Puerto Rico’s Act 60, Income Sourcing and IRS Scrutiny in the Age of Cryptocurrency | Insights

Puerto Rico’s Tax Incentives Code (Act 60) has shortly risen to the forefront of tax planning conversations, drawing intense curiosity from entrepreneurs, traders, cryptocurrency merchants and taxpayers holding carried pursuits in hedge funds, enterprise capital or personal fairness. The promise is tantalizing: transfer to Puerto Rico, change into a bona fide resident and doubtlessly pay little to no U.S. federal tax on Puerto Rico‑sourced earnings. Qualifying Puerto Rican firms are topic to a company tax charge of simply 4 p.c, and particular person Puerto Rican residents pay zero p.c tax on capital beneficial properties accrued after establishing bona fide residency and an entire tax exemption on curiosity and dividends.

However finally, every little thing hinges on the earnings sourcing guidelines. The IRS has made very clear – most just lately in the United States v. Suresh Gajwani case and IRS Workplace of Chief Counsel Memorandum 202538025 supplemented by AM 2024‑005 – that it’s going to scrutinize whether or not earnings is actually Puerto Rico‑sourced. For taxpayers hoping to leverage Act 60, understanding these guidelines shouldn’t be optionally available; it is important.

The Authorized Framework

A number of provisions of the Inner Income Code (I.R.C.) and associated U.S. Division of the Treasury rules govern how earnings is sourced:

• I.R.C. § 861, § 865. Common guidelines for sourcing providers earnings to the location the place the providers are being bodily carried out
• I.R.C. § 861, § 862. Common guidelines for sourcing dividends and curiosity to the location of the payer
• I.R.C. § 865. Common guidelines for sourcing private property gross sales, together with capital beneficial properties earnings, that are sourced to the taxpayer’s residence at the time of the sale; word that cryptocurrency is handled as property below IRS Income Ruling 2019-24 and is sourced below these guidelines
• I.R.C. § 937. Common guidelines for sourcing of earnings to U.S. possessions, together with Puerto Rico
• I.R.C. § 937(b) and Treas. Reg. § 1.937‑2. Supplies a particular 10-year lookback rule that applies to the sale of property by people who moved to Puerto Rico. For such people, achieve from the sale of sure property owned previous to the particular person turning into a Puerto Rican resident shouldn’t be thought of Puerto Rican supply earnings if the property is offered inside 10 years of shifting to Puerto Rico. Software of this rule to the sale of property a person switch to a partnership or different pass-through entity and subsequently offered shouldn’t be fully clear, though current IRS casual steering suggests the 10-year lookback ought to apply.

Collectively, these authorities type the basis upon which IRS depends when disputing Puerto Rico earnings sourcing disputes.

Sourcing Providers Income: Location, Location, Location

For service suppliers, the rule is deceptively easy: earnings is sourced to the place the place the providers are carried out.

• Beneath the Act 60 Export Providers Incentive (previously Act 20), earnings from providers carried out by taxpayers in Puerto Rico for shoppers exterior Puerto Rico is Puerto Rico‑sourced and taxed at simply 4 p.c.
• Examples embrace consulting, advertising and marketing, software program improvement and monetary providers.
• The lure: If the taxpayer performs providers exterior Puerto Rico – say, whereas touring in New York or Miami – that portion of earnings is U.S.‑sourced and topic to U.S. tax.

The IRS has emphasised that taxpayers should hold meticulous data of the place providers are carried out. Journey logs, contracts and billing data are essential in a sourcing dispute.

Sourcing Funding Income: Residency Is King

Beneath the Act 60 Resident Particular person Investor Incentive (previously Act 22), sourcing of funding earnings relies upon largely on residency:

• Capital Features. Beneath I.R.C. § 865(a)(2), beneficial properties are sourced to the taxpayer’s residence at the time of sale. If a taxpayer sells inventory after turning into a Puerto Rico resident, the achieve is Puerto Rico‑sourced and exempt below Act 60. If offered earlier than residency, it stays U.S.‑sourced.
• Dividends and Curiosity. Usually sourced to the payer’s location, Puerto Rico‑supply dividends and curiosity are exempt for residents, however U.S.‑supply dividends (e.g., from U.S. firms) should still be taxed by the IRS.
• Cryptocurrency. Income Ruling 2019‑24 treats crypto as property. Thus, beneficial properties are sourced like inventory to the residence of the vendor at the time of disposition.

