The Investment Summit
Scaling the Acts 20/22 Mountain
The 2016 Puerto Rico Investment Summit kicked off at the Convention Center in Miramar on Thursday, Feb. 11, bringing together executives, attorneys, CPAs, institutional investors, investment bankers and private equity professionals for two days of informative panels on investment opportunities, public officials pitching the latest tax incentives and networking among the attendees.
In a way, the yearly forum that began in 2014 has become a sort of tradition: crowds of wealthy investors, most of them recent arrivals to Puerto Rico, make their way to the conference rooms of a five-star hotel to learn about the latest and greatest tax lures that the Caribbean island has in store for anyone willing to establish a business in Puerto Rico and a place of residence for at least 183 days of the year.
It is all part of a concerted effort by public officials—particularly the island’s Economic Development & Commerce Department (DDEC by its Spanish acronym) and its secretary, Alberto Bacó Bagué—to inject much-needed cash and jobs into Puerto Rico’s embattled economy. What began as a trickle of offshore investors coming to the island after Acts 20 and 22 were signed into law in 2012, has now turned into a stream, if not an outright flood, of investment activity.
For the uninitiated, a brief rundown: Act 20 encourages the establishment of companies that export services from Puerto Rico. The law provides a corporate income-tax rate of 4%, no tax on dividends paid to local residents and no withholding tax on outbound dividends to nonresident owners. Act 22, meanwhile, seeks to attract new residents to Puerto Rico and exempts those residents from commonwealth taxes on investments and passive income, namely, interest, dividends and capital gains.
Oddly enough, some of the biggest investments in Puerto Rico have been carried out by individuals who haven’t necessarily benefited from Acts 20/22 incentives, according to their own words. These include billionaire John Paulson, who has bought a bevy of properties in Puerto Rico, among them the aforementioned Vanderbilt and the nearby La Concha Hotel, the St. Regis Bahía Beach in Río Grande; and fellow billionaire Nicholas Prouty, who purchased La Ciudadela, a commercial residential complex in San Juan’s Santurce district, and Marina Puerto del Rey in Fajardo. All of these properties have undergone significant redevelopment following their buyouts.
Nevertheless, other cases abound of investors who have set up shop on the island as a direct result of perks granted by Acts 20/22, as well as other incentive laws such as Act 273 of 2012, which provides tax exemptions to international financial entities, and Act 185 of 2014, which establishes similar tax decrees for private equity funds. Other lesser-known incentive laws include Act 73 of 2008, which provides a wide range of incentives related to manufacturing; Act 399 of 2004, aimed at insurance companies; and Act 27 of 2011, which seeks to spur the local film industry.
This year’s Investment Summit comes at a key juncture in the island’s ongoing economic and fiscal crisis, with the local government quickly running out of options to fulfill future bond obligations—and in fact already defaulting on some of them—and congressional discussions in Washington, D.C., rife with talk of establishing a federal fiscal-control board to manage the commonwealth’s finances, which include a $70 billion debt load.
Coupled with all the above is a rapidly downsizing labor market and nearly record numbers of people leaving the island; in fact, Puerto Rico’s net migration reached more than 200,000 people in 2014. Further underlining the need for foreign capital is that overall investment on the island has declined in the past two years and is now 29% below 2006 figures, representing a loss of $559.4 million, according to a recent study by Estudios Técnicos. As public spending continues to decline, gross domestic investment is projected to drop further in the coming years.
Moreover, for perhaps the first time since the tax incentives have been established, the efforts to lure investors and foreign capital to the commonwealth are being looked at with more optimism and a better idea of the benefits they could yield for the local economy. This is in great part due to the Estudios Técnicos study—commissioned by DDEC—that provides the first clear picture of the economic activity resulting from the tax lures.
Caribbean Business obtained an exclusive glimpse at preliminary results in late January, but now that the whole report has been released, several facts jump out regarding the growing role that Acts 20/22 applicants and other investors are having on the local economy, particularly when it comes to Act 20.
More than 5,800 direct jobs created
First, as of Nov. 2, 2015, the government had approved 360 Act 20 decrees, with another 574 Act 22 decrees also approved. In terms of direct employment, both programs generated 5,800 jobs in the first four years of their enactment, with Acts 20/22 generating about 3,349 and 2,483 jobs, respectively.
Under Act 20, a total of 7,033 direct, indirect and induced jobs have been generated by Act 20 companies in the four years since the program was enacted. These translate to 3,349 direct jobs that were generated, which in turn helped to generate 2,163 indirect jobs and 1,520 induced jobs.
Act 20 companies reported a total payroll of $137.1 million and an average salary of $42,301 a year, the study reported. “With these salaries, employees would have paid an estimated individual income tax of $17.6 million annually, under the current tax system,” the report states. “This totals $3.6 million in sales tax paid by the employment created under Act 20 beneficiaries.”
