Puerto Rico’s solvency may hang on a potentially unconstitutional corporate tax

February 2, 2014

Last June, I asked if the U.S. Treasury was bailing out Puerto Rico with an unusual interpretation of the federal tax code. This waiver or exemption allowed U.S. multinationals operating in Puerto Rico to credit taxes that were paid to Puerto Rico on their federal tax bill. The tax, referred to as Act 154, was passed by the Puerto Rico legislature in 2011. It brought in approximately $1.6 billion in 2011.

When preparing its 2014 budget, Puerto Rico had a massive $1.5 billion deficit to fill. The governor had proposed expanding the “sales and use tax” (SUT or Cofina) by 73 percent, but this was met with strong resistance from the business community. The corporate excise tax (Act 154) was raised and part of the budget deficit was filled (an $800 million deficit is still projected for the current fiscal year).

Last week an excellent explanation of the corporate excise tax was published by Martin Sullivan on The Tax Analysts Blog. Sullivan highlighted the tax’s importance at 20 percent of general fund revenues:

On February 28, 2013, the government of Puerto Rico, citing the need for additional tax revenue because of continued poor economic conditions, expanded and extended the life of the excise tax to 2017 (Act 2-2013). Under the revised law, the tax rate will be 4 percent beginning on July 1, 2013, and through its new expiration date of December 31, 2017. The tax is now expected to raise $1.96 billion in fiscal 2014 (which began in July 2013). As shown in Figure 1, that is more than 20 percent of expected general fund revenue.

Sullivan questioned the validity of the tax and noted that the IRS had not ruled on whether it conformed to the U.S. tax code. Sullivan surveyed five tax attorneys who all had serious doubts about its constitutionality:

It has been two years and 10 months since Notice 2011-29 was issued, but the IRS and Treasury still have not reached a final decision about the credibility of the (Act 154) tax. The law firm of Steptoe & Johnson LLP, which in the employ of the government of Puerto Rico helped design the tax, issued an 84-page opinion letter stating that the tax is a creditable tax and that it does not violate the commerce clause or the due process clause of the Constitution. However, five out of five tax attorneys contacted by Tax Analysts had serious doubts that the tax was constitutional.

The author of the Steptoe letter, Philip West, is widely considered one of the top practitioners of international tax law. His biography says:

[West] also devotes significant attention to helping clients favorably resolve controversies with, and obtain rulings from, the IRS, and he has been particularly active with competent authority matters and with attest auditors on FIN 48 and other financial statement issues.  Mr. West also has extensive practical experience advocating his clients’ interests before the IRS, Treasury Department and Congress on both technical matters and on issues of broad policy significance.

West opened his 2011 testimony to the Senate Finance Committee on reforming of the international tax code by saying:

Near the end of my tenure at the Treasury Department, a wise man said to me: ‘There is no objective truth in international tax policy. Ultimately, the choices are political.’

Maybe the Obama administration views the review process for Puerto Rico’s tax issue as political, or maybe it actually takes several years for the IRS to resolve these issues. But the possible unconstitutionality of this tax is an enormous risk factor, which is disclosed in Puerto Rico’s bond offering document.

The Act 154 tax, which generates about 20 percent of general fund revenues, is the keystone for Puerto Rico to repay its general obligation bondholders. The Official Statement for the 2012 $2 billion general obligation bond offering disclosed this risk to bondholders on page A-117:

Thomson Reuters International Financing Review reported on Puerto Rico’s possible financing:

Puerto Rico is taking a gamble that it can regain access to capital markets before government coffers run out of cash later this year, with the commonwealth turning down an unsolicited approach from private investors to lend it $2 billion on onerous terms.

The approach was arranged by Morgan Stanley, which was reportedly ready to put together a general obligation bond with a coupon as high as 11 percent. One manager said the approach came on behalf of one of its hedge fund clients. Morgan Stanley declined to comment.

Although the $2 billion bond deal was unsolicited, it would have spared the commonwealth from being ‘humiliated’ in the public debt markets if it now failed to sell debt in the primary markets, said one investment banker.

It was not the first time Morgan Stanley had tried to tempt Puerto Rico with a high-yield offering. Late last year, the bank put together a $1.5 billion deal, according to sources who claim to have been asked to participate in that deal. That too was rejected by San Juan.

The IFR story suggests that the market is more than willing to fund Puerto Rico, albeit at high rates. Puerto Rico Governor Alejandro García Padilla acknowledged last Friday that the “winds are blowing” toward a downgrade in Puerto Rico’s credit rating, according to Caribbean Business. Puerto Rico faces some enormous struggles that are likely to be hurricane-size.

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PR is a commonwealth and can levy any tax it wants. Corporations get a credit for foreign taxes (yes, PR is technically not “foreign” but PR citizens do not vote in federal elections and do not pay federal taxes). So, what is the problem?
The $2B borrowing is being forced on PR by the same clowns from S&P who, in their defense against a federal lawsuit, declared that their ratings “are not indicators of investment merit, are not recommendations to buy, sell or hold any security, and should not be relied upon as investment advice.” So, why do these clowns, along with their friends from Moody’s, wield so much power that they can manipulate a commonwealth of over 3.5M people? Is it because of the CYA, or is it that they have friends on WS who would gladly collect $200M a year in interest on the induced loan?
Instead of describing what is really going on, the media, including this blog, continue to focus on the negatives. Why don’t you write about upcoming Barclay’s underwriting of the new debt or commend the gov for trying to balance the budget a year ahead of schedule? Now, that would be too positive a news in the sea of gloom and doom, wouldn’t it?

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