The Operation and Effect 

of th,e Possessions Corporation 

· System of Taxation 

I 

Fourth Report 

Department of the Treasury 

February 1983 
THE OPERATION AND EFFECT OF THE 

POSSESSIONS CORPORATION SYSTEM OF TAXATION 

FOURTH REPORT 

DEPARTMENT OF THE TREASURY 

February 1983 

LIBRARY 

MAY 251983 

ROOM 5 0 

T EASURY DEPAR MENT 

For sale by the Superintendent of Documents, U. S. Government Printing Office 

Washington, 0. C. 20402 
THE SECRETARY OF THE TREASURY 

WASHINGTON 

February 22, 1983 

Dear Mr. Chairman: 

The Report of the Committee on Finance on H.R. 10612 (Public 

Law 94-455), the Tax Reform Act of 1976, provides that "the 

Treasury is to submit an annual report to the committee setting 

forth an analysis of the operation and effect of the possessions 

corporation system of taxation," and that the reports are to be 

submitted within 18 months following the close of the calendar 

year, with the first report covering calendar year 1976. 

Pursuant to that provision, I hereby submit the fourth annual 

report entitled, The Operation and Effect of the Possessions 

Corporation System of Taxation. This report covers tax return 

information for 1979 and 1980, and other economic data available 

through mid-1982. 

The Tax Equity and Fiscal Responsibility Act of 1982 provided 

new rules for the allocation of income between a U.S. parent 

corporation and an affiliated possessions corporation. The 

effect of the new provisions, which apply to tax years beginning 

after December 31, 1982, will be examined in future Annual 

Reports. 

I am sending a similar letter to Robert Dole, Chairman of the 

Committee on Finance. 

The Honorable 

Dan Rostenkowski 

Chairman, Committee on Ways 

and Means 

United States House of Representatives 

Washington, D.C. 20515 

Enclosure 
THE SECRETARY OF THE TREASURY 

WASHINGTON 

February 22, 1983 

Dear Mr. Chairman: 

The Report of the Committee on Finance on H.R. 10612 (Public 

Law 94-455), the Tax Reform Act of 1976, provides that "the 

Treasury is to submit an annual report to the committee setting 

forth an analysis of the operation and effect of the possessions 

corporation system of taxation," and that the reports are to be 

submitted within 18 months following the close of the calendar 

year, with the first report covering calendar year 1976. 

Pursuant to that provision, I hereby submit the fourth annual 

report entitled, The Operation and Effect of the Possessions 

Corporation System of Taxation. This report covers tax return 

information for 1979 and 1980, and other economic data available 

through mid-1982. 

The Tax Equity and Fiscal Responsibility Act of 1982 provided 

new rules for the allocation of income between a U.S. parent 

corporation and an affiliated possessions corporation. The 

effect of the new provisions, which apply to tax years beginning 

after December 31, 1982, will be examined in future Annual 

Reports. 

I am sending a similar letter to Dan Rostenkowski, Chairman 

of the Committee on Ways and Means. 

The Honorable 

Robert Dole 

Chairman, Committee on Finance 

United States Senate 

Washington, D.C. 20510 

Enclosure 
-iTABLE OF CONTENTS 

List of Figures and Tables iv--vi 

Chapter 

1. INTRODUCTION AND SUMMARY •••••••••••••••••••••••••••••• 1 

2. 

3. 

UNITED STATES AND PUERTO RICAN LAW 9 

I. United States Tax Provisions 

II. 