Total investment for Act 20 firms was calculated at nearly $143 million. “This means Puerto Rico’s economy has benefited from an injection of productive capital of almost $70 million when real estate, and machinery & equipment are added up,” the study says. Notably, most of the investment is concentrated in real estate, machinery and equipment. “This validates the fact that most businesses are new foreign companies establishing their operations in Puerto Rico.”
When it comes to tax revenue, Act 20 alone has generated close to $60 million, stemming from total revenues of almost $1.2 billion for Act 20 companies. Out of this total revenue, Act 20 firms reported aggregate net income of $387 million, which provides fiscal revenues of almost $34.3 million in the form of corporate income taxes. Moreover, since salaries from Act 20 businesses are relatively high, individual income taxes represent close to 30% of all tax revenues, to the tune of $17.6 million. Further broken down, the study estimates that the program has also generated some $17.6 million annually in individual income taxes, $3.6 million in sales tax and $2.3 million in municipal taxes.
Data compiled by Estudios Técnicos shows that annual payroll for Act 20 companies averages close to $43,000 per job, and businesses had a total payroll of $137.2 million. When compared to Puerto Rico’s average salary for all private- and public-sector jobs, which is $27,510 a year, Act 20 companies represent almost double that figure.
Regarding the types of jobs being generated, the services with the highest share of new employment opportunities are concentrated in consulting services. Nonetheless, advertising and public relations, call centers, architectural and engineering services, as well as accounting and management services, also account for a substantial share of employment. Of note is that the average number of jobs per decree is close to 9.3 jobs, and most of the contracting is done locally, since 87% of total employment is local residents.
Perhaps more impressive regarding Act 20, in terms of the effects on gross national product (GNP), the economic impact in the form of revenues could represent close to 1% of Puerto Rico’s GNP for 2014.
50,000 direct jobs could be created by 2024
Forecasts regarding Act 20 activity several years down the line also look promising, with the study estimating that by 2024, nearly 50,000 direct-employment opportunities could be created. By the same token, Act 20 companies would have accumulated more than $38.5 billion in gross revenue and paid over $800 million in corporate income taxes by 2024.
Over the 10-year period from 2015 to 2024, a total of 2,351 additional decrees are expected to be added under Act 20, according to the report. These are expected to generate an average of 4,237 employees per year, or a total of 44,656 new jobs in Puerto Rico. The gross income generated by these decree holders would amount to an additional $3.8 billion a year, or a total $38.51 billion over the 10-year period. The accumulated corporate income tax paid throughout the period would amount to $808.9 million.
While such figures could be interpreted as quite optimistic, they offer a more pared-down prediction from numbers supplied by DDEC, which estimated that Act 20 decrees will essentially double year-by-year, with similarly notable increases in tax revenue and employment.
Statistical data concerning Act 22—which has been singled out by critics and was even the target of a KPMG tax-reform report in early 2015 calling for its repeal—paints a slightly less significant yet nevertheless positive picture, especially when it comes to Puerto Rico’s stagnant real-estate sector and widening the island’s tax base.
Currently, Act 22 has added more than $266 million in acquired real estate, and by 2020, grantees could make nearly $1 billion in real-estate investments. “These investments will provide an injection of capital to the local construction industry,” the report adds. “Moreover, the total value of individual expenditures of Act 22 grantees will reach over $830 million by 2024.”
In residential real estate alone, total investment under Act 22 has exceeded $150 million, with average property values hovering around $1.5 million. According to the report, Act 22 investors were initially more interested in renting properties rather than buying. This trend changed in mid-2014 when there was a noticeable increase in property sales, with real-estate firms in Puerto Rico moving about $40 million to $50 million a year in transactions related to Acts 20/22 investors.
Most Act 22 grantees who are buying homes in Puerto Rico are acquiring real-estate properties in San Juan’s Condado neighborhood, as well as the municipalities of Dorado, Humacao and Río Grande. Moreover, the process of purchasing, remodeling and improving hotels, office buildings and marinas, as well as establishing partnerships with local businesses, have generated an additional investment of $125 million for the local economy.
Of note is that 52% of Act 22 grantees have established new businesses in Puerto Rico, generating 2,483 new jobs. These direct jobs helped to generate 1,604 indirect jobs and 1,127 induced jobs. The direct, indirect and induced employment account for a total of 5,214 jobs.
Most Act 22 grantees have a net worth of less than $10 million
The report also provides a glimpse into the profile of individuals who apply for Act 22 tax lures. Out of 573 approved decrees generated so far, a total of 344 grantees had a residence in Puerto Rico at the time of the application and 232 had a business established on the island. Based on the information the program participants provided, nearly 66% had a net worth of less than $10 million; only 10% had a net worth between $10 million and $50 million.
Out of all the decrees, 510 (89%) reported having their previous residence in the mainland U.S. The other 11% had previous residence in countries such as Venezuela, the United Kingdom and Spain. As with Act 20, the participants’ main business (52.5%) is consulting and financial services.
