Private equity and hedge funds in Puerto Rico – key tax considerations

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: (i) the enactment of former Act 185-2014, known as the Private Equity Funds Act (the PEF Act), which is now codified in the Puerto Rico Incentives Code (the PR Incentives Code or Act 60); and (ii) the influx of financial industry professionals moving to the island to take advantage of certain tax benefits available to individuals under the PR Incentives Code and prior laws.  

This alert focuses on the requirements that must be complied with under Act 60 in order for private funds and their sponsors and investors to qualify for certain Puerto Rico tax benefits.

Notably, there is no requirement that private funds must comply with Act 60 Funds and investors of funds that do not comply will simply be subject to ordinary Puerto Rico income tax rules. However, sponsors of such funds who are the beneficiaries of tax grants under Act 60 may enjoy certain tax benefits depending on the location of the fund, the investors of the fund and the nature of the investments made by the fund.

Sponsors should also be aware that all US federal securities laws, including those relating to investment company and investment adviser regulation, are applicable in Puerto Rico to the same extent as in any US state or territory, and Puerto Rico also regulates such activities.

Act 60 grants special Puerto Rico tax treatment to funds that meet certain requirements (Qualifying Funds), 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).

A PEF must:

1. Have a physical office located in Puerto Rico
   
   
2. Invest at least 80 percent of its paid-in capital (excluding cash and cash equivalents) in securities that at the time of acquisition are not offered at public securities markets in the United States or any foreign country
   
   
3. 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
   
   
4. Only admit accredited investors[1]
   
   
5. 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 (unless exempt from registration)
   
   
6. Operate as a diversified investment fund, which means that no later than four years from the date of its organization, and on the close of each subsequent taxable year, no more than 50 percent of a qualifying fund's capital may be invested in a single business (disregarding fluctuations in the value of such investments)
   
   
7. Maintain 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
   
   
8. 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.
   
   
9. In the case of a foreign partnership or foreign limited liability partnership, the managing partner or investment adviser, must be engaged in trade or business in Puerto Rico and derive at least 80 percent of its gross income from Puerto Rico sources or consists of income that is effectively connected or treated as effectively connected with the conduct of a trade or business in Puerto Rico

In addition, no later than four years after its organization and on the last date of each subsequent fiscal year, a PEF shall maintain at least 15 percent of its paid-in capital (excluding cash and cash equivalents) in one or more of the following:

1. promissory notes, bonds, stocks, notes (including secured and unsecured loans and including collateral) and any other security of similar nature issued by an entity that is engaged in an active trade or business (the Issuing Entity) that, at the time of acquisition, was not listed or publicly traded in securities markets of the United States or foreign countries and was issued by:
   
   
   1. a domestic corporation, domestic limited liability company, or domestic partnership or
      
      
   2. a foreign entity that during the last three taxable years has derived at least 80 percent of its gross income from sources within Puerto Rico or from income that is effectively connected or treated as effectively connected with the conduct of a trade or business in Puerto Rico in accordance with the provisions of the Internal Revenue Code of Puerto Rico.
      
      
2. promissory notes, bonds, notes, or other debt instruments issued by the Government of Puerto Rico, its instrumentalities, its agencies, its municipalities, or any other political subdivision (collectively with the securities mentioned in subsection (1) above, the Eligible Securities)

For purposes of Act 60, an Issuing Entity is actively engaged in trade or business, if such trade or business is carried on by such Issuing Entity, or by an entity controlled by the Issuing Entity. An entity is a controlled entity if 50 percent or more of the capital shares or the proprietary interests with voting rights of such entity are owned by the Issuing Entity.

A Qualifying Fund that is a PRPEF is required to comply with all of the aforementioned requirements, except for the 15 percent investment requirement in Eligible Securities mentioned above. In the case of PRPEFs, such a Qualifying Fund must no later than four years after organization, and on the last date of each subsequent year, maintain a minimum of 60 percent of its paid-in capital (excluding cash and cash equivalents) invested in:

1. Eligible Securities
   
   
2. exempt investment trusts under Section 1112.02 of the Internal Revenue Code of Puerto Rico or
   
   
3. Eligible Securities issued by entities directly or indirectly engaged in an active trade or business outside Puerto Rico, which securities are not listed or traded in any public securities market of the US or a foreign country at the time of acquisition, provided the operations of said entity are transferred to Puerto Rico within six months of the acquisition of the notes, bonds, shares of stock or similar securities, plus any additional period authorized by the Puerto Rico Treasury Department under reasonable cause, and during the calendar 12-month period from the first day of the month following the transfer of operations to Puerto Rico and the following 12-month period, that at least 80 percent of its gross income is from sources within Puerto Rico or effectively connected to Puerto Rico.

Last but not least, to qualify as a PEF or PRPEF under Act 60, the entity must file a tax decree application with the Department of Economic Development and Commerce (the DEDC) prior to making any offering.

Puerto Rico income tax rates and exemptions

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 will have a 75 percent exemption from real and personal property tax, other than stock, notes, bonds, participation interest and other securities or debt instruments issued by entities organized in or outside Puerto Rico, that are owned by the fund, which are 100 percent exempt from property taxes in Puerto Rico.

Puerto Rico income tax treatment of investors

One of the most attractive features of the Act is that resident investors[2] that invest in a PEF are entitled to deduct from taxable income up to a maximum of 30 percent of the adjusted basis of the investment made in the PEF within a maximum period of ten years, provided that the maximum deduction does not exceed 15 percent of their net income prior to such deduction.

On the other hand, resident investors that invest in a PRPEF are entitled to deduct up to a maximum of 60 percent of the adjusted basis of the investment made in the PRPEF 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 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 of an investor of the income derived by a Qualifying Fund, the general rule is that an investor's distributive share of income derived by a Qualifying Fund from interest and dividends is subject to an income tax of 10 percent. In addition, an investor's distributive share of capital gains realized by the Qualifying Fund is exempt from Puerto Rico income tax.

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 and their distributive share of capital gains is subject to a tax of 2.5 percent. 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. 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 rate 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 the reduced Puerto Rico tax rates provided by Act 60 are of no particular benefit to an investor holding a decree under Act 22-2012 or an individual resident investor decree under Act 60 because the distributive share of such investor in interest, dividends and capital gains derived by a Qualifying Fund is fully 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 for investors in Qualifying Funds 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 fees, performance allocation or carried interest under Sections 2031.01 and 2021.01 of Act 60 (former Acts 20 and 22, respectively) in connection with funds that operate for non-Puerto Rico investors. Again, the interplay between the Puerto Rico and US tax regimes needs to be analyzed and understood as 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.

DLA Piper attorneys have the experience and knowledge required to assist clients in navigating these areas of law and establishing private equity and hedge funds in Puerto Rico. Find out more by contacting any of the authors.

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[1] The definition of "accredited investor" in Act 60 is similar to, but not the same as, the definition of that term in the Securities Act of 1933, as amended.

[2] 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.