A. Historical Background • • • • • • • • • • • • • • • • • • • • • • • • 9 

B. Possessions Corporation Exemption under the 

Tax Reform Act of 1976 • • • • • • • • • • • • • • • • • • • • • • • 11 

C. Source of Income Rules ••••••••••••••••••••••• 14 

D. Treatment of Income from Intangibles under 

Pre-1982 Law ••••••••••••••••••••••••••••••••• 14 

E. Treatment of Income from Intangibles under the 

Tax Equity and Fiscal Responsibility Act of 

198 2 • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • 20 

Puerto Rican Tax Provisions 

A. Historical Background 

B. Present System ••••••••••••••••••••••••••••••• 

23 

25 

ECONOMIC DEVELOPMENT IN PUERTO RICO 32 

I • Growth Since 1948 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 

II. Investment in Puerto Rico . . . . . . . . . . . . . . . . . . . . . . . 36 

III. Profitability and Location in Puerto Rico 

A. General Considerations ····················~· 42 

B. Wage Rates in Puerto Rican Manufacturing 

Indus tr i es • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • 4 3 

c. Reductions in U.S. Tariffs and the Expansion 

of Industry in Developing Countries •••••••••• 47 

D. Changes in U.S. Tax Law ••••••••••••••••••••• 49 

IV. Composition of Puerto Rican Manufacturing by 

Industry, 1960-1981 •••••••••••••••••••••••••••••• 50 
-iiChapter 

4. IMPACT OF POSSESSIONS CORPORATIONS ON PUERTO RICAN 

ECONOMIC GROWTH • • • • • • • • . . • • • • • • • • • • • • • • • • • • • • • • • • • • • • • 56 

I. Operations Attracted to Puerto Rico by Tax 

Exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 

A. Physical Assets •••••••••••••••••••••••••••••• 56 

B. Patents, Trademarks, and Know-how •••••••••••• 57 

C. Financial Assets ••••••••••••••••••••••••••••• 58 

D. Asset Composition of Puerto Rican Investment • 59 

I I. How Does Each Asset Contribute to Puerto Rican 

Gr ow th? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 6 

I I I. Impact 

Growth 

of 936 Fina·ncial Assets on Puerto Rican 

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A. Legal Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . B. Empirical Analysis ••••••••••••••••••••••••••• 

5. CHARACTERISTICS OF POSSESSIONS CORPORATIONS AND REVENUE 

68 

70 

81 

EFFECT OF SECTION 936 •••••••••••••••••••••••••••••••• 101 

I• Characteristics of Possessions Corporations 

A. Assets and Income in 1980 •••••••••••••••••••• 

B. Payroll and Employment Data in 1980 •••••••••• 

C. Summary Data for 1974 - 1980 ••••.••••••••••.• 

101 

111 

115 

II. Estimates of Linkages 

A. Forward Linkages ••••••••••••••••••••••••••••• 118 

B. Backward Linkages •••••••••••••••••••••••••••• 119 

III. Revenue Impact of Section 936 

A. Projections and Estimating Procedure ••••••••• 121 

B. Alternative Tax-saving Routes ••••••••••••••• 125 

6. IMPACT OF CHANGING FROM SECTION 931 TO SECTION 936 AND 

OF CHANGES IN THE PUERTO RICAN TOLLGATE TAX AND 

INDUSTRIAL INCENTIVES PROGRAM ••••••••••••••••••••••••. 130 

I. Dividend Repatriation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130 

II. Impact on Federal and Puerto Rican Tax Revenues •• 131 
-iiiAPPENDICES 

A. Operation of the Possessions Corporation System of 

Taxation in American Samoa, Guam, and and the 

Virgin Islands • • • • • • • • • • . • • • • • • • . • • • • • • • • • • • • • • • • • 135 

I. American Samoa, Guam, and the Panama Canal 

Zone 

A. Federal and Possessions Taxation . ........ 136 

B. Characteristics of Possessions Corporations Operating Outside Puerto Rico ...... 138 

II. Virgin Islands 

A. Taxation of Corporations Operating in the 

Virgin Islands •••••.••••••••••••••••••••• 138 

B. Taxation of Dividends Received from 

Corporations Operating in the Virgin 

Islands . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142 

C. Allocation of Income Attributable to 

Intangibles • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • 144 

B. Characteristics of Corporations, Partnerships, and Sole Propietorships Eligible 

for Virgin Islands Tax Rebates ••••••••••• 144 

B. Possessions Corporations in Tax Year 1979 •.•••.••• 151 

I. Assets and Income in 1979 ................... A. Assets ••••••••••••••••••••••••••••••••••• 

B. Retained Earnings ••.•••••••••.••••••••.•• 

C. Total Receipts •..••••••••.••••••••..•.••• 

D. Net Income per Tax Return ••••.•••••••••.• 

E. Reduction in U.S. Tax Liability ••..•••••• 

F. Distributions ••••••••.•••••••••••••.••.•• 

II. Payroll and Employment in 1979 

c. Sources and Limitations of the Data 

D. Tax Forms from Which Data Included in This Report 

151 

151 

155 

155 

159 

159 

159 

159 

162 

Were Obtained ••••••••••.•.••••••••••••••••••..•••• 165 
-ivLIST OF FIGURES AND TABLES 

Figures 

I Total and Per Capita Gross National Product of 

Puerto Rico, 1947-1981 ••••••••••••••••••••••.••• 34 

II Components of Real Investment in Puerto Rico, 

III 

Tables 

3-1 

3-2 

1960-1981 • . . . . . . . . • • • . . . . . . . . . . . . . . . . . . . . . . . . . . . 39 

Tax Benefits per Employee and Average Employee 

Compensation, Selected Manufacturing Industry 

Groups, 1980 .................................. . 

