Puerto Rico’s Value Added Tax (VAT) Explained
Update June 1, 2016: The the elimination of VAT was recently approved by the Legislative Assembly of Puerto Rico with immediate effect
Although the Sales and Use Tax (SUT) remains in effect at a rate of 10.5% for the state and 1% for municipalities, there will no longer be any transition to a VAT collection structure. In addition, B2B transactions will continue to be taxed at 4% for applicable services rendered to other businesses. All businesses required to file the Monthly Return Sales and Use Tax should continue filing the same through the Integrated Merchant Portal ( "PICO") traders.
Puerto Rico's new Value Added Tax (VAT, IVU in Spanish) system is in effect as of 1 June 2016. The VAT was introduced as part of recent legislative reforms designed to invigorate the Puerto Rican economy and plug budget deficit gaps.
Background to Puerto Rico's VAT
On the basis of Puerto Rico House Bill 2482 (Act 72), signed into law on 29 May 2015, Puerto Rican legislators have introduced the new VAT in two transitory phases:
- Increased the pre-existing Central Government Sales and Use Tax (SUT) from 6% to 10.5%, effective from 1 July 2015 - 31 March 2015,
- Applied a special, interim 4% SUT to the provision of B2B services and designated professional services (DPS) in regulated sectors like law, medicine, and architecture, between 1 October 2015 - 31 March 2016 May 2016,
- Replaces both the SUT and special B2B/DPS SUT with the current 10.5% VAT on 1 June 2016.
Note that a 1% Municipal SUT has remained unchanged throughout the transition process, leaving a combined VAT / SUT topline rate of 11.5% on relevant transactions.
Background to the VAT Concept
Tax regulators have embraced the VAT concept all around the world with the United States as a notable exception, so far. While limited variations of a VAT have appeared in Michigan and Hawaii, Puerto Rico's VAT is the first of its kind anywhere in the US or its territories.
For sheer tax revenue generation power, a VAT is difficult to beat. A VAT is like an economy-wide sales tax that is refundable to everyone except end customers. In other words, sellers (whether to other businesses or end consumers) pay the tax but eventually receive reimbursement (technically, "input recovery"). Consumers at the end of the chain are left with the final bill. For example, under a VAT system, even a relatively simple transaction like buying chewing gum will have a series of taxable "touch points" behind it from the manufacturer, wholesaler, and retailer, all who can claim input recovery, before reaching the customer, who can't. Compare with a US-style sales tax which generally does not apply to services and has only one taxable "touch point" when an end consumer buys a product.
Regulators prefer the VAT method because it improves transparency. For example, if the chewing gum manufacturer and wholesaler both pay the tax and request a credit and the retailer does not, it sends a red flag to regulators that the retailer may not be paying taxes collected from the consumer.
Key Rules of Puerto Rico's VAT System
Here is a short list of the 5 key rules governing Puerto Rico's VAT system. Many of the rules are conceptually similar to those of VAT systems in other countries, but in some cases there are details specific to Puerto Rico.
General rule 1: Local sales are subject to VAT.
A sale of a good is considered local when the good and the buyer are in Puerto Rico at the time of sale. A sale of a service will be local when the service recipient is in Puerto Rico at the time of the sale.
General rule 2: Imports generally are subject to VAT, exports generally are not.
A service exported from Puerto Rico will not generally be VAT-able, but a service imported to Puerto Rico will generally be VAT-able. Likewise, a product imported to Puerto Rico will be VAT-able, but a product exported from Puerto Rico will not. In these situations, local importers are responsible for making VAT payments to the authorities, as would sellers if the transaction had been local (as described in the next general rule).
General rule 3. Local sellers are responsible for collecting VAT payments from buyers.
Acting as “withholding agents,” local sellers, or "merchants" under Puerto Rico's VAT law, collect and remit the VAT to the authorities. Sellers can be reimbursed from the authorities, i.e. "claim input recovery." Merchants that use VAT need to record VAT amounts paid and to claim input recovery.
To claim input recovery, seller merchants should generally:
a) keep records of the VAT they pay to other merchants and
b) subtract that VAT amount (paid to other merchants) from the VAT amount to be remitted to the authorities (on behalf of buyers).
In a situation where a merchant builds up a sizable amount of VAT from buyers that is not able to be offset by outgoing VAT payments, that merchant can apply directly to the authorities for input recovery. This option is available only to merchants with an "Eligible Merchant's Certificate."
General rule 4: Small sellers have relaxed VAT collection requirements.
Puerto Rican merchants who qualify for a "Small Merchant's Registration Certificate," thanks to having an annual turnover of less than $75,000, do not need to collect VAT from their buyers. These merchants, however, may not claim VAT input recovery on the VAT they pay to other merchants.
General rule 5: Some goods and services get special treatment.
Mainly as a result of political decisions, some goods and services fall into "0%," "exempt," or "excluded" VAT categories. For end consumers, there is no real difference between the zero-rated, exempt, or excluded VAT categories because, simply, they don't pay VAT anyway. Merchants, however, can claim input recovery after a 0% VAT sale, but not after an exempt sale. And an excluded sale exists outside the scope of the VAT is not reportable at all for VAT purposes.
