THE PUERTO RICAN ECONOMIC ACTIVITY TAX CREDIT: CURRENT PROPOSALS AND SCHEDULED PHASEOUT
CRS Report for Congress
The Puerto Rican Economic Activity Tax Credit:
Current Proposals and Scheduled Phaseout
David L. Brumbaugh
Specialist in Public Finance
Government and Finance Division
U.S. firms have long received a tax benefit for operations in Puerto Rico and other
U.S. possessions; the benefit’s purpose is to generate employment-creating investment
in the possessions. Prior to 1996, the provision was known as the Possessions Tax
Credit and was provided under section 936 of the Internal Revenue Code. In the years
following World War II, the government of Puerto Rico depended on the credit and its
own set of tax benefits to attract investment to Puerto Rico from the U.S. mainland. The
tax benefit and the inflow of investment it stimulated helped transform the Puerto Rican
economy from one based on agriculture to one based on manufacturing, services, and
trade. However, the credit was criticized on several grounds: that it had a high revenue
cost compared to its employment effect; that a large share of the benefit did not accrue
to residents of Puerto Rico; and that it distorted deliberations over Puerto Rico’s political
status. As a result, over the past 20 years the credit has been subject to a series of
modifications designed to limit its revenue cost and tie the credit’s benefit and effects
more tightly to Puerto Rico. The modifications culminated with the Small Business Job
Creation Act of 1996, which scheduled the credit for phaseout and ultimate repeal in
2005. The tax credit–renamed the Puerto Rican Economic Activity Credit (EAC)–is
now authorized by section 30A of the tax code. (A separate phase-out schedule and
rules apply to the possessions other than Puerto Rico.) The Clinton Administration for
several years has proposed extending a modified version of the credit beyond its
expiration date, and several proposals in Congress would also modify and extend the
credit. This report will be updated as legislative developments occur.
The Possessions Tax Credit Prior to 1993
While the tax benefit for possessions1 investment is technically a tax credit that
reduces taxes rather than taxable income, prior to 1993 the credit was equal to a firm’s full
federal tax liability on possessions-source income. The effect of the credit, then, was that
1 American Samoa, Guam, Northern Marianas, Puerto Rico, and the U.S. Virgin Islands.
Congressional Research Service The Library of Congress
of a full tax exemption for income U.S. firms could attribute to operations in the
possessions. To qualify for the credit, a corporation was required to earn at least 80% of
its income in a possession and at least 75% of its income was required to be from the
active conduct of a trade or business in the possessions.
Most firms that used the possessions tax credit did so by establishing subsidiary
corporations that met the section 936 requirements; it was the qualifying subsidiaries
(called possessions corporations) that earned tax-favored possessions-source income.
Further, since the possessions corporations were U.S.-chartered corporations, their
mainland parents could generally qualify for the dividends-received deduction the tax code
provides for payments between related U.S. corporations. This removed the possibility
that taxes might apply when the exempt possessions income was remitted to the mainland
parent corporations as intra-firm dividends.
While the tax credit is scheduled to expire in 2006, it should be noted that even
without the tax credit full federal taxation would not necessarily apply to U.S. firms in
Puerto Rico. Corporations chartered in the possessions are considered “foreign”
corporations, for tax purposes, and so can use an alternative tax benefit known as
“deferral” that is available for the operations of U.S. firms in foreign countries. Under
deferral, U.S. firms can postpone U.S. tax on foreign income as long as the foreign income
is reinvested abroad. Still, the possessions tax credit (and the current EAC) is a permanent
exemption, while for some firms, deferral is only temporary. In addition (notwithstanding
restrictions imposed in 1982 and 1986), relatively generous income-allocation rules apply
under the possessions tax credit that potentially make it easier for firms to shift income
from various sources to the possessions, where the income is protected from taxation by
the tax credit.
Legislation, 1976–1993: Issues of Targeting and Revenue Cost
Legislation aimed at limiting the benefit’s revenue cost and targeting it more tightly
to the possessions began with the Tax Reform Act of 1976 (P.L. 94-455), which restricted
the tax exemption to income earned in the possessions themselves.2 Prior to the Act, as
long as a corporation qualified as a possessions corporation, all its income–from the
possessions and other sources alike–was exempt from tax. Legislation with the same cost
and targeting concerns was again considered in 1982, but now focused on income shifting.