Total and Per Ca pi ta Gross National Product of 

Puerto Rico, and Net Migration of the Resident 

Population, 1947-1981 ••••••••••••••••••••••••••• 

Puerto Rican Unemployment Rate and Di str i but ion 

of Employment in Selected Years, 1950-1981 •••.•. 

114 

35 

37 

3-3 Components of Real Investment in Puerto Rico, 

3-4 

3-5 

3-6 

3-7 

3-8 

3-9 

1960-1981 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 

Average Hourly Earnings of Production Workers in 

Puerto Rico and the United States, Selected 

Industries, 1955-1980 ••••••••••••••••••••••••••• 

Percentage of Workers in Various Industry Classifications in Puerto Rico Earning Exactly the FLSA 

Minimum and Certain Specified Rates above It, 

1975-77 ..•..•......••........................... 

Federal Grants-in-Aid and Taxes Transferred to 

Puerto Rico, Selected Years, 1968-1981 •••••••••• 

Net Income Originating in Puerto Rican Manufacturing, 1960, 1970, and 1981 •••••••••••••••••••• 

Distribution of Employment in Puerto Rican Manufacturing, 1968-1981 •••••••••••••••••••••••••••• 

Employment, Payroll and Value-Added of Puerto 

Rican Manufacturing Industries, 1972 and 1977 ••• 

44 

46 

48 

51 

53 

54 
Tables 

4-1 Possessions 

Operating in 

and Land as 

Year-end 1980 

-vCorporations and Corporations 

the U.S. -- Net Plant, Equipment, 

a Percentage of Total Assets, 

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 

4-2 Possessions Corporations and Corporations Operating in the United States: Before-tax Operating 

Income in Relation to Operating Assets and 

Page 

60 

Employment, 1980 • • • • • • • • • • • • • • . • • • • • • • • • • • • • • • • • 62 

4-3 Estimated 

ments of 

Composition 

Possessions 

of the Financial InvestCorporations at Year-end 

1981 . . . . . . . . . . . . . . . . . . . . . . • . . . . . . . . . . . . . . . . . . . . . 71 

4-4 

4-5 

Estimated Composition of the Financial Investments of Possessions Corporations in Manufacturing at Year-end 1981 •••••••••••••••••••••••••••• 

Net Capital Inflows into Puerto Rico, 1970-1981 • 

72 

82 

4-6 Components of the Puerto Rico Capital Account, 

1970-1981 . . . . . . . . . . . . . . . . . . . . . . . . . . • . • . . . . . . . . . . 83 

4-7 Distribution of 936 Funds, 

Assets, and Change in 936 Funds 

Excess Eligible 

. . . . . . . . . . . . . . . . . 

4-8 Selected Assets and Liabilities of All Commercial 

Banks in Puerto Rico - Year-End 1979 to Year-End 

90 

1981 . . . • • . . . • . . . • . . . . . . . . . . • . . • . . • • . . . . . . . . • . . . . 93 

4-9 Comparison of Interest Rates on 936 and Eurodollar Deposits, January 1980 - April 1982 ••••••••• 95 

4-10 Change in Total 936 Funds and Eligible Assets 

from December 1980 to December 1981 ••••••••••••• 97 

4-11 Interest Costs on Puerto Rican Bond Issues Sold • 98 

5-1 Selected Balance Sheet Information by Industry, 

1980 • • • • • . . • • • • • . • • • • • • . • • • • • • • • • • • • • • • • • • . • • • • • 10 3 

5-2 

5-3 

Selected Income Statement 

Benefits by Industry, 1980 

Tax Benefits, Employment, 

Employees by Industry, 1980 

Information and Tax 

. . . . . . . . . . . . . . . . . . . . . . 108 

and Compensation of 

. . . . . . . . . . . . . . . . . . . . . 112 
-viTables Page 

5-3A Tax Benefits, Employment, and Compensation of 

Employees by Size of Tax Benefits Per Employee, 

1980 • • • • • . • • • • • • • • • • • • • • • • • . . • • • . • • • • . . . • • • . . • • . 116 

