Page 188 - TaxAdviser_2022

TAX CLINIC

as a foreign country for purposes of the income tax on the sale of assets. How- (Regs. Sec. 1.937-2(f)). These provi-
Sec. 865 sourcing rule (Sec. 865(i)(3)). ever, regulations finalized in 2008 under sions permit two approaches to sourcing
Therefore, if a U.S. citizen who is a bona Sec. 937(b), described in the following the gains between Puerto Rico and the
fide resident of Puerto Rico sold stock section, likely address the issue of U.S. United States depending on the type of
or similar property at a gain, the gain persons moving to Puerto Rico to avoid asset: one for marketable securities and
would generally be Puerto Rican–source taxes on assets prior to becoming resi- one for property other than marketable
income not subject to income tax in the dents of Puerto Rico. securities (Regs. Secs. 1.937-2(f)(1)(vi)
United States, pursuant to the exclusion (A) and (B)).
in Sec. 933. Special sourcing rule for Marketable securities: For mar-
However, in an exception to this property owned before residency ketable securities, the taxpayer may treat
general rule, Sec. 865(g)(2) provides that in Puerto Rico a portion of the gain sourced to Puerto
a U.S. citizen or resident shall not be U.S. citizens and residents who move Rico by reference to the market value of
treated as a nonresident with respect to to Puerto Rico are subject to a second the property at the close of the market
any sale of personal property unless an sourcing rule that causes the gain on as- on the first day the taxpayer becomes
income tax equal to at least 10% of the sets owned at the time of the move to be a bona fide resident of Puerto Rico
gain derived from such sale is actually subject to U.S. taxation and not eligible (see Regs. Sec. 1.937-2(f)(1)(vi)(A)).
paid to the foreign jurisdiction. This rule for the exclusion under Sec. 933. This For purposes of this rule, “marketable
would seem to frustrate the purposes of rule curtails the ability of U.S. taxpayers securities” means property that is ac-
Puerto Rico’s incentive programs. with appreciated assets to avoid U.S. tively traded on an established financial
However, there are two exceptions to income tax on the growth by establish- market within the meaning of Regs. Sec.
the 10% tax rule in Sec. 865(g)(2). First, ing residence in Puerto Rico. Regs. Sec. 1.1092(d)-1(a).
Sec. 865(g)(3) provides that the rule 1.937-2(f) provides the general rule
does not apply to the sale of stock in a that income from Puerto Rican sources Example: A private-equity manager
corporation that is engaged in an active does not include the gain on the sale who is a U.S. citizen resident in the
trade or business in Puerto Rico and of investment property (such as stocks, United States owns an interest in
that earns most of its gross income from bonds, and other passive-income- the stock of Company A, which was
activities in Puerto Rico. generating assets) that was owned before acquired in 2015 for $100. In 2020,
Second, Sec. 865(j)(3) authorizes the taxpayer became a bona fide resident the manager moved to Puerto Rico
Treasury to prescribe regulations that of Puerto Rico and where the taxpayer and established bona fide residence.
waive the 10% tax rule of Sec. 865(g)(2) was a U.S. citizen or resident and not a Company A is publicly traded on a
for purposes of the Sec. 933 exclusion. bona fide resident of Puerto Rico during national exchange. On the first day
With this authorization, the gain from any of the 10 years preceding the year of the manager’s bona fide residence
the sale of certain property by Puerto of the sale. Since such gain would not in Puerto Rico, his interest in the
Rican residents could be exempt under be income from sources within Puerto Company A stock had a market value
Sec. 933 even if the gain was subject to Rico, the Sec. 933 exclusion does not at the close of the market of $500. In
very low income taxation under Puerto apply. Therefore, in many cases, a U.S. 2022, the manager’s interest is sold
Rico’s incentive programs. Although this citizen or resident cannot avoid U.S. for $1,000. Under the general rule
provision was enacted in 1988, Treasury income taxation on gains associated in Regs. Sec. 1.937-2(f), the entire
has not issued regulations. However, with appreciation in investment assets $900 gain would be U.S.-source
the Service did publish Notice 89-40, by establishing bona fide residence in income and not exempt from U.S.
which announced that regulations would Puerto Rico unless recognized after 10 income taxation under Sec. 933,
provide that the 10% tax payment rule years of bona fide residence in Puerto since the manager owned the interest
of Sec. 865(g)(2) does not apply to bona Rico. The Puerto Rican tax incentives before becoming a bona fide resident
fide residents of Puerto Rico for the and the exemption from U.S. taxes gen- of Puerto Rico and is a citizen of
entire tax year. erally apply to income and appreciation the United States. However, the
Sec. 865(j)(3) specifically provides occurring after establishing residence in manager may elect to treat the $500
that the regulations may include provi- Puerto Rico. of gain occurring after establishing
sions comparable to the old expatriation The regulations do enable taxpayers bona fide residence in Puerto Rico as
rules under Sec. 877 to prevent U.S. to exclude some portion of taxable gain income from sources within Puerto
citizens who are only temporarily attributable to appreciation occurring Rico. The remaining $400 of gain is
residents of Puerto Rico from escaping during their residence in Puerto Rico U.S.-source income that is ineligible

18 April 2022 The Tax Adviser