The Gajwani case illustrates this level. The U.S. Tax Courtroom thought of whether or not cryptocurrency beneficial properties claimed as Puerto Rico‑sourced have been in reality U.S.‑sourced. The choice underscored that residency timing and documentation are crucial. A taxpayer can’t anticipate to maneuver to Puerto Rico and instantly promote crypto with out scrutiny – the IRS could deal with the appreciation as U.S.‑sourced if it accrued earlier than residency was established.

IRS Scrutiny: Classes from Gajwani and Past

The IRS has signaled that it’s going to aggressively police Act 60 claims. In Gajwani, the courtroom targeted on:

• residency exams below I.R.C. § 937 (183‑day presence, tax dwelling and nearer connection)
• timing of beneficial properties (pre‑ vs. publish‑residency)
• documentation of the place providers or buying and selling exercise occurred

Chief Counsel Recommendation (CCA) 202538025 as supplemented by AM 2024‑005 bolstered this stance, cautioning that taxpayers can’t merely “re‑characterize” U.S.‑sourced beneficial properties as Puerto Rico‑sourced by way of Sub-S firms and partnerships. The IRS is especially cautious of crypto merchants who transfer to Puerto Rico to try to shelter giant beneficial properties.

Sensible Takeaways

1. Residency Should Be Actual. Bona fide residency requires extra than simply paperwork. Bodily presence, a Puerto Rico tax dwelling and a more in-depth connection to Puerto Rico are important.
2. Doc Every part. Journey logs, brokerage statements and service contracts ought to clearly present the place earnings was earned.
3. Timing Issues. Features realized earlier than residency stay U.S.‑sourced. Plan tendencies fastidiously.
4. Entities Complicate Issues. Cross‑by way of guidelines imply U.S. resident house owners should still face U.S. tax, even when the entity operates in Puerto Rico.
5. Crypto Is Property. Deal with cryptocurrency beneficial properties like inventory gross sales. The IRS won’t permit shortcuts.
6. Beware of Judicial Doctrines. In its casual steering, the IRS is telegraphing that the literal language of the statutes could not management, and it would use judicial doctrines similar to the step-transaction and combination versus entity guidelines to implement the sourcing guidelines.

Conclusion: Act 60 Is No Loophole

Puerto Rico’s Act 60 provides extraordinary tax advantages, however it isn’t a loophole. It’s a statutory regime constructed on exact sourcing guidelines. The IRS has proven – by way of Gajwani, Income Ruling 2019‑24 and CCA – that it’s going to implement these guidelines rigorously, particularly in the risky world of cryptocurrency.

For taxpayers, the message is evident: Act 60 rewards compliance, not creativity. Those that align their info with the sourcing guidelines in I.R.C. § 865, § 937, § 933, Treas. Reg. § 1.937‑2 and associated steering can reap the advantages. Those that lower corners threat audits, penalties and disappointment.

In the finish, Puerto Rico’s tax incentives are highly effective, however solely for individuals who play by the guidelines.

Data contained in this alert is for the basic training and information of our readers. It isn’t designed to be, and shouldn’t be used as, the sole supply of info when analyzing and resolving a authorized drawback, and it shouldn’t be substituted for authorized recommendation, which depends on a selected factual evaluation. Furthermore, the legal guidelines of every jurisdiction are completely different and are consistently altering. This info shouldn’t be meant to create, and receipt of it doesn’t represent, an attorney-client relationship. If in case you have particular questions concerning a selected reality state of affairs, we urge you to seek the advice of the authors of this publication, your Holland & Knight consultant or different competent authorized counsel.