5-4 Summary Data on Possessions Corporations, 1973-

1980 • • • • • • • . . • . . . • • • • . • . • • • • • . • . • • • • • • . . • . • . • . • . 117 

5-5 

5-6 

5-7 

6-1 

A-1 

A-2 

Destination of Shipments by Puerto Rican Manufacturing Industries, 1977 ••••••••••••••••••••• 

Federal Revenue Cost Estimates and Projections, 

Possessions Corporation Provisions, 1973-1988 ••• 

Effective U.S. Tax Rates 

Assets, Selected Industries 

Elections under Section 936 

on New Depree i able 

. . . . . . . . . . . . . . . . . . . . . 

Possessions Corporations Outside of Puerto Rico -

Income and Estimated Tax Benefits, 1980 ••••••••• 

934 (b) Corporations in the Virgin Islands 

Selected Balance Sheet and Income Statement Items 

and Tax Benefits by Type of Corporation, 1980 ••• 

A-3 934 (b) Corporations in the Virgin Islands 

Selected Balance Sheet and Income Statement Items 

120 

122 

126 

132 

139 

146 

by Industry, 1980 •••••••••••••••••••••••••••.•••• 148 

A-4 934(b) Corporations in the Virgin Islands - Tax 

Benefits, Employment, and Compensation of 

Employees by Size of Tax Benefits per Employee, 

1980 • • • • . . . . • • . • . • . . • • . • • • • . • . • • . . • • . . . . • • • . • • . • 150 

B-1 Selected Balance Sheet Information by Industry, 

1979 • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • • 152 

B-2 

B-3 

Selected Income Statement 

Benefits by Industry, 1979 

Tax Benefits, Employment, 

Employees by Industry, 1979 

Information and Tax 

156 

and Compensation of 

. . . . . . . . . . . . . . . . . . . . . 160 
Chapter 1 

INTRODUCTION AND SUMMARY 

This is the fourth report to the Congress on the 

possessions corporation system of taxation. Possessions 

corporations, also known as 936 corporations, are U.S.-

chartered 1/ companies which are exempt under section 936 of 

the Internal Revenue Code 2/ from Federal tax on business 

income and qualified nonbus1ness income from Puerto Rico and 

certain other U.S. possessions. The body of this report 

covers tax return information for 1980 and other economic 

data available through mid-1982. Appendix B covers tax 

return information for 1979. 

The U.S. tax exemption for possessions corporations was 

originally added to the Code in 1921 for the purpose of 

promoting the competitiveness of U.S. business operating in 

the possessions. In 1948, Puerto Rico enacted a complementary program of tax exemption under its independent tax 

law. 3/ This program, called Operation Bootstrap, has been 

important in creating modern manufacturing and banking 

sectors in Puerto Rico. 

In 1976, Congress denied the benefits of tax exemption 

for income which possessions corporations derived from 

foreign countries, but retained the exemption for possession 

business profits and qualified investment income. In so 

doing, Congress stated that it wanted to "assist the U.S. 

possessions in obtaining employment-producing investments by 

_!_/ Although Puerto Rico and other U.S. possessions are 

included in some definitions of the United States, for 

convenience of exposition the term "United States" in 

this Report includes only the fifty States and the 

District of Columbia. 

~/ Unless otherwise indicated, all section references are 

to the Internal Revenue Code of 1954, as amended (the 

"Code") • 

ll Since 1960, other U.S. possess ions have also enacted 

tax-exemption programs. 
-2-

u.s. corporations ... "!/ Congress also directed the Treasury 

Department to review the operations of section 936 

corporations: 

The Treasury is to submit an annual report to the 

Congress setting forth an analysis of the operation and 

effect of the possessions corporation system of 

taxation. Among other things, the report is to include 

an analysis of the revenue effects of the provision as 

well as the effects on investment and employment in the 

possessions. ~/ 

For fiscal year 1980, the reduction in U.S. tax under 

the possessions corporation system of taxation is estimated 

at $1,195 million. In making this estimate, it is assumed 

that in the absence of section 936, the net income of all 

U.S. corporations in the aggregate would not chanqe. Over 

99 percent of the estimated U.S. tax cost of the possessions 

corporation system was attributable to U.S. corporations 

operating in Puerto Rico. The remainder, or $2 million, was 

attributable to U.S. corporations operating in Guam, 

American Samoa, or other U.S. possessions. 

