What Was the Section 936 Possessions Tax Credit?
Understand the former U.S. tax law that shaped corporate investment in its possessions and the policy shift that occurred following its repeal.
Section 936 of the Internal Revenue Code, the Possessions Tax Credit, was a tax provision for U.S. corporations operating in designated U.S. possessions. It offered a credit that could substantially reduce or eliminate U.S. federal income tax on income from business activities and certain investments within these territories, with Puerto Rico being the most prominent location. This tax incentive was designed to encourage investment and create employment in the possessions. The provision was officially repealed and is no longer part of the U.S. tax system.
Eligibility for the Possessions Tax Credit
To benefit from the Possessions Tax Credit, a U.S. corporation had to elect to be treated as a “possessions corporation” by filing Form 5712. This election required the company to satisfy two gross income tests over a three-year look-back period.
The first was the source-of-income test. This mandated that at least 80% of the corporation’s gross income for the three-year period had to be derived from sources within a U.S. possession, linking the tax benefit to income generated in the territories.
The second was the active-business-income test, which required that at least 75% of the corporation’s gross income for the same period be from the active conduct of a trade or business within a U.S. possession. This prevented passive investment vehicles from qualifying and targeted the credit toward companies with tangible business operations. For the purposes of this law, U.S. possessions included Puerto Rico, Guam, American Samoa, and the U.S. Virgin Islands.
Methods for Calculating the Credit
The default calculation for the Section 936 credit allowed a credit equal to the portion of its U.S. tax liability attributable to its non-U.S. source taxable income. This income primarily consisted of active business income from the possessions and qualified possession source investment income (QPSII). This could completely offset the federal tax on profits earned in the possession.
Alternatively, a possessions corporation could elect one of two limitation methods. The Economic Activity Limitation tied the credit to specific economic contributions within the possession. This method calculated the credit based on the sum of 60% of qualified compensation, a percentage of depreciation deductions for qualified tangible property, and a portion of the possession income taxes it paid.
The second option was the Percentage Limitation. This method allowed a corporation to take a credit equal to a fixed percentage of the credit that would otherwise be allowed under the default rules. The applicable percentage was reduced over the years as part of legislative changes. A corporation’s choice between these methods depended on its specific operational structure, such as whether it was capital-intensive or labor-intensive.
Repeal and Phase Out Period
The Small Business Job Protection Act of 1996 initiated the end of the Possessions Tax Credit, driven by concerns about its cost and effectiveness. Critics argued the tax expenditure, amounting to billions in forgone revenue, disproportionately benefited capital-intensive industries, like pharmaceuticals and electronics, without creating a corresponding number of jobs, becoming an inefficient subsidy.
Instead of an immediate elimination, the 1996 law established a 10-year phase-out period for existing credit claimants. This allowed companies to continue claiming the credit with increasing restrictions through taxable years beginning before January 1, 2006. During this transition, the income eligible for the credit was generally capped based on a company’s historical income levels.
The phase-out provided a gradual transition for corporations and the economy of Puerto Rico, which had become reliant on these investments. For any new business activity, the credit was unavailable after 1995. The Section 936 credit was fully repealed after December 31, 2005.
The Subsequent Tax Framework for US Possessions
With the repeal of Section 936, the tax treatment of U.S. subsidiaries in Puerto Rico changed. These entities, which had enjoyed near tax-exempt status on their earnings, were now generally treated as Controlled Foreign Corporations (CFCs). This change brought them under the broader U.S. international tax system, making their income potentially subject to U.S. tax under anti-deferral regimes like Subpart F and the Global Intangible Low-Taxed Income (GILTI) rules.
During the phase-out, a temporary, less generous credit under Section 30A was available. This provision offered a wage-based economic activity credit, but it did not survive as a long-term replacement. The end of the federal incentive prompted the government of Puerto Rico to create its own tax incentives to remain attractive for investment.
To counteract the loss of Section 936, Puerto Rico enacted local tax laws that culminated in Act 60, the Puerto Rico Incentives Code. This legislation offers low-to-zero percent tax rates on certain types of income for businesses that export services from the island and for new residents, representing a shift from a U.S. federal subsidy to a local tax-based development strategy.