The possessions tax credit was heavily used by firms that invest intensively in intangible
assets – the credit’s use by pharmaceutical firms and electronics companies, for example,
was especially high. Prior to 1982, there were concerns that firms were using transfers of
intangibles at unrealistic prices to shift large amounts of what was really mainland-source
income to possessions subsidiaries that qualified for the exemption and that could shelter
the mainland income from tax. In response to these concerns, the Tax Equity and Fiscal
Responsibility Act of 1982 (TEFRA; P.L. 97-248) provided a set of rules governing the
allocation of income from intangibles in the case of possessions corporations and their
2 For a history of the possessions tax credit to 1985, see: U.S. Congress. Congressional Research
Service. Puerto Rico and Federal Taxes under Section 936: History and Proposed Changes.
Report No. 85-196 E, by David L. Brumbaugh. Washington, 1985. 37 p. Copies can be obtained
by contacting the author at CRS.
Proposals for change continued after TEFRA. With its 1985 proposals for broad tax
reform, the Reagan Administration pointed out that the possessions tax credit provided no
direct incentive for firms to boost their employment in the possessions. (Indeed, since the
corporate income tax is a tax on the return to capital, an exemption is an incentive to
employ capital, not labor.) The Reagan Administration proposed replacing the possessions
tax credit with a tax credit equal to a specified portion of a firm’s wages paid in the
possessions.3 However, Congress did not include the Administration’s proposals for
section 936 reform when it passed the landmark Tax Reform Act of 1986 (TRA86; P.L.
shifting to possessions corporations.
A modified version of the wage credit proposal was ultimately adopted in 1993 with
the Omnibus Budget Reconciliation Act (OBRA93; P.L. 103-66). The measure was
initially proposed by the Clinton Administration, which stated that a disproportionate share
of the provision’s benefit was realized by intangible-intensive industries “that create
relatively few jobs in the possessions” and that “while section 936 has created employment
in Puerto Rico, the number of jobs created is too small in relation to the tax expenditure.”4
OBRA93’s provisions remain essentially intact under current law (subject to new
phase-out rules), so they are worth describing in some detail. The new law altered section
936 by imposing a cap on the existing full tax exemption. A firm calculated its possessions
tax credit as under prior law, but the maximum credit it could claim was limited by the cap.
The cap was equal to one of two alternative limitations; which applied was up to the
taxpayer. Under the first – known as the “percentage limitation” – a firm’s possessions
tax credit was equal to a specified percentage of the credit the firm could have claimed
under prior law; after a phase-in period, the percentage was set at 40%.
Under the second alternative – known as the “economic-activity” limitation–a firm’s
maximum credit was limited to an amount equal to the sum of three factors. One factor
was 60% of a possessions corporations’ wages paid in the possessions; qualified wages,
however, were limited for each employee to 85% of the amount subject to Social Security
taxes. The second factor was a specified percentage of the possessions corporation’s
depreciation deductions for the taxable year. The applicable percentage depended on the
type of property: 15% for property with a relatively short recovery period; 40% for
property with a medium-length recovery period; and 65% for long-lived property.5 For
firms whose tax credit was constrained by the limitations, the caps functioned in a manner
similar to a wage credit and a credit for investment. For example, a firm subject to the
constraint could reduce its tax bill by 60 cents for each additional dollar spent on wages.6
3 U.S. President (Reagan). The President’s Tax Proposals to the Congress for Fairness, Growth,
and Simplicity. Washington, 1985. P. 309.
4 U.S. Department of the Treasury. Summary of the Administration’s Revenue Proposals.
Washington, 1993. P. 51.
5 Short-life recovery property is property having a 3- or 5-year recovery period; medium-life
recovery property is 7- or 10-year property; long-life property is that with a recovery period
exceeding 10 years.
6 For additional analysis of the credit as enacted, see: U.S. Library of Congress. Congressional
The Small Business Job Creation Act of 1996
Congress continued to focus on the possessions tax credit after OBRA93. In
November, 1995, Congress passed the Balanced Budget Act (H.R. 2491), and included
a provision phasing out the credit over 10 years. President Clinton vetoed the bill, and the
tax credit’s phaseout was one provision the Administration singled out for criticism. The
President proposed to instead restrict the credit’s calculation to OBRA93’s economic
activity limitation that links the benefit with wages and tangible possessions investment.