Because the principal impact of section 936 is on Puerto 

Rico, the body of this report deals almost exclusively with 

Puerto Rico. The impact of section 936 on other U.S. 

possessions is described in Appendix A. This Appendix also 

covers the tax incentive program for corporations operating 

in the Virgin Islands, which is delimited by section 934(b) 

of the Code. In 1980, the amount of income tax forqi ven 

under the Virgin Islands tax incentive program was $41 

million, of which $38 million was attributable to Virgin 

Islands subsidiaries of U.S. corporations. 

In Puerto Rico, the possessions corporation system is 

based upon the interaction of the tax laws of the United 

States and those of the Commonweal th. This report first 

reviews those tax laws and then undertakes an economic 

analysis of their impact. Chapter 2 discusses the U.S. tax 

legislation for possessions corporations and the modifications to the legislation in the Tax Equity and Fiscal 

ii Joint Committee on Taxation, General Explanation of the 

Tax Reform Act of 1976, p. 274. Similar language is 

used in the Reports of the House Committee on Ways and 

Means and the Senate Committee on Finance. 

~/ Ibid., pp. 277-8. 
-3-

Responsibility Act of 1982 (TEFRA). The chapter also 

describes the U.S. tax law and administrative releases which 

apply to the transfer of patents, trademarks, and other 

assets by a U.S. parent corporation to an affiliate, and the 

rules which relate to the allocation between affiliated 

corporations of income from intangible assets. Although 

these tax rules have broader application than the possessions context, they are critical to an understanding of the 

operations of possessions corporations. Under TEFRA, new 

rules for the allocation of income from patents, trademarks, 

and other intangibles will apply to possessions corporations 

for tax years beginning after December 31, 1982. 

Chapter 2 concludes with a review of Puerto Rico's 

Industrial Incentive Acts, under which grants of partial and 

total exemption from Puerto Rican income, property, and 

excise taxes have been offered as incentives to corporations 

to establish manufacturing plants in Puerto Rico. Chapter 2 

also discusses Puerto Rico's tollgate tax on dividends paid 

out of Puerto Rican source income to U.S. parent 

corporations. 

Chapter 3 surveys Puerto Rican economic growth since 

1948, and the impact of the U.S. and Puerto Rican tax 

exemptions in shaping that growth. From the late 1940s to 

the early 1970s, the combined effect of tax exemption, low 

wages relative to the United States, and exemption from U.S. 

tariffs contributed to a sustained high rate of Puerto Rican 

economic growth. In the 1948-1973 period, Puerto Rican real 

gross national product (GNP) grew at an average annual rate 

of six percent, and real GNP per capita grew by five percent 

per year. 

Since 1973, however, the average annual rate of growth 

of real GNP in Puerto Rico has fallen to one-third the rate 

in the 1960s. The annual flow of private investment in new 

plant and equipment in 1980 and 1981, measured in constant 

dollars, was about 70 percent of its value in 1973. ~/ 

~/ The trend in annual investment in Puerto Rico between 

1973 and 1981 is unchanged when private refinery 

construction is excluded. Private refinery construction 

represented 30 percent of total private investment in 

Puerto Rican plant and equipment in the period 1970-72, 

but dropped to 4 percent in 1973 and most subsequent 

years. The short-lived boom of the Puerto Rican 

petrochemical industry was based on Puerto Rico's large 

allocation of U.S. oil import quotas for foreign oil 

(which before 1973 was cheaper than domestic oil). See 

p. 38 below. 
-4-

Employment growth also has slowed. Between 1970 and 

1981, employment fell by 54 ,000 jobs in Puerto Rican 

construction and agr icul tu re. These losses were offset by 

employment gains in government, services, and manufacturing, 

but the aggregate increase did not keep pace with population 

growth. Unemployment, which declined steadily through the 

1960s to just over 10 percent of the measured labor force, 

has been at 17 percent or above since 1975, and rose to 23.5 

percent in the year ending June 30, 1982. 