Notable examples of goods and services excluded from Puerto Rico's VAT are:
- financial securities,
- intangibles except for computer programs,
- water from the Puerto Rico Aqueduct and Sewer Authority,
- services provided by affiliated entities
- services by an employee
- services by small merchants (as outlined above) or non-merchants
Notable exemptions from Puerto Rico's VAT are the sale and/or import of:
- a variety of health related products including prescription medicines and medical equipment,
- products to / by a hospital, farmer, or tourism businesses with a “Certificate for Exempt Purchases”
- food and food ingredients,
- financial services (except those that cause bank charges),
- commercial leases (e.g. for office space),
- items imported as part of a move, and
- real estate. Real estate leases for one's primary residence are also exempt.
Notable zero-rated supplies are:
- sales of goods for export
- exported services
- imports and sales of raw materials to be used by a manufacturing plant with an “Eligible Manufacturing Plant” certificate,
The Puerto Rico VAT and New Residents
As outlined above, sellers are responsible for collecting the VAT, and end consumers are responsible for paying it. The tax looks similar, therefore, to a US-style sales tax. Newcomers to Puerto Rico from the US are unlikely to notice much of a systematic difference between Puerto Rico's VAT and a US-style sales tax. The combined Puerto Rico VAT / SUT rate of 11.5%, however, is higher than any sales tax in the US. (Tennessee's sales tax comes in second at 9.45%.)
Despite the high combined VAT / SUT rate in Puero Rico, many “key” products that new residents are likely to consider essential, such as food, real estate (both sales and rentals), and cars, are exempt from the VAT. New Puerto Rico residents hailing from the US, however, may notice higher taxes on services in Puerto Rico, as services in the US are generally not subject to a sales tax.
New residents who run “local” businesses (i.e. selling goods and services to other Puerto Rican residents) with annual turnovers of more than $75,000 will be responsible for VAT compliance, including collecting VAT payments from buyers, remitting them to the authorities, and filing VAT returns every month.
Puerto Rico's VAT and Act 22
Puerto Rico Act 22, also known as the “Individual Investors Act,” provides full exemptions on interest, dividends, and certain capital gains to bona fide residents of Puerto Rico. See a full description here.
Puerto Rico's new VAT system exempts the sale of securities and financial services, including those provided by investment companies (a.k.a mutual fund companies). Therefore the core benefits to an investor under Act 22 should remain largely unaffected by the new VAT.
On the other hand, investment management services, from an investment advisor in the U.S. for example, rendered directly to a resident of Puerto Rico, as opposed to a mutual fund in the U.S. for example, may trigger Puerto Rico VAT payable by the Puerto Rico resident. Professional advice is recommended.
Puerto Rico's VAT and Act 20
Puerto Rico Act 20, also known as the “Export Services Act,” provides incentives for duly certified Puerto Rican businesses that export services to non-residents.
While services exported by any Puerto Rico merchant are zero-rated for VAT purposes, Puerto Rico Act 159, which is a “follow-up” to the original Act 172 laying out the legal framework for the VAT, highlights that services exported by Puerto Rican businesses certified under Act 20 are zero-rated.
Additionally, Act 159 allows a VAT exclusion for services imported by an Act 20 company in Puerto Rico from a member of the same controlled group of companies, i.e. a “sister company” or “mother company,” located outside of Puerto Rico.
Therefore, a Puerto Rican Act 20 company that is exporting services will remain largely unaffected by the new VAT system. The Act 20 company will also be unaffected by services flowing in the other direction, from abroad, provided that they are from a related entity. Importing goods and services to the Act 20 company from an unrelated entity, however, will trigger a VAT payment obligation.
It’s important to note that importing goods and services used toward your company’s export services may be exempt but you will still need to file monthly in order to receive credits.
The New VAT is Largely Neutral Towards New Residents....
In summary, residents of Puerto Rico, including new residents taking advantage of the Puerto Rico incentive programs under Acts 20 and 22, will generally face higher tax bills for local goods and services thanks to the new VAT system. New residents, especially those from US states with low or no sales tax, may take note.
On the other hand, several items that most Act 20 or 22 beneficiaries would consider essential early in their settling-in period, such as real estate (both sales and rentals), cars, food, and items imported as part of their move, are exempt from the new VAT. Therefore, it is unlikely that new residents will face initial “sticker shock” thanks to the new VAT. More likely will be some form of “sticker curiosity” over the longer term as to price differences – not necessarily due only to the VAT - between local goods and services and those back home.
… But Pay Attention to Imported Services
By design, the new Puerto Rican VAT system coexists in harmony with the system of tax incentives granted by Puerto Rico Acts 20 and 22, and new residents taking advantage of them can generally expect not to face VAT payment responsibilities in most circumstances, apart from day-to-day shopping.
In a limited set of instances involving imported services to residents, including investors under Act 20 and companies under Act 20, VAT may be payable. Professional advice is recommended.
Do you want to find out more information about how the VAT tax applies to your business? Consult with a tax incentive expert to find out more.