MEMORANDUM TO CLIENTS AND FRIENDS
Tax 2006-12
October 26, 2006
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Retirement Plans Update - Part VIII

Highlights of Revised Regulations under Act 87

On Tuesday evening, the Puerto Rico Treasury Department (the “PR Treasury”) issued Regulation No. 7235 (the “Regs.”) (1) which repeals Regulation No. 7153 and provides new guidance concerning the provisions of Act 87 of May 13, 2006 (“Act 87"). (2) In this Memorandum, we highlight the most important provisions of the Regs., including the application of Act 87 to defined benefit plans (“DB Plans”) and the option of allowing participants to receive a distribution from a qualified plan in order to prepay the 5% tax under Act 87. (3) The Regs.:

• Clarify that the 5% tax prepayment (4) under Act 87 is applicable only with respect to vested balances.
  
  
• Provide that the provisions of Act 87 are not applicable with respect to distributions to non-resident aliens (i.e., non-U.S. citizens). Distributions to non-resident aliens are subject to a 29% withholding tax and must be reported in PR Treasury Form 480.6C. (5)
  
  
• Confirm that the provisions of Act 87 are applicable to both active and inactive participants in plans that are qualified under PR Code Section 1165(a) (i.e., qualified defined contribution plans, defined benefit plans and “Keogh” type plans for the self-employed).
  
  
• Confirm that the 5% tax rate on distributions during the Window Period (6) is applicable only with respect to distributions on account of separation from service.
  
  
• Confirm that distributions during the Window Period are subject to a 5% tax withholding and that the withholding agent must use PR Treasury Form 480.9D (7) to deposit the tax withheld on or before the 15th of the month following the month of the distribution.
  
  
• Provide that a participant may prepay the 5% tax on the vested “undistributed accumulated balance.”
  
  
• Provide that the vested “undistributed accumulated balance” in a defined contribution plan or cash-balance plan is the vested account balance in the participant’s account.
  
  
• Provide that in the case of DB Plans with no individual accounts, the employer or the plan administrator is required to calculate the “undistributed accumulated balance” and must provide a statement to each participant who so requires it reflecting the “undistributed accumulated balance.”
  
  
• Provide various formulas (8) for the calculation of the “undistributed accumulated balance” for the DB Plans with no individual accounts in the case of:
  • a plan that provides a distribution in the form of lump-sum and the participant has reached the retirement age required to receive the maximum benefit under the terms of the plan;
    
    
  • a plan that provides a distribution in the form of lump-sum and the participant has not reached the retirement age required to receive the maximum benefit under the terms of the plan;
    
    
  • a plan that provides a distribution in the form of an annuity and the participant has reached the retirement age required to receive the maximum benefit under the terms of the plan; and
    
    
  • a plan that provides a distribution in the form of an annuity and the participant has not reached the retirement age required to receive the maximum benefit under the terms of the plan.
    
    
• Provide that in the case the plan provides for a distribution in the form of both a lump-sum and an annuity, the employer or plan administrator will calculate the “undistributed accumulated balance” using the formula for a lump-sum distribution.
  
  
• Provide various formulas for the calculation of the “undistributed accumulated balance” for the DB Plans with no individual accounts in the case the participant or beneficiary is already receiving annuity payments from a qualified plan:
  
  
  • in the form of a lifetime annuity; and
    
    
  • in the form of a fixed-term annuity.
    
    
• Provide that a plan may (i.e., optional) be amended to allow in-service distributions for the pre-payment of the 5% tax under Act 87, in which case, the amount distributed must be reported in a form to be provided by the PR Treasury and will be exempt from taxation on the year of distribution.
  
  
• Require that the plan amendment for purposes of the in-service distribution for the prepayment under Act 87 must provide that said distribution will be made by certified check, manager’s check or money order payable to the order of the Puerto Rico Secretary of the Treasury. In case the participants uses the amount received for a purpose other than the prepayment of the 5% tax, the amount distributed will be subject to tax in the year distributed at the ordinary income tax rates.
  