In part, the decline in investment and in the growth of 

employment in Puerto Rico is traceable to the U.S. economy, 

which was in recession in 1974-1975 and has not grown 

rapidly since. In addition, Puerto Rico's ability to 

compete for investment has been hurt by Federal minimum wage 

laws. As a result of successive increases in the minimum 

wage rates applicable to Puerto Rico and the expansion of 

Puerto Rican coverage between 1966 and 1976, the U.S. 

mainland minimum wage applied to virtually all Puerto Rican 

manufacturing and non-manufacturing industries by 1981. In 

many Puerto Rican industries, including apparel and leather 

goods, the hourly wage paid to most workers is at, or near, 

the legal minimum and has risen as the minimum wage has 

increased. 

The competitiveness of Puerto Rican products also has 

been undercut by structural changes in the world economy. 

Increases in investment in developing countries have created 

new manufacturing centers there. After the Kennedy round of 

tariff reductions in 1967, exports of manufactures from 

developing countries were able to penetrate the U.S. market 

and compete successfully with Puerto Rican-produced goods. 

Chapter 4 reviews .the ways in which the tax exemption 

affects the kind of operations attracted to Puerto Rico. 

The relative tax advantages of a Puerto Rican location vary 

for physical and financial investments and for the holding 

of intangible assets. 21 Puerto Rico is, on tax grounds, a 

21 "Physical investment" consists of expenditures to buy 

newly produced capital goods, plant, equipment, and 

inventories. "Financial investment" means the purchase 

of securities, such as stocks and bonds and certificates 

of deposit (CDs). Some "intangible assets," such as 

patents and know-how, are produced by investment in 

research and development and training; other i ntang ibles, such as trademarks, acquire value because of 

expenditures on advertising and promotion. 
-5-

more attractive location than the United States for plant 

and equipment and other operating assets. But the tax 

advantages of a Puerto Rican location for physical assets 

may not be significantly better than those available in a 

low-tax developing country. On the other hand, Puerto Rico 

offers special advantages for financial assets, such as 

deposits, bonds, and other securities. Section 936 provides 

that qualified possession source investment income (QPSII) 

is free of U.S. tax. For most U.S. taxpayers, no alternative to Puerto Rico exists for receiving tax-free, highyield returns on financial investments. 

Chapter 4 also describes how some U.S. corporations have 

sought to increase the attractiveness of Puerto Rico as an 

investment location by transferring patents, trademarks, and 

other intangible assets to Puerto Rico. Assets can be 

transferred between U .s. corporations on a tax-free basis 

under section 351 of the Code. Since a 936 corporation is a 

U.S., not a foreign corporation, U.S. parent corporations 

have relied on section 351 to effect tax-free transfers of 

patents and other intangibles to their 936 affiliates. If 

the income attributable to the intangibles is treated as 

earned by the 936 corporation, rather than the parent, the 

effect of the transfer will be to increase the pool of taxexempt Puerto Rican income earned by the 936 corporation and 

thus augment the incentive for investing in Puerto Rico. 

The Internal Revenue Service has contested the claimed 

allocation to 936 corporations of returns on the transferred 

intangibles on the ground that it distorts the income of the 

parent corporations. The controversy is in litigation in 

the U.S. Tax Court, and has been largely resolved for future 

years by the amendments to section 936 under TEFRA. 

While the Code generally allows assets to be transferred 

tax-free between related domestic corporations, the right to 

transfer assets free of tax to a controlled foreign corporation is limited. In particular, administrative guidelines 

under section 367 of the Code impose a tax (a toll charge) 

on the transfer from a U.S. corporation to a foreign corporation of the U.S. rights to an intangible, e.g., a patent 

to produce goods which will ultimately be sold in the United 

States. Based on this di st i nction in U.S. tax law between 

domestic (including 936) and foreign corporations, and 

depending on the ultimate resolution of the Tax Court 

litigation, Puerto Rico has offered a significant advantage 

over foreign low-tax jurisdictions for holding patents, 

trademarks, and other intangibles. Under the amendments to 

section 936 in TEFRA, a Puerto Rican location will continue 

to offer unique advantages with respect to intangibles. 
-6-

The mix of assets in Puerto Rico reflects the differinq 

tax incentives offered to physical and financial investments 

and the holding of intangible assets. In 1980, fixed assets 

(plant, equipment, and land) represented 12 percent of the 

total book assets of 936 manufacturing corporations, 

compared to 37 percent for manufacturing corporations 

operating in the United States. The share of fixed assets 

in total assets was smaller for 936 companies than for 

companies operating in the United States in all but one of 

the industries for which data are available. The 12 percent 

share of 936 fixed assets in total 936 book assets increases 

to about 15 percent if all property owned by the Puerto 

Rican government for lease to investors is counted as assets 

of 936 firms. 

