Update for law firms with clients in Puerto Rico

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Puerto Rico: How changes in sourcing rules impact foreign law firms

At the end of 2018, the Governor of Puerto Rico signed into law House Bill 1544 as Act 257-2018 (Act 257). Act 257 amends numerous provisions of the Puerto Rico Internal Revenue Code of 2011 (PRIRC), including reducing the corporate and individual income tax rates, changing certain sourcing rules and amending the information reporting requirements. Key provisions of Act 257 are expected to impact US law firms serving the government of Puerto Rico as their client.

Puerto Rico sourcing rules impact

Sourcing rules for providing services to the Puerto Rico Government: Impact on US Law Firms

Payments made on or after December 10, 2018, for services rendered to the Puerto Rico (PR) Government are considered PR-source income to the extent that the payments made out to the law firm are made with funds from the PR Government’s General Fund, whether or not such legal services were physically provided in Puerto Rico.

Observations: 

  • Nonresident individuals and foreign corporations or partnerships not engaged in a trade or business in Puerto Rico that provide services to the PR Government within or without Puerto Rico will be subject to a 29% withholding tax on the gross fees.
  • Nonresident individuals and foreign law firms engaged in a trade or business in Puerto Rico where part of the legal services provided to the PR Government are rendered outside Puerto Rico will be subject to PR taxation on 100% of the fees associated with the project. This tax must be satisfied through estimated tax payments.
  • Nonresident individuals and foreign corporations or partnerships that take the position that they are not engaged in trade or business in Puerto Rico may have to evaluate whether the activities they carry out in Puerto Rico give rise to a trade or business so they can file a PR income tax return and claim expenses associated to earning such PR source income.
  • Firms should consider the impact that both positions have on their general limitations and branch foreign tax credit baskets.

Foreign tax credit considerations

This change in the PR-sourcing rules presents a challenge at the US federal level with respect to foreign tax credits that a US taxpayer might claim on a US federal income tax return.

Services performed within the United States will not be considered foreign source income in the taxpayer’s foreign tax credit limitation formula. As such, there is inherent tension for the utilization of credits on taxes owed to Puerto Rico for these services taxable under the new market based sourcing rules.

On the other hand, to the extent the firm takes a position that it's not engaged in a trade or business in Puerto Rico and thus it's not a branch of the US firm, these credits would accrue to the firm’s general limitation basket rather than the foreign branch basket. If the taxpayer has excess general limitation foreign source income, these credits might be absorbed—despite the sourcing differences that exist between the US and Puerto Rico rules.

Firms should consider modeling to determine whether it may be possible for their partners to realize a tax benefit, depending upon whether they take the position that the firm is or is not engaged in a trade or business in Puerto Rico.

Contact us

Carole Symonds

Partner, Law Firm Services Tax Leader, PwC US

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