A P.R. Branch of a Non-Puerto Rico (foreign) Corporation will be subject to regular income tax in a manner similar to a domestic (Puerto Rico) Corporation on its income effectively connected with conduct of a Puerto Rico trade or business (“IEC”). U.S. corporations are foreign corporations for Puerto Rico income tax purposes. All income from sources within Puerto Rico received or accumulated by the P.R. Branch is IEC. Subject to several exceptions, income from sources outside Puerto Rico is not IEC, and therefore, it is not subject to Puerto Rico income tax. In determining taxable income, the P.R. Branch will take into consideration items of income effectively connected with the conduct of a trade or business in Puerto Rico. The P.R. Branch is allowed to deduct the expenses directly allocable to the Puerto Rico business. In addition, a reasonable apportionment of expenses not directly related to any item of income is permitted as a deduction. Thus, the P.R. Branch would be entitled to deduct on the Puerto Rico income tax return a reasonable allocation of overhead expenses incurred by the home office. This allocation is often challenged by the tax authority during an examination or audit. Moreover, payments for services rendered outside Puerto Rico by a related person are disallowed when computing the alternative minimum tax applicable to a P.R. Branch.
A P.R. Branch is generally subject to Puerto Rico corporate income tax on any gain recognized on the sale exchange or other disposition of capital assets if the gain is IEC. This gain qualifies for an alternative tax of 20% if it qualifies as a long-term capital gain.
Branch Profit Tax
A second level tax, the “branch profit tax” (BPT), is imposed to tax the P.R. branch operations as if it were a foreign subsidiary. The purpose of a branch profit tax is to treat as dividends the remittances of funds to the home office as a foreign parent. A foreign corporation is not subject to the branch profit tax if in the current and two preceding taxable years at least 80% of its gross income was IEC. In this case, however, a dividend distribution made by a foreign corporation satisfying this requirement constitutes income from sources within Puerto Rico and is subject to a 15% withholding tax if the shareholder is a nonresident individual, or 10% if the shareholder is a foreign partnership or corporation that is not engaged in a Puerto Rico trade or business.
The BPT generally represents a 10% tax upon the “dividend equivalent amount.” Broadly speaking, the BPT would be imposed if the earnings and profits derived by the Branch were not reinvested in Puerto Rico as of the end of the taxable year. Comparing the net equity at the end of the taxable year and the net equity at the beginning of the taxable year makes the determination whether the amount was invested or reinvested. The BPT and the regular tax would represent a maximum effective tax burden of 37%. The BPT, as well as the income tax burden, may be reduced through the reasonable allocation and apportionment of overhead expenses. Note, however, that the allocation of expenses may be questioned by the Puerto Rico tax authorities if considered excessive or unrelated to the Puerto Rico operations.