The Obama administration is eying a secretive tax deal critics charge is an indirect bailout for Puerto Rico to the tune of billions of taxpayer dollars.

The U.S. territory, desperate for revenues in the midst of the recession, surprised industry with a $6 billion tax on foreign firms – including a significant bloc of U.S. pharmaceutical firms – late October in a rare weekend legislative session without any public debate in advance.

But now U.S. taxpayers, not the firms, could end up footing at least a significant chunk of the bill.

Gov. Luis Fortuño signed the new tax into law Oct. 25. That day, the Washington, D.C.-based whiteshoe law firm Steptoe & Johnson issued him a legal brief arguing U.S. firms should receive money from the U.S. government to offset the Puerto Rico tax increase, which Fortuño sent to the Internal Revenue Service, where a decision is pending.

The international tax law in question is complicated, but experts agree the tax, and the request, are an unusual use of portions of the tax code intended to avoid double taxation on U.S. firms in countries that have reciprocity treaties with the U.S.

“We would call it creative,” said James Hines, an expert on international tax issues and the L. Hart Wright Collegiate Professor of Law at the University of Michigan Law School. “It’s an unusual tax for sure.”

It’s an “indirect bailout,” said Dan Mitchell, an international tax expert and senior fellow at the Cato Institute.

Factions within the IRS are fighting over the decision.

“The IRS is very careful about giving away U.S. taxpayer dollars,” said Roberto Monserrate, assistant executive vice president for the Puerto Rico Manufacturers Association. “This is big money we’re talking about.”

Fortuño promised worried businesses the matter would be decided by Dec. 24 but the IRS had not made up its mind late Monday.

The IRS could deny the request by deeming the tax increase a “soak up” tax designed to prey only on firms that could offset the increase with tax credits from the U.S. government.

Hines explained the credits are different from how state tax increases are treated, though Puerto Rico is an American territory and receives federal funding.

“It’s a difference, but it’s only a difference of degree,” he said. Taxes paid by U.S. firms to U.S. states can be subtracted from the income level by which those firms are taxed by the federal government. For instance, a firm with $1 million in income that paid $100,000 in state taxes would be taxed by the federal government for $900,000 worth of income.

In this case, some firms could receive a dollar-for-dollar credit for the increase in Puerto Rico taxes. For instance, a firm with $1 million in income that paid $100,000 in the new Puerto Rican tax would have its U.S. tax burden reduced by $100,000.

Monserrate said his organization estimated that if international firms with subsidiaries in Puerto Rico did not change their business structure to additionally benefit from the credit they could offset $3.5 billion of the $6 billion tax.



Businesses are already racing to take advantage of the credits and otherwise shield themselves from the surprise liability.

The tax increase has roiled relations between the Puerto Rican government and the sizable bloc of international businesses which house subsidiaries there.

“The international sector have taken this as a betrayal,” said Monserrate. “I’ve seldom seen a situation where firms are so enraged.”

“I think they’re playing with fire,” said Hines. “The last thing you want to do is discourage firms from investing in Puerto Rico. It’s a tough time to be putting up new taxes on businesses.”

Experts disagreed whether the tax credits would only apply to income generated in Puerto Rico that is “repatriated,” or sent to their U.S. parent corporations. But it is clear that there are some cases where the credits would not cover the tax.

One potential instance is if the U.S. parent corporation sustained losses in its U.S. business, but enjoyed profits in its Puerto Rican affiliate.

In that case, the firm would not be paying U.S. corporate income taxes, so there would be no tax burden to credit.

Still, the amount credited would likely be in the billions of dollars.

The deal would not send U.S. dollars to the Puerto Rican government. Instead, a tax paid to Puerto Rico would be credited from U.S. firms’ U.S. tax burden, ultimately reducing revenues to the U.S. Treasury.

One tax expert downplayed the issue, saying it is a technical legal dustup without clear answers. “This is the kind of issue high-priced lawyers spend years battling out,” said J.D. Foster of the Heritage Foundation.

Legally, Puerto Rico is treated for tax purposes as if it is a foreign country. Citizens and businesses located there do not pay U.S. income taxes.

But it is a U.S. territory that receives federal funding, including money from President Obama’s economic stimulus package.

Many U.S. pharmaceutical firms are located there because of decades of tax breaks that rewarded sectors with significant intellectual property assets.

A pharmaceutical industry source blasted Puerto Rico for the tax, which the source said has companies scrambling to plan for.

“Companies need certainty,” said the source, who noted that the implementing regulations were promulgated after only a ten day comment period.

The request by Puerto Rico for tax creditability was first reported by John Marino in Caribbean Business.

A spokesman for the IRS did not reply to a request for comment sent Friday. No one answered a phone call to Fortuño’s office Monday.