Chapter 4 also analyzes the impact of intangible and 

financial assets on Puerto Rican growth. Some intangible 

assets, such as management techniques, contribute to Puerto 

Rican growth by increasing productivity in much the same way 

as physical capital. With respect to other intangibles, in 

particular patents, trademarks and trade names, a distinction can be drawn between the right to use the intangibles 

and ownership of the intangibles. The right to use patents, 

trademarks and other product-specific intangibles increases 

the productivity of Puerto Rican workers by giving them an 

opportunity to participate in the production of advanced 

products. Transferring the ownership title to a productspecific intangible may also benefit Puerto Rico. Provided 

the transfer is accompanied by additional investment in 

physical assets and additional employment in Puerto Rico, it 

will increase Puerto Rican productivity and growth. The 

impact of the transfer of product-specific intangibles on 

Puerto Rican economic development will be closely related to 

the volume of physical investment that accompanies the 

transfer of such intangibles. 

By restricting to Puerto Rican source income the tax 

exemption on financial investments, the Tax Reform Act of 

1976 induced possessions corporations to brinq to Puerto 

Rico the large pool of funds that had been invested in the 

Eurodollar market. The intent of the QPSII provision in 

section 936 was to lower interest costs and promote real 

private and public investment in Puerto Rico. In an attempt 

to realize this objective, the Puerto Rican government has 

issued a series of regulations designed to isolate Puerto 

Rico from world capital markets so as to interfere with the 

normal equalization of financial returns among markets. 
-7-

Chapter 4 notes that at least through mid-1981, this 

objective has been frustrated. Total Puerto Rican financial 

assets held by exempt possessions corporations at year-end 

1981 were $7.6 billion. However, these assets tended to 

flow out again through the banking system, or to result in 

shifts in the ownership of Puerto Rican government debt and 

in investments abroad by Puerto Rican government corporations. Thus, the return to possessions corporations on taxexempt certificates of deposit in banks in Puerto Rico was 

close to the Eurodollar interest rate. On December 17, 

1981, the Puerto Rican Treasury issued new regulations, 

effective February 1, 1982, which substantially tightened 

the rules governing the use of 936 funds by bankers, 

brokers, and Puerto Rican borrowers. As a result of the new 

regulations, the interest rate on 936 deposits relative to 

Eurodollar deposits fell in March and April of 1982. The 

new regulations also appear to have resulted in a rise .in 

the growth of Puerto Rican commercial loans between February 

and May 1982. 

Chapter 5 presents background statistical information on 

936 corporations, including balance sheet, income statement, 

and employment and payroll data by industry. In 1980, the 

pharmaceutical industry accounted for approximately one-half 

of total net income of 936 manufacturing corporations. The 

next largest industry in terms of income was electrical and 

electronic equipment, which accounted for one-fifth of the 

total net income. 

In enacting section 936, Congress sought to assist 

Puerto Rico in obtaining employment-producing investments. 

Matching income tax return information with Federal 

unemployment insurance tax returns for individual 936 

corporations provides one indication of the extent to which 

this objective has been realized. Based on the sample of 

corporations for which employment information is available, 

it is estimated that in 1980, employment in all possessions 

corporations in manufacturing industries was approximately 

72,000. This represents 9 percent of total employm~nt in 

Puerto Rico and one-half of all employees in Puerto Rico's 

manufacturing sector. 

Possessions corporations' tax benefits in relation to 

their employment varied substantially by industry. In 1980, 

the tax savings per employee averaged $59,000 in the 

pharmaceutical industry and $4, 000 in the low-technology, 

labor-intensive industries. Over all manufacturing industries, corporate tax savings per Puerto Rican employee 

averaged $17, 000, as compared to average compensation of 

possessions corporation employees of $12,000. 
-8-

Chapter 6 reviews the impact of the 1976 Tax Reform Act 

and recent changes in Puerto Rican law on dividend 

repatriations and Puerto Rican tax revenues. Until 1976, 

possessions corporations paid virtually no dividends . to 

their U.S. parents, since pre-1976 law subjected such 

dividends to U.S. tax. Between 1978 and 1981, however, 

possessions corporations repatriated one-third to one-half 

of each year's earnings. In 1976, Puerto Rico modified its 

tollgate tax to apply to dividends repatriated by possessions corporations. That tax yielded $56 million in 

revenues in the year ending June 1981. Puer.to Rico also 

modified its income tax-exemption program in 1978, to 

provide that new investors would be eligible for only 

partial income tax exemption and that the amount of the 

exemption would decline over the life of each firm's taxexemption grant. The combined effective rate of Puerto 