The Administration viewed its proposal as a further movement in the direction begun in
Instead, in 1996 Congress passed – and the President signed – the Small Business Job
Protection Act (P.L. 104-188), which contained among its various tax provisions the
essential elements of the 1995 phase-out proposal. Under its terms the credit is phased out
over a 10-year period, and is scheduled for repeal beginning in 2006. In providing for the
phaseout and repeal, Congress cited reasons of fairness and revenue concerns, stating that
understood that the tax benefits provided by the Puerto Rico and possession tax credit
are enjoyed by only the relatively small number of U.S. corporations that operate in the
possessions. Moreover, the Congress was concerned about the tax cost of the benefits7
provided to these possession corporations that is borne by all U.S. taxpayers.
The repeal of the tax credit was effective immediately for firms not already using the
benefit. For other firms (“existing claimants,” in the Act’s language), the credit’s phase-
out rules depended on whether they use the economic activity limitation or the alternative
40% exemption. For economic activity firms, the amount of the credit is determined as
under OBRA93 through 2001. Beginning in 2002, the credit for these firms is subject to
an additional cap. The cap restricts income eligible for the credit to the firm’s average
profits during a base period prior to 1996, increased for inflation and a proxy for economic
growth. For firms using OBRA93’s alternative 40% exemption, the 1996 Act applied the
base-period income cap beginning in 1999. (Firms were permitted to change the particular
limitation they had chosen under OBRA93’s rules.)
While the repeal of the credit applies to all possessions, existing claimants in
possessions other than Puerto Rico and the U.S. Virgin Islands (i.e., Guam, American
Samoa, and the Northern Marianas) were exempted from the base-period cap. In addition,
for firms in Puerto Rico using the economic activities limitation, the 1996 Act moved the
credit’s authorizing provisions to new section 30A of the Internal Revenue Code and
renamed the credit the Puerto Rican economic activities credit.
Research Service. The Possessions Tax Credit: Economic Analysis of the 1993 Revisions. CRS
Report No. 94-650 E, by David L. Brumbaugh. Washington, 1994. 18 p.
7 U.S. Congress. Joint Committee on Taxation. General Explanation of Tax Legislation Enacted
in the 104th Congress. Joint Committee Print, 104th Cong., 2d Sess. Washington, U.S. Govt.
Print. Off. 1996. P. 207-13.
To recap, in 2000 the state of the phaseout in Puerto Rico is this: only existing
claimants can now claim the tax credit. For firms who have elected OBRA93’s 40%
exemption, the credit is now restricted by an added limitation linked to base-period
earnings. Firms using the EAC are not currently subject to the base-period cap, but will
be, beginning in 2002. The credit will expire completely on January 1, 2006.
Current Proposals and Issues
In each of the four budgets the Clinton Administration has submitted since 1996, it
has proposed extending a modified version of the Puerto Rican tax credit. The
Administration stated that the proposals’ purpose is to provide a “more efficient and
effective tax incentive for the economic development of Puerto Rico and to continue the
shift from an income-based credit to an economic-activity credit that was begun in
OBRA93.”8 The first three of the proposals would have disallowed the optional 40%
exemption, but extended the EAC indefinitely. The proposals also would have allowed
new claimants to use the credit, and would have repealed the base-period earnings
limitation that is scheduled to begin in 2002. The most recent Administration budget
proposal (for FY2001) would remove the “existing claimant” restriction on the credit, and
would extend the EAC version of the credit. In contrast to the preceding budgets,
however, the present proposal would extend the credit only through 2008.9
Two bills to extend the EAC have been proposed in Congress. Like the
Administration’s latest proposal, S. 212 (Sen. Moynihan) would extend the credit through
2008, but would restrict its use to firms using the EAC version of the credit. The bill
would relax but not eliminate the existing claimant rules and would repeal the base-period
cap. H.R. 2138 (Rep. Crane) would also restrict the credit to the EAC and would repeal
the base-period cap. In contrast to the Senate bill, however, H.R. 2138 would replace the
extension through 2008 with a flexible extension. Under its provisions, the credit would
be extended indefinitely, but only if certain economic indicators for the possession are not
exceeded. (Stated differently, if a possession’s economy meets certain performance
standards, the credit would expire.) If a possession’s unemployment for a particular year
does not exceed 150% of mainland unemployment; the possession’s per capita income is
at least 60% of that of the mainland; and the possession’s poverty level does not exceed
30%, the tax credit for that possession would be repealed in the fourth year following the
year in which the performance indicators are met.