  
• Require that the plan’s trustee or administrator must maintain records of the “undistributed accumulated balance” for which the 5%v tax was prepaid in order to correctly withhold on and report any subsequent distributions.
  
  
• Require that any amount that is distributed after the prepayment of the 5% tax (including in-service distributions) be allocated among amounts for which the 5% tax was prepaid and other amounts (i.e., taxable and non-taxable amounts)(9) on a pro-rata basis.
  
  
• Provide that, only for purposes of taxation upon distribution, amounts for which the 5% tax was prepaid will be considered employee contributions in the case the participant receives a distribution in the form of an annuity, or as after-tax contributions in the case of the participant receives a distribution in the form of a lump-sum.
  
  
• Provide that amounts for which the tax was prepaid may not be distributed earlier than as provided in the plan, subject to the distributable events of PR Code Section 1 165(e)(2)(B). We understand that to mean that such amounts must remain subject to the provisions of the plan to which they were subject before the prepayment. That is, amounts for which the tax was prepaid may not be recharacterized as after-tax contributions for purposes other than tax withholding and reporting purposes.
  
  
• Provide that the participant may not claim a credit or refund for any tax paid on account of any difference between the amount for which the tax was prepaid and the amount actually distributed (e.g., as a result in a decrease of the value of the account investments). However, the Regs. provide that, based on the facts and circumstances of each case, such difference could constitute a deductible loss to the participant.
  
  
• Provide that a participant should not consider amounts for which the 5% tax has been prepaid or amounts distributed which were subject to the special tax for purposes of the calculation of the estimated income tax.

If you have any questions or comments, or wish additional information regarding these matters, please contact any of the attorneys listed below, members of our Employee Benefits Practice Group:

The content of this memorandum has been prepared by us for information purposes only. It is not intended as, and does not constitute, either legal advice or solicitation of any prospective client. An attorney-client relationship with McConnell Valdés cannot be formed by reading or responding to this memorandum. Such a relationship may be formed only by express agreement with McConnell Valdés.

1 The full text of the Regs. is available in Spanish at the PR Treasury’s website: http://www.hacienda.gobierno.pr/pdf/reglamentos/REG-7235.pdf.

2 Act 87 provides for a special tax rate on lump-sum distributions from qualified retirement plans and for the pre-payment of the tax on undistributed balances on qualified retirement plans. For prior discussions regarding the provisions under Act 87 and Regulations No. 7153, please see our prior Memoranda to Clients and Friends (Tax 2006-04, 05, 06 and 10).

3 See footnote no. 2.

4 Form SC 2911, "Election for Prepayment of Special Tax on Accumulated Amounts in Employee's Trusts" is available at the PR Treasury’s website: http://www.hacienda.gobierno.pr/downloads/pdf/formularios/SC%202911.pdf.

5 Distributions, and applicable tax withholding, with respect to amounts for the 5% tax was prepaid are reported to the participant in PR Treasury Form 480.6B. The PR Treasury is considering amending PR Treasury Forms 480.6A and 480.6B in order to provide for the reporting of both taxable and non-taxable distributions.

6 The Window Period remains from May 16 to November 15, 2006. Proposed legislation would extend the Window Period until December 31, 2006, if enacted into law.

7 A sample of PR Treasury Form 480.9D is available at the PR Treasury’s website: http://www.hacienda.gobierno.pr/downloads/pdf/formularios/480.9D.pdf.

8 The formulas provided by the Regs. are based on 7% interest rate and use the life expectancy depending on age and sex of the participant on the date the calculation is made in accordance with the life expectancy table (“periodic life table”) issued by the Social Security Administration dated June 27, 2006, which may found at: http://www.ssa.gov.OACT/STAT/table4c6.html

9 Note that amounts for which the 5% tax was not prepaid and any employer and employee contributions made, and earnings accumulated, after the date of the prepayment, are all subject to the applicable withholding and tax rates upon distribution.