Ten years ago, private equity funds and hedge funds were practically nonexistent in Puerto Rico. This has changed dramatically as the result of two main developments: the enactment of Act 185-2014, known as the Private Equity Funds Act and (ii) the influx of financial industry professionals moving to the island to take advantage of the tax benefits available under Acts 20 and 22 (for a more detailed discussion of those benefits, please see Puerto Rico's Act 20 and Act 22 – key tax benefits1).
The Act grants special Puerto Rico tax treatment to qualifying funds that meet certain requirements, as well as to their investors. The core requirement is that qualifying funds be engaged in the business of buying and selling securities which are not offered at public securities exchange markets in the United States or any foreign country.
Qualifying funds and requirements
There are two types of qualifying funds: Private Equity Funds (PEF) and Puerto Rico Private Equity Funds (PRPEF). Each must:
- have an office located in Puerto Rico
- invest at least 80 percent of its paid-in capital (excluding cash and cash equivalents) in securities issued by entities that at the time of acquisition are not offered at public securities markets in the United States or any foreign country
- invest its remaining paid-in capital in certain short-term securities and obligations of the government of the United States or Puerto Rico, short-term repurchase agreements with certain specified institutions and collateral, FDIC-insured CDs, checking and deposit accounts and certain other specified investments
- only admit accredited investors2
- use an investment adviser with a business office in Puerto Rico, engaged in trade or business in Puerto Rico and duly registered with the relevant authorities
- operate as a diversified investment fund, which means that no later than four years from the date of its organization no more than 20 percent of a qualifying fund's capital may be invested in a single business (disregarding fluctuations in the value of such investments)
- have a minimum capital of $10 million no later than 24 months after the first issuance of its partnership or membership interests and each year thereafter and
- appoint at least one of its investors or limited partners to an advisory board where matters of interest and concerns regarding the fund are discussed and evaluated.
In addition, all qualifying funds are required to, no later than four years after organization, maintain a minimum of 15 percent of paid-in capital (excluding cash and cash equivalents) invested in securities that at the time of acquisition are not offered at public securities exchange markets in the United States or any foreign country and which have been issued by companies engaged, directly or indirectly, in an active trade or business and organized under Puerto Rican law, or entities which derive at least 80 percent of their gross income from sources within Puerto Rico or are effectively connected to Puerto Rico.
On the other hand, a qualifying fund that is a PRPEF is required to, no later than four years after organization, maintain a minimum of 60 percent of paid-in capital (excluding cash and cash equivalents) invested in securities that at the time of acquisition are not offered at public securities exchange markets in the United States or any foreign country and which have been issued by entities that derive at least 80 percent of their gross income from sources within Puerto Rico or effectively connected to Puerto Rico.
Finally, to qualify as a qualifying fund, the entity must file an election with the Puerto Rico Secretary of the Treasury within 90 days of its creation.
Puerto Rico tax treatment of qualifying funds
Qualifying funds are treated as partnerships for Puerto Rico income tax purposes and, therefore, are not subject to any Puerto Rico income tax. In addition, income derived by qualifying funds as well as any distributions made by qualifying funds will not be subject to municipal license tax. All property owned by a qualifying fund is exempt from property tax.
Puerto Rico income tax treatment of investors
One of the most attractive features of the Act is that resident investors3 that invest in a PEF are entitled to deduct from taxable income up to a maximum of 30 percent of their "initial investment" within a maximum period of 10 years, provided that the maximum deduction does not exceed 15 percent of their net income prior to such deduction.
Resident investors that invest in a PRPEF are entitled to deduct up to a maximum of 60 percent of their "initial investment" within a maximum period of 15 years ‐ provided that the maximum deduction does not exceed 30 percent of their net income prior to such deduction. An additional interesting feature of these rules is that the 30 percent or 60 percent deduction (as the case may be) may be claimed for the taxable year that precedes the taxable year in which the "initial investment" is made if it is made prior to the due date for filing the tax return for such prior taxable year.
In terms of the tax treatment to an investor of the income derived by a qualifying fund, the general rule is that an investor's share of income derived by a qualifying fund from interest and dividends is subject to an income tax of 10 percent. However, the distributive share of Investors that are registered (or exempt) investment advisers, private equity firms or general partners in interest and dividends derived by a qualifying fund will be subject to income tax at the rate of 5 percent. In addition, an Investor's distributive share of capital gains realized by the qualifying fund is exempt from Puerto Rico income tax. In contrast, an investor's distributive share of any type of income derived by a qualifying fund that does not consist of interest, dividends or capital gains is subject to the normal Puerto Rico income tax rules and rates.