In addition to these two bills, Chairman Roth of the Senate Finance Committee
included a proposal to liberalize the credit’s phase-out rules in his “chairman’s mark” of
the Community Renewal and New Markets Act. While the proposal would not extend the
ability of firms to earn the credit beyond 2005, it would liberalize the “existing claimant”
rules, remove the base-period limitation, and increase the economic activity limitation for
firms that increase their employment.
8 Office of Management and Budget. Budget of the United States Government. Fiscal Year 1998.
Analytical Perspectives. Washington, U.S. Govt. Print. Off. 1997. P. 48.
9 The budget does not explicitly mention the base-period limitation, while the previous budgets’
proposals stated that the limit would be removed. We thus assume the limitation would remain
under the current proposal. It is not clear, however, how the limit would apply to new claimants.
As noted above, the purpose of the Puerto Rico tax credit is to stimulate
employment-generating investment in Puerto Rico. For policy purposes, a crucial
economic question is therefore: what is the effect of the tax credit and its modifications
on employment in Puerto Rico? What will be the impact of its repeal?
Employment and compensation by firms that use the tax credit are an important part
of Puerto Rico’s manufacturing sector, and the manufacturing sector, in turn, is an
important part of Puerto Rico’s economy.10 Thus, any impact that may result or has
resulted from the 1993 redesign of the credit could potentially be important for Puerto
Rico’s economy. Likewise, the impact of the provision’s scheduled repeal is potentially
important. The most recent rigorous study of the tax credit was published by Grubert and
Slemrod in 1998, and assessed the effect of the provision in its pre-1993 form. It found
that the ability of firms to use the credit to shelter non-possessions income from tax is “the
predominant reason for U.S. investment in Puerto Rico,” and that without the ability to
shift taxable income to Puerto Rico, the operating capital and payroll of U.S. firms in
Puerto Rico would be more than two-thirds lower.11 But this result does not rule out the
possibility that linking the tax benefit more directly with tangible investment and
employment (as with OBRA93) will or already has produced a larger impact on U.S.
firms’ employment in Puerto Rico than did prior law’s version of the credit. Indeed, an
earlier study by the same authors found that adoption of a wage credit would increase U.S.12
firms’ Puerto Rican payroll substantially.
Presumably, evidence of any large effect by OBRA93’s changes could be visible by
now. We can note that Puerto Rico’s economy has registered real growth of between13
however, a thorough analysis of the evidence is beyond the scope of this report.
10 Based on 1995 data, the U.S. Internal Revenue Service (IRS) estimated that manufacturing firms
using the credit employed 113,444 workers and paid $2,703,933 thousand in employee
compensation. (U.S. Internal Revenue Service. Statistics of Income Bulletin. V. 19. Summer,
1999. P. 184.) For the same year, the Puerto Rico Planning Board reported employment of
172,000 persons in the entire manufacturing sector and total employee compensation in
manufacturing of $3,561,800 thousand. (Puerto Rico Planning Board. Economic Report of the
Governor, 1998. San Juan, 1999. P. A-38; A-12. The IRS figures are 66% of the Planning
Board’s total for employment and 76% for compensation. While the two data sets are not
necessarily strictly compatible, they support the general point that tax-favored firms from the
mainland make up a substantial part of employment and compensation in Puerto Rico’s
11 Grubert, Harry, and Joel Slemrod. The Effect of Taxes on Investment and Income Shifting to
Puerto Rico. Review of Economics and Statistics. V. 80. August, 1998. P. 365.
12 Cited in Ibid., p. 372.
13 Posted by the Government Development Bank of Puerto Rico on its web site at [http://www.gdb-