Puerto Rico sources. The source rules in Secs. 861 through 865 apply in determining whether income is from sources within Puerto Rico.
Income From Sale of Personal Property
Income from the sale of personal property by a U.S. resident is considered sourced in the United States, while income from such a sale by a nonresident is considered sourced outside the United States. 15 This means that capital gains' source "follows" the residence of the seller. Consequently, gains from trading securities and commodities by bona fide residents of Puerto Rico generally constitute Puerto Rico-source income (see holding period discussion below).
Interest and Dividends
When a U.S. corporation pays interest, dividends, and other investment income to a bona fide Puerto Rico resident, it remains U.S.-source income. This income is therefore subject to U.S. income tax in the hands of the Puerto Rico resident. This income remains U.S.-source income, even if it derives from the U.S. corporation's conduct of a trade or business in Puerto Rico.
Income From a Trade or Business in the United States
All income "[e]ffectively connected with the conduct of a trade or business within the United States" is treated as U.S.-source income. 16 This includes income from performance of personal services within the United States but can exclude trading in securities and commodities.
Trading in U.S. Securities and Commodities by Puerto Rico Residents
Traders in securities and commodities who become bona fide residents of Puerto Rico can continue to trade on U.S. markets without effectively connecting the income to the United States if certain conditions are met, based on the following safe-harbor rules.
Trading Through a Broker
The term "engaged in trade or business within the United States" does not include effecting transactions in the United States in securities or commodities through a resident broker, commission agent, custodian, or other independent agent. This applies to any taxpayer, except if at any time during the tax year the taxpayer has an office or other fixed place of business in the United States through which, or by the direction of which, the transactions in stocks or securities are effected. 17
For the Trader's Own Account
The term "engaged in trade or business within the United States" also does not include effecting transactions in the United States in securities or commodities for the taxpayer's own account, irrespective of whether such transactions are effected by or through:
- The taxpayer himself or herself while present in the United States;
- Employees of the taxpayer, whether or not such employees are present in the United States while effecting the transactions; or
- A broker, commission agent, custodian, or other agent of the taxpayer, whether or not such agent, while effecting the transactions, is (1) dependent or independent, or (2) resident, nonresident, or present in the United States, and irrespective of whether any such employee or agent has discretionary authority to make decisions in effecting such transactions. 18
Through a Partnership
A nonresident alien individual, foreign partnership, foreign estate, foreign trust, or foreign corporation is not considered to be engaged in trade or business within the United States solely because that person is a member of a partnership (whether domestic or foreign) that, pursuant to discretionary authority granted to such partnership by such person, effects transactions in the United States in stocks or securities for the partnership's own account or solely because an employee of such partnership, or a broker, commission agent, custodian, or other agent, pursuant to discretionary authority granted by such partnership, effects transactions in the United States in stocks or securities for the account of such partnership. 19
This provision does not apply, however, to any member of:
- A partnership that is a dealer in stocks or securities; or
- A partnership (other than a partnership in which, at any time during the last half of its tax year, more than 50% of either the capital interest or the profits interest is owned, directly or indirectly, by five or fewer partners who are individuals), the principal business of which is trading in stocks or securities for its own account, if the principal office of such partnership is in the United States at any time during the tax year. 20
The source rules applicable to determining when income is derived from sources within Puerto Rico also contain an anti-conduit rule. Under that rule, if a bona fide resident of Puerto Rico receives income from a Puerto Rican payer and the payer of the income (or another person) provides the same consideration (or consideration of a like kind) to a third person in exchange for U.S.-source income, then the income paid to the bona fide resident of Puerto Rico is treated as U.S.-source income. 21
Traders Might Trade Their Address
These recently enacted tax incentives available under Puerto Rican tax laws available to new residents and businesses, in combination with U.S. tax provisions allowing bona fide residents of the U.S. possession to exclude income derived from sources in Puerto Rico, make it worth considering as a destination in which to relocate. Moreover, because of favorable treatment of sourcing of gains from the disposition of certain property, traders in securities and commodities may want to consider whether these tax benefits, weighed with other factors, make moving to Puerto Rico advisable.
1 Act to Promote the Relocation of Individual Investors to Puerto Rico,2012 P.R. Laws 22.
2 Act to Promote the Export of Services, 2012 P.R. Laws 20.
3 International Financial Center Regulatory Act, 2012 P.R. Laws 273.
4 Sec. 933(1).
5 As defined in Regs. Sec. 1.937-1(c)(5).
6 Regs. Sec. 1.937-1(d)(1).
7 IRS Publication 463, Travel, Entertainment, Gift, and Car Expenses, p. 3 (January 2014).
8 Regs. Sec. 301.7701(b)-2(d).
9 Sec. 933(1) and Regs. Sec. 1.933-1(a)(1).
10 Regs. Sec. 1.937-1(f).
11 Regs. Sec. 1.937-2.
12 Regs. Sec. 1.937-2(f)(1)(vi)(B).
13 Regs. Sec. 1.937-1(f).
14 Sec. 933(1).
15 Sec. 865(a).
16 Regs. Sec. 1.937-2(c)(1)(ii).
17 Regs. Sec. 1.864-2(c)(1).
18 Regs. Sec. 1.864-2(c)(2)(i).
19 Regs. Sec. 1.864-2(c)(2)(ii).
21 Regs. Sec. 1.937-2(c)(2).
|Boris Popov is a tax practitioner in Houston. For more information about this article, contact Mr. Popov at email@example.com.|