More on Puerto Rico Debt

More on Puerto Rico Debt
David R. Kotok
Cumberland February 9, 2014



IRS Notice 2011-29 & Puerto Rico: An as-yet legally untested US tax credit for the excise tax US multinational companies pay to Puerto Rico essentially functions as a form of ongoing back-door financial aid to the economically distressed Commonwealth.

To delve into the details and determine what to make of them, we will begin by excerpting from the IRS notice regarding the Puerto Rican excise tax, linked here: PDF. Research credits and additional informational links follow at the end of this commentary.

On October 25, 2010, Puerto Rico enacted legislation amending the Puerto Rico Internal Revenue Code of 1994 (“PR IRC”) … Technical corrections to the legislation were enacted on October 28, 2010, and January 31, 2011. Final regulations relating to the Expanded ECI Rules and the Excise Tax were published on December 29, 2010. The Expanded ECI Rules and the Excise Tax are generally effective for income accruing and acquisitions occurring, respectively, after December 31, 2010.

Some other key points are excerpted, and the boldface is ours:

Section 901 allows a credit against U.S. income tax for the amount of any income … tax paid or accrued during the taxable year to any foreign country or to any possession of the United States.”… The IRS and the Treasury Department are evaluating the Excise Tax. The provisions of the Excise Tax are novel … The determination of the creditability of the Excise Tax requires the resolution of a number of legal and factual issues.

And here is a key additional paragraph:

Pending the resolution of these issues, the IRS will not challenge a taxpayer’s position that the Excise Tax is a tax in lieu of an income tax under section 903. This notice is effective for Excise Tax paid or accrued on or after January 1, 2011. Any change in the foreign tax credit treatment of the Excise Tax after resolution of the pending issues will be prospective, and will apply to Excise Tax paid or accrued after the date that further guidance is issued.

Here are some key points in bullet form.

1. PR collects the excise tax on so-called foreign companies with local manufacturing operations, and the paying companies then take a credit against their US federal tax liability. Note that 33 of the 34 companies paying the tax are American; all but 300 of the 17,000 workers in these firms are employed by US multinationals.

2. For the current PR fiscal year, the amount of revenue derived from the excise tax is estimated at about $2 billion, or about 20% of the PR general fund budget.

3. The IRS has had nearly 3 years to study this “novel” excise tax and has not yet issued an opinion as to whether it should actually qualify for a tax credit. In the meantime, it does, and almost every dollar companies pay to PR is a dollar they don’t otherwise pay in US taxes.

4. As of 2013, in light of continuing economic weakness, PR has not only extended the tax but raised it; it is now set to expire at the end of 2017 (an interesting coincidence, given the 2016 election cycle).

5. According to writer Martin Sullivan of Tax Analysts (, five attorneys contacted by Tax Analysts “seriously” doubt the constitutionality of the tax; yet constitutional questions about this tax and credit remain untested. The tax is levied based on an 84-page legal opinion from the law firm hired by PR when PR Governor Luis Fortuño held office. He is now a partner of the Washington law firm that issued the opinion. See: Steptoe

6. On January 6, 2014, Treasury and the IRS stated they are continuing to evaluate the excise tax. They also affirmed that any change will be prospective.

7. Neither Moody’s (Feb. 7) nor Standard & Poor’s (Feb. 4) mentions the overhanging and unresolved tax issue in their recent credit downgrades of PR; both rating agencies continue to keep PR on “negative” watch status.

Enough bullets! Let’s step out of the weeds to look at the big picture.

Here is how we see it. (1) By not issuing an opinion the IRS and US Treasury postpone the constitutional test litigation and perpetuate a policy that funnels an indirect subsidy of $2 billion a year to PR. (2) US taxpayers are consequently funding almost one-fourth of the PR general fund budget without congressional approval, under the public radar screen, and based on an administrative deferral technique. (3) The actual cost to the businesses that pay the tax to PR is very small since they take a direct credit for that tax on their US federal tax returns. (4) The rating agencies know that this is a fragile financial operation, and they also know that PR is collecting the tax and will continue to collect it until the IRS gives an opinion. (5) The amount involved each year is about equal to the annual interest payment on ALL of PR’s outstanding debt. (6) This tax structure is based on a special provision of US law enacted in 1921. (7) By continuing to “evaluate” the tax, the Obama Administration avoids a possible embarrassing default by PR; however, it simultaneously raises uncertainty for the businesses that do not know how to plan their PR tax policy. Thus debt markets price PR bonds as junk, and rating agencies maintain a negative outlook. The uncertainty premium in PR debt just grows and grows.

Cumberland does not hold PR debt in its managed accounts that call for investment-grade credit. We view PR bonds as a distressed debt in the junk category. The tax structure outlined above has not been enough to stabilize or revive PR, though it has no doubt assisted PR in avoiding, thus far, an outright default on its debt. PR’s troubles in gaining market access at a reasonable interest rate continue to intensify.

Many thanks to Erin Arvedlund of the Philadelphia Inquirer for some research help. We applaud Martin Sullivan at Tax Analysts for his detailed January 27 paper entitled “The Treasury Bailout of Puerto Rico.” .


David R. Kotok, Chairman and Chief Investment Officer

Cumberland’s Michael Comes offered invaluable assistance in the research effort that led to this commentary.

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