Puerto Rico wants to be America’s tax haven, but it has plenty of Caribbean competition

March 11, 2013
Obsession
Modern States
March 11, 2013

Hedge fund manager and subprime bubble popper John Paulson is considering a move to Puerto Rico after a new law exempted immigrants from capital gains taxes in a bid to attract new residents with Paulson-esque levels of wealth.

There’s really only one question to ask: What took Puerto Rico so long?

The island nation is well positioned to join other offshore locations, like UK territories Jersey and the Cayman Islands, in helping wealthy individuals pay less tax. Puerto Rico is a US territory, which means it is technically part of the United States but largely administered by an insular local government. It is a four-hour flight from New York City, offers a nice climate, and doesn’t have another obvious strategy for economic growth. But most important is the law passed last year, which exempts new residents from the island’s already small 10% capital gains tax.

The local government is pitching investment managers like Paulson, who can often treat their salaries as capital gains, along with other wealthy Americans whose income is largely investment returns, on moving to the island, with the hope that their arrival will coincide with investments in real estate, more service consumption, and perhaps new businesses forming here. One hedge fund actually set up shop in the capital, San Juan, in part for the tax benefits but also because its manager, Pascal Forest, is married to a Puerto Rican native.

Will Paulson, or anyone else, take up this offer? The law does offer a significant financial advantage, but before it was enacted, capital gains were taxed at only 10%—still more than fifteen percentage points lower than the American rate, which could have still attracted wealthy residents. People taking advantage of the law must live on the island for 183 days a year, among other residency requirements, and depending on how strictly they are enforced, Puerto Rico may be more of a retirement destination for the super-wealthy than the kind of place where they operate a business.

But for all its advantages as a potential tax haven, Puerto Rico may have missed the boat. It faces a lot of competition in a race to the bottom with its Caribbean neighbors and other low-tax jurisdictions, especially as the United States and other advanced economies redouble their efforts to sweep up tax avoiders under deficit pressure.

The bigger issue, though, are Puerto Rico’s economic woes: 14% unemployment, little in the way natural resources, growing pension obligations, and a robust grey market have the country on the budgetary ropes, with raters looking to downgrade its already junk-level bonds. Those high yields are attracting investors, but they are essentially betting on the expectation that the US won’t let its territory go under. They might not be wrong: The UK, after all, rescued the Caymans when that country foundered financially, but it attached a number of strings, including efforts to limit tax avoidance. While the government guarantees the capital gains tax break through 2035, a country looking to raise revenue will find a way to tap the pockets of its wealthiest residents.

Indeed, tax incentives have proven to be both a boon and a bane to Puerto Rico: The country’s recent economic troubles can be traced in part to the end of costly manufacturing tax breaks the US government gave to companies who made goods on the island. But when those breaks ended, in 2006, many companies kept their facilities on the island while transferring ownership to Cayman Islands subsidiaries, avoiding taxes in both Puerto Rico and the United States.

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