What Was the Section 936 Tax Credit in Puerto Rico?

Section 936 of the U.S. Internal Revenue Code was a tax credit enacted in 1976 to encourage economic development in U.S. possessions, most notably Puerto Rico. It provided a significant incentive for U.S. corporations by effectively exempting the income earned by their subsidiaries in these territories from federal corporate taxes. This policy played a role in shaping Puerto Rico’s industrial landscape, attracting investment from manufacturing and technology firms. The provision allowed companies to repatriate profits from their possession-based operations without incurring U.S. tax.

The Section 936 Tax Credit Explained

The possessions tax credit, as established under Section 936, offered a dollar-for-dollar reduction against U.S. federal income taxes on income derived from a U.S. possession. This meant a corporation could eliminate its federal tax liability on the profits earned by its Puerto Rican subsidiary. The credit was calculated based on the corporation’s “possession source taxable income,” which included income from the active conduct of a trade or business within the possession and certain investment income generated there.

Amendments to the tax code in 1986 introduced two alternative methods for calculating the credit, creating limitations to address concerns that benefits were not sufficiently tied to local economic activity. The first method was the economic activity limitation. This approach tied the tax credit to specific economic contributions the company made within the possession, including set percentages of wages paid to employees, depreciation deductions for business property, and any income taxes paid to the possession.

A second option was the percentage limitation method. Under this alternative, a company could elect to claim a credit based on a statutorily defined percentage of the credit it would have otherwise been able to claim. This percentage was gradually reduced over time, reflecting a legislative effort to scale back the benefits of the program.

Qualifying as a Possessions Corporation

To benefit from the Section 936 tax credit, a U.S. corporation had to meet requirements to be classified as a “possessions corporation.” These qualifications were designed to ensure that the tax benefits were directed toward companies with a substantial economic presence in a U.S. possession. Eligibility was determined by two primary tests based on the source of the corporation’s income over a three-year look-back period.

The first requirement was the 80% gross income test. This rule stipulated that for the three-year period, at least 80% of the corporation’s total gross income must have been derived from sources within a U.S. possession. This test ensured that the company’s revenue-generating activities were geographically concentrated in the location the tax credit was meant to support.

The second requirement was the 75% active business income test. This mandated that for the same three-year period, at least 75% of the corporation’s gross income must have been derived from the active conduct of a trade or business. This test distinguished passive investment income from earnings generated through genuine business operations.

Repeal and Phase-Out

In 1996, Congress passed legislation to repeal Section 936, citing concerns over its cost-effectiveness and fairness. A primary driver for the repeal was the loss of federal tax revenue, as studies suggested the cost to the U.S. Treasury for each job maintained in Puerto Rico by a Section 936 company was high. It was argued that these companies, particularly in capital-intensive industries, were able to shield large amounts of income from taxes without creating a corresponding level of local employment.

The repeal was not immediate but structured as a 10-year phase-out to mitigate the economic shock to Puerto Rico. Corporations that were existing claimants of the credit were allowed to continue receiving benefits until the end of 2005, although with certain restrictions. New claims for the credit were disallowed after 1995.

During this transitional period, the law introduced an alternative tax credit under Section 30A. This provision offered a wage-based credit, which was calculated as a percentage of wages and fringe benefits paid to employees in the possession. The phase-out concluded on December 31, 2005.

The Post-Section 936 Tax Landscape

The expiration of Section 936 fundamentally altered the tax treatment of U.S. companies operating in Puerto Rico. With the tax credit gone, Puerto Rican subsidiaries of U.S. parent companies were reclassified and treated as Controlled Foreign Corporations (CFCs). A CFC is a foreign corporation in which U.S. shareholders own more than 50% of the stock, which meant U.S. parent companies could be subject to U.S. tax on the earnings of their Puerto Rican subsidiaries.

This shift to the CFC framework brought Puerto Rican operations under the same international tax rules that apply to U.S. companies’ subsidiaries in other foreign countries. In response, Puerto Rico enacted its own tax incentives to remain attractive for investment. This included Act 154, a 4% excise tax, which was later largely replaced by a 10.5% income tax under Act 52-2022 to ensure taxes paid on the island could be credited against U.S. corporate taxes.

The U.S. tax landscape was further transformed by the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA introduced new international tax provisions, including the Global Intangible Low-Taxed Income (GILTI) regime. GILTI subjects a U.S. shareholder’s portion of a CFC’s low-taxed foreign income to immediate U.S. taxation, directly impacting operations in lower-tax jurisdictions like Puerto Rico.