MEMORANDUM TO CLIENTS AND FRIENDS
Tax 2006-07
June 22, 2006
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Act 98 of May 16, 2006

Act No. 98 of May 16, 2006 (“Act 98”) , entitled Act for the Imposition of an Extraordinary Tax of 2006, requires certain taxpayers to file a special return and pay an extraordinary 5% tax on their nonexempt net taxable income. The Puerto Rico Treasury Department (“Treasury”) has issued regulations, effective June 15, 2006, providing additional guidance.

Who is obligated to pay the extraordinary tax

Act No. 98 imposes this obligation on all corporations and partnerships, domestic or foreign, engaged in a trade or business in Puerto Rico, which generated gross income of more than $10,000,000 during the taxable year ended on or before December 31, 2005. The term “gross income” for such purposes is as defined by Section 1022 of the Puerto Rico Internal Revenue Code of 1994 (the “Code”), except in the case of insurance companies, where Sections 1202 and 1207 will apply.

Excluded from this obligation are: (1) special partnerships and corporations of individuals operating under Sub-Chapters K and N of Chapter 3 of the Code; (2) exempt organizations under Section 1101 of the Code, including churches and unions; and (3) registered investment companies under Section 1361 of the Code.

How is the 5% tax computed

The 5% tax is imposed on the corporation’s or partnership’s nonexempt net taxable income reported on the income tax return for the last taxable year ended on or before December 31, 2005. The regulations provide that the tax is imposed on the net income subject to regular tax, as defined in Section 1015 of the Code (Sections 1201, 1204, and 1207 in the case of insurance companies). If an extension to file the 2005 return was filed and the return has not been filed by the time the extraordinary tax is due, then the taxpayer will compute the 5% tax on the basis of the amounts reported in the request for extension, and any necessary adjustments will be made once the return is filed.

The tax is not imposed on industrial development income (Industrial Incentives Acts of 1987 and 1998), tourism development income (Tourism Incentives Act of 1983 and Tourism Development Act of 1993), or income derived from the rendering of exempt health-hospital services (Act No. 168 of June 30, 1968).

Note that pursuant to Act 98, as enacted, if a taxpayer derived gross income (whether subject to the extraordinary tax or not) in excess of $10,000,000, any amount of nonexempt income will be subject to the 5% extraordinary tax. This means, for example, that if a beneficiary of any of the incentives laws mentioned in the previous paragraph generates income from a nonexempt operation (i.e., non IDI ), then income from that activity will be subject to the 5% extraordinary tax even if such income did not exceed the $10,000,000 threshold.

How to report and pay for the extraordinary tax

New Form 484, available at Treasury’s offices and web site, www.hacienda.gobierno.pr, must be filed on or before July 31, 2006. Copy of Form 484 is enclosed.

Credit for the extraordinary tax paid

In the case of domestic taxpayers, the total amount of extraordinary tax paid will be allowed as a credit against income taxes for taxable years commenced after December 31, 2005. The credit shall be claimed in four equal installments, during the four taxable years commenced after the taxable year following the year when the taxable year was paid.

Foreign taxpayers may claim the extraordinary tax paid as a credit against their income taxes for the following four taxable years, as described above. However, if such taxpayers have net operating losses in any of such four taxable years, the credit may be claimed in subsequent years, without extending the four-year period allowed to claim the credit or increasing the amount allowed per year. As enacted, Act 98 does not provide for the net operating loss year extension to domestic taxpayers.

Although the objective was to have the collections available for the government’s fiscal year 2006-07, and to allow the credit in four equal installments for fiscal years 2007-08 and thereafter, Act 98 has been interpreted as allowing the credit up to 100% of the taxable years tax liability, and the unused credit balance in four equal installments in subsequent taxable years. The current text of Act 98 gives room for the two interpretations. Treasury’s officials have informally confirmed that Treasury’s position is that the credit may be claimed in four equal installments only.

This issue is expected to be clarified by a proposed amendment to Act 98 (H.B. 2712), which would provide for a maximum credit per year of 25% of the extraordinary tax paid with no limitation as to the number of taxable years in which such credit may be claimed. H.B. 2712 would eliminate any distinction between foreign and domestic taxpayers in this context.

Foreign taxpayers must show that, for any of the years in which the credit is claimed, no foreign tax credit or deduction was allowed with respect to the extraordinary tax by other jurisdictions. In this respect, note that the extraordinary tax may be considered a “soak-up” tax and, thus, not a creditable tax, for purposes of federal income taxes, in accordance with Section 901 of the U.S. Internal Revenue Code of 1986, as amended, and the regulations thereunder. H.B. 2712 would eliminate this condition.

Penalties for failure to comply

Failure to timely file Form 484 will cause the imposition of an addition to tax, as follows: 5% of the tax if the omission does not exceed 30 days, and an additional 10% for every 30-day period, or portion thereof, up to 25%, as provided by Section 6049 of the Code. The addition will not be imposed if there was just cause and not willful neglect in the failure to timely file Form 484.

Closing agreements and undue hardship

The regulations provide that Treasury will be authorized to enter into closing agreements relating to the extraordinary tax within the provisions of Section 6126 of the Code.
In addition, the regulations provide that a taxpayer who will suffer undue hardship by reason of the application of the extraordinary tax may request Treasury to waive this requirement under Section 6126 of the Code. The request must be made on or before July 31, 2006.

In this context, undue hardship includes situations where in order to pay the extraordinary tax the taxpayer will have to obtain a loan, risk failing to comply of payroll obligations or postpone investments that were previously budgeted and that are necessary for the business. The taxpayer will be required to submit copy of the financial statements for the taxable year ended on or before December 31, 2005, or any other document evidencing the taxpayer’s hardship situation.

Other developments

The regulations issued under Act 98 may be amended if H.B. 2712 is enacted into law. We will issue a memorandum updating this information if necessary.

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If you have any questions or comments, or wish additional information, please contact any of the attorneys listed below, members of our Tax Department:

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.