Under this alternative, the parent company organizes a wholly owned foreign corporation through which Puerto Rico business will be conducted. The parent company will not be engaged in trade or business in Puerto Rico for the mere fact of owning a subsidiary that does business solely in Puerto Rico.

In determining taxable income, the foreign subsidiary will take into consideration items of income effectively connected with the conduct of a trade or business in Puerto Rico. The foreign subsidiary will be 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 shall be allowed as a deduction. Thus, the foreign subsidiary would be entitled to deduct on the Puerto Rico income tax return a reasonable allocation of overhead expenses incurred by the Parent Company or any Affiliate in a foreign country or the United States to the extent they are related to the Puerto Rico operations. This allocation is often challenged by the tax authority during an examination or audit. Dividends will be subject to a 10% Puerto Rico withholding tax when distributed to the foreign Parent Company. This withholding tax and the regular tax would represent a maximum effective tax burden of 37%.