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Puerto Rico debt investigator opposes reintroducing Section 936 tax credits

By on August 22, 2018

SAN JUAN – The independent investigator hired by Puerto Rico’s fiscal oversight board to probe the causes of the island’s $74 billion debt said it did not find sufficient evidence to support that a reintroduction of a federal tax-exemption provision for manufacturing would substantially improve the island’s financial state.

“The evidence suggests that, to engender more self-sustaining growth, tax policy should focus on addressing structural challenges like outmigration, human capital development and local investment,” reads Kobre & Kim’s report, which was published Monday.

In addition to investigating the public debt, the firm studied the impact of the phaseout of the so-called Section 936 tax incentives to understand Puerto Rico’s financial crisis and how the incentive’s elimination affected the island’s ability to access capital markets.

Congress enacted the “Possession Tax Credit” as Section 936 of the U.S. Revenue Tax Code in 1976 to replace prior measures dating back to 1921 that had been repealed amid a then-developing U.S. fiscal crisis.

Section 936 essentially sheltered from federal taxes the corporate income that subsidiaries of U.S. companies earned in Puerto Rico if certain conditions were satisfied. The companies could benefit from this treatment regardless of whether they subsequently passed those profits back to their stateside parent entities. Many companies only paid a minor Puerto Rico tax on such income.

The tax incentive was repealed after a 10-year phaseout that began in 1996 to reduce the federal deficit and congressional discontent over the lost revenue to the U.S. Treasury from the credit, which benefitted pharmaceuticals.

Some supporters of the repeal, mainly New Progressive Party members, characterized Section 936 as “corporate welfare.” It was later learned that the pro-statehood party members’ support for the repeal of Section 936 was a quid pro quo for Puerto Rico’s admission as a state.

After the repeal, many large companies shuttered their operations in Puerto Rico, causing the loss of more than 200,000 jobs. The last year of the phaseout, 2006, was also the last time some have said Puerto Rico had a sound economy. Opponents of the repeal have blamed the provision’s repeal for Puerto Rico’s recession.

According to the report, Section 936 did not help the island’s economy.

“Ultimately, we did not find sufficient support for any conclusion that reintroducing the Possession Tax Credit would substantially improve Puerto Rico’s current circumstances… This is in part due to the lack of reliable evidence demonstrating that the Possession Tax Credit caused Puerto Rico’s local economy to experience any meaningful degree of permanent or self-sustaining growth,” the Kobre & Kim report reads.

However, the investigator acknowledged that Section 936 has been correlated with positive effects for Puerto Rico such as the increase in pharmaceuticals; food and related products; chemicals; machinery; and electronics. Also, that new local industries were formed; unemployment declined from 1982 to 1996; income grew; and banks had more liquidity.

“We also recognize that the repeal of the Possession Tax Credit coincides with the onset of Puerto Rico’s fiscal crisis… In addition, certain witnesses suggested that the repeal may have contributed to Puerto Rico’s debt culture. They observed that bond endeavors became more important after the repeal, as liquidity and incentives for external corporate investment dwindled. Puerto Rico was forced to find new sources of capital and debt issuances were natural options because of investor appetite stemming from the triple tax-exempt status,” the report states.

On balance, however, Kobre & Kim said the incentive failed to remedy deeper problems in a manner that might have led to long-term prosperity.

The report said Section 936 tied its benefits to the generation of income that could be attributed to Puerto Rico, if only on paper. The tax credit did not order companies to create a certain number of jobs for local residents or that they pass a percentage of their tax-exempt profits along to local employees in the form of better pay or that they invest a certain amount per year in local plants or equipment.

“As a result, the measure disproportionately attracted businesses that could glean substantial income from non-labor-intensive endeavors, such as profit generating intangibles like trademarks and patents. These companies used their subsidiaries in Puerto Rico to hold such assets, which enabled them to reap significant amounts of income that was technically generated in Puerto Rico, but required comparatively little investment in Puerto Rico’s economy,” the report authors wrote.

“It is thus not surprising that although the Possession Tax Credit conferred enormous tax savings on certain companies, researchers have identified few clear benefits for local residents,” the report said, citing different studies such as a U.S. Treasury study that found that despite receiving approximately half of the benefits of the tax credit, pharmaceutical companies employed less than 20% of the island’s workers.

The report also said the evidence did not demonstrate a clear cause-and-effect relationship between the phaseout and the contraction of Puerto Rico’s economy in 2006.

“As the Government Accountability Office recently noted, the phase-out began in 1996 and Puerto Rico’s economy continued to grow through,” the report said.

The tax credit also failed to encourage the locally centered economic improvement that many believe is necessary for sustainable long-term growth, according to the report. “Far from equipping Puerto Rico residents with the tools for self-sufficiency, the measure maintained Puerto Rico’s dependency on external investment,” the report added.

Section 936 was also a political solution, according to the investigator. “As such, it was vulnerable to political whim. The positive impacts of the Possession Tax Credit largely evaporated together with the tax incentive, when lawmakers phased it out in furtherance of President Clinton’s desire to reduce the federal deficit and the anti-pharma preferences of certain members of Congress,” the report concluded.

Among Puerto Rico debt investigator’s recommendations: debt-issuance validations to regain investor confidence

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