The general rule is that capital gains realized by an investor upon the sale of shares in a qualifying fund are subject to income tax at a rate of 5 percent. However, if the investor is a registered (or exempt) investment adviser of the qualifying fund, a general partner of the qualifying fund or a private equity firm, then the gain will be subject to an income tax at a rate of 2.5 percent. As an exception, capital gains realized by investors upon the sale of shares in a qualifying fund will not be subject to the 5 percent or 2.5 percent tax (as the case may be) if the gross proceeds from the sale are reinvested in a PRPEF within 90 days from the date of sale, in which case the capital gains will not be subject to income tax.
A very important point to note is that, notwithstanding the reduced Puerto Rico tax rates provided by the Act, the distributive share of an investor holding an Act 22-2012 decree in interest, dividends and capital gains derived by a qualifying fund should be exempt from Puerto Rico income tax.
The distributive share of net capital losses incurred by a qualifying fund may be taken as a deduction by resident investors, to the extent that such losses are incurred in connection with an entity which derives 80 percent of its income for the prior three years from Puerto Rico or from income effectively connected to Puerto Rico. Such losses can only be used to offset income from other qualifying funds or to reduce capital gains from other sources and can be carried over indefinitely. These rules also apply to investors that are registered (or exempt) investment advisers, private equity firms or general partners.
Sponsors and Investors in private equity funds should consider examining the interplay between these provisions and US income tax provisions (and in certain cases the income tax provisions of other jurisdictions). The optimal tax structure will vary depending on numerous factors, including (i) the tax residence of the investment manager, the General Partner, the owners of the investment manager and General Partner, the fund, and the investors in the fund and (ii) the types of investments made by the fund and the location of the issuers of such investments. Prudence suggests examining these complex tax issues on a case-by case basis with a sophisticated tax practitioner.
The benefits available under Act 185 are not available for funds that invest in publicly traded securities and other assets (colloquially known as hedge funds). However, hedge fund managers that establish residence in Puerto Rico may still obtain beneficial tax treatment with respect to their advisory fee, performance allocation or carried interest under Acts 20 and 22. Again, the interplay between the Puerto Rico and US tax regimes needs to be analyzed and understood: improper structures may encounter several potential pitfalls, especially as a result of the US tax reform enacted into law in December 2017. Regulatory considerations also need to be considered and addressed.
Nikos Buxeda is the managing partner of DLA Piper’s San Juan office. Nikos primarily advises clients on corporate and securities law transactions, including M&A, private placements, project finance, public-private partnerships and spin-offs. He also has experience advising clients on the organization of Puerto Rico mutual funds and private equity funds, distribution contracts, debt issuances and loan financing. Nikos is ranked as a Leading Individual in the Corporate Commercial Field by Chambers & Partners in both its Global and Latin American Guides, as a Leading Individual by the IFLR 1000, and as a Best Lawyer by US News & World Report.
Manuel López-Zambrana ("Nolin") is a tax partner in DLA Piper’s San Juan office. Nolin represents clients in a variety of industries such as financial, mutual funds, manufacturing, not for-profit, insurance airline transportation, maritime transportation and telecommunications industries. Nolin's expertise is highly sought after in all stages of tax controversies. He is considered by Chambers and Partners as a "standout tax practitioner who receives glowing recommendations from sources as one of the leading lawyers in the field." Nolin has also served as advisor to the Puerto Rico Department of the Treasury and to the Government Development Bank for Puerto Rico.
Camille Alvarez is an associate in DLA Piper’s San Juan office. Camille focuses her practice on corporate and tax law matters, with an emphasis on designing tax-efficient strategies tailored to take advantage of available tax incentives, negotiating and obtaining tax incentive grants for individuals and corporations, and making elections for special treatment under local and federal tax laws. She also advises clients on corporate transactional matters and has ample experience in Puerto Rico corporate governance, mergers and acquisitions, healthcare laws and securities regulations.
Juan Carlos Feliciano has over ten years of experience in providing tax services. He provides inbound and outbound US federal and PR income tax advice to local and multinational clients in financial services (banking, private equity and hedge funds), renewable energy, IT, manufacturing, and tourism industries. Juan works closely with clients in developing tax-efficient structuring strategies, and assists them with obtaining PR tax incentives. Juan is admitted to practice law in the Commonwealth of Puerto Rico and earned an Executive LL.M. in Taxation (International Tax) from the Georgetown University Law Center. He is also a CPA in Puerto Rico.
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2 The definition of "accredited investor" in the Act is similar to, but not the same as, the definition of that term in the Securities Act of 1933, as amended
3 A "resident investor" means an individual resident of Puerto Rico, a US citizen who does not reside in Puerto Rico, an entity organized outside Puerto Rico if all its shareholders are residents of Puerto Rico and an entity organized under the laws of Puerto Rico