Acts 20/22 decree holders also have more than 730 bank accounts in local banking institutions, with some institutions having nearly $100 million in deposits from these clients. Individual investors have generated over $85 million in residential mortgage closings and utilized local banking services for investments of more than $5 million.
Looking ahead, Act 22 decrees are expected to produce an average of 1,195 jobs a year, for a total of 11,945 jobs added over the 2015-2024 period. The value of real estate purchased by Act 22 decree holders could reach $1.7 billion, depending on the available local inventory.
The study recommends DDEC establish thresholds related to jobs created and investment requirements for Acts 20/22. “The objective of Act 22 should be to incentivize the arrival of foreign entrepreneurs toward eligible Act 20 activities or some other type of investment,” the document states.
In a similar vein, the report stresses that efforts should also focus on incentivizing local firms to obtain these types of decrees, a goal made possible through complementary tax decrees under Act 185. “Due to all the structural inefficiencies on the island, the benefits of tax alleviation to local firms are bound to be greater in comparison to foreign firms.”
Lastly, the study concludes that in the long run, maintaining both policy tools could render strong yields for the local economy, particularly if the central government and service providers are able to capture the spillover effects of Acts 20/22 grantees. “Incentivizing the service sector, even though the injection of foreign capital, will bring about stronger economic growth.”
Private Equity Funds Act Provides Level Playing Field for P.R. Investors
P.R. Investment Summit Panel to Discuss Combining Incentives Under Acts 185 and 20
Amid the hoopla surrounding the tax benefits that the likes of Acts 20 and 22 are providing to investors in Puerto Rico, other incentive laws that could be just as significant have slipped under the radar.
A case in point is Act 185 of 2014, also known as the Private Equity Funds Act. As the name implies, the law “lays [out] a framework for partnerships of limited liability companies investing in private securities,” according to a January 2015 report by accounting firm BDO Puerto Rico. Such investment vehicles can be domestic or foreign private equity funds (PEFs).
Businessman Miguel A. Ferrer, chairman of Latin Media House and publisher of Caribbean Business, said that perhaps more importantly, Act 185 opens the door for investors who are also full-time residents in Puerto Rico to hop onto the tax incentive bandwagon. “Act 185 allows for a more level playing field among the investment community in Puerto Rico,” Ferrer said. In short, investors who are Puerto Rico residents stand to benefit from deductions for net capital losses as well as additional deductions with their investments in an eligible fund, he noted.
The act also gives Puerto Rico companies, which do not have access to public capital markets, the opportunity to be financed by a group of investors. “It broadens the scope of investments that can be incentivized on the island to create additional economic activity and job creation,” Ferrer added.
Incentives under Act 185 can also be combined with tax perks provided by Act 20, which promotes the export of services. This distinction will be discussed in a P.R. Investment Summit morning panel on Feb. 12 titled, “Pairing up the Laws: Act 20 Meets Act 185,” which will feature Ferrer as a panelist alongside Gaby Hernández, of BDO Puerto Rico; Ismael Vincenty, of law firm O’Neill & Borges; and Frank Holder of Berkeley Research Group.
“Through the panel, we want more people to know about Act 185 and the opportunities they represent, both for investment purposes and as an instrument to spur the Puerto Rican economy,” Ferrer noted, adding that while Act 185 has had a relatively low profile, at least five investment firms have signed up since the law was signed.
The benefits of Act 185
Through Act 185, PEFs gain full tax exemption on interest and dividends income as well as capital gains. Accredited investors only have to pay a 10% rate on interest and dividends income and 0% on capital gains. In the event an investor sells an ownership interest in the fund, the investor is subject to a fixed-tax rate of 5%; that is, unless the proceeds are reinvested within 90 days into a domestic PEF. Lastly, general partners and registered investment advisers with the fund are subject to a 5% tax rate on interest and dividend income, and a 2.5% tax rate on capital gains.
As for the requirements for PEFs to apply for the tax perks offered by Act 185, they differ slightly, depending on whether the PEF is domestic or foreign. As for common requirements, both types of PEFs need to have an office in Puerto Rico and a minimum of 80% of their capital invested in nonpublicly traded (i.e., private) securities. The remaining 20% has to be invested in either short-term securities or other instruments such as certificates of deposit. Similarly, they must have at least $10 million in minimum capital and restrict investment in any one business to 20% of the fund’s capital.
An important requirement is that they need to have a minimum of their capital in private securities that derive at least 80% of their gross income from sources within Puerto Rico or connected directly to the island, a requirement known as the 80% P.R.
Gross Income Rule
In the case of domestic PEFs, at least 60% of their capital needs to comply with this rule, while for foreign PEFs, the requirements go up to 80%.
Finally, Act 185 explicitly states that any tax treatments under Act 20—or Act 22 for that matter—are not limited by the PEF incentives. When it comes to Act 20, its incentives include a 100% tax exemption on earnings and profit distributions on income generated from export services; a 4% flat income-tax rate on income generated from export services; and a 100% property-tax exemption.