Rican tollgate and income taxation in 1981 was approximately 

3. 5 percent of the net income of 936 manufacturing 

corporations. The average Puerto Rican tax rate will rise 

somewhat in future years as more firms become subject to 

only partial tax exemption and as the amount of the 

exemption provided to each firm declines. 
-9-

Chapter 2 

UNITED STATES AND PUERTO RICAN LAW 

The possessions corporation system of taxation consists 

of a set of rules under which a U.S. manufacturing 

corporation deriving qualifying income from Puerto Rico pays 

no tax on that income to the United States and currently 

pays,on average, less than 5 percent of that income in taxes 

to Puerto Rico. 

Like other U.S. corporations, a 936 corporation is 

subject to Federal tax on its worldwide income. However, a 

special credit available under section 936 fully offsets the 

Federal tax on income from a trade or business in Puerto 

Rico or from qualified possession source investment income 

(QPSII). A U.S. parent corporation can, in turn, offset 

dividends received frqm a wholly owned 936 subsidiary with a 

100 percent dividends-received deduction, which frees the 

dividend income from Federal tax. 

Puerto Rico has primary jurisdiction to tax Puerto Rican 

source income; the United States has secondary jurisdiction 

to tax the Puerto Rican source income of U.S. corporations, 

citizens, and residents. However, because the Puerto Rican 

rules have been fashioned to take maximum advantage of the 

Federal rules and have changed when the Federal rules have 

changed, the Federal rules are described first. 

I. United States Tax Provisions 

A. Historical Background. The main elements of the 

possessions corporation tax exemption became part of U.S. 

law as section 262 of the Revenue Act of 1921. Proponents 

of this legislation had sought tax exemption for the foreign 

source income of any domestic corporation deriving a~ least 

80 percent of its income from foreign sources. They 

stressed the tax-induced disadvantage of U.S. firms 

operating abroad in competition with British firms. British 

law deferred taxation on foreign income of British firms 

until it was remitted to Great Britain, while the United 

States taxed the foreign income of U.S. corporations as it 
-10-

was earned • . !/ The proponents of exemption, chiefly U.S. 

corporations doing business in the Philippines, ultimately 

settled for an exemption for the foreign source income of 

U.S. persons deriving at least 80 percent of their income 

from U.S. possessions. ~/ 

The possessions corporation exemption continued 

unchanged from 1921 until 1976. To qualify for the 

exemption on income derived from sources outside the United 

States, a U.S. corporation had to meet two gross income 

tests. The corporation had to derive 80 percent or more of 

its gross income from the possessions, and 50 percent or 

more of its gross income from the active conduct of a trade 

or business in the possessions. These gross income tests 

had to be satisfied in the tax year in which the exemption 

was claimed, and also in the two preceding tax years if the 

corporation had conducted a trade or business in a 

possession during that period. A corporation which met the 

80-50 income tests was known as a "possessions corporation." 

Such a corporation was usually organized as a special 

purpose subsidiary of a U.S. parent company in order to 

!/ Under U.S. law at that time, foreign incorporation also 

deferred the taxation of foreign source income until 

profits were remitted to the United States. However, 

U.S. companies at the time generally preferred not to 

incorporate subsidiaries under foreign laws; foreign 

operations were typically conducted through either a 

branch of the U.S. parent or a u.s.-chartered 

subsidiary. 

~/ The possessions until 1946 included the Philippines, and 

the exemption orginally applied to U.S. citizens as well 

as U.S. corporations doing business in the possessions. 

Currently, the possessions include Puerto Rico, American 

Samoa, Guam, the Northern Mariana Islands, and certain 

other insular areas. The Virgin Islands was specifically excluded from the definition of "possession" under 

the 1921 Act, presumably because the U.S. income tax 

laws were in force in the Virgin Islands under the Naval 

Appropriations Act of 1922 (enacted July 12, 1921). 

Since foreign and U.S. corporations operating in the 

Virgin Islands were alike subject to U.S. income tax 

laws under that Act, U.S. corporations operating there 

did not suffer any tax-induced disadvantage. Including 

the Virgin Islands in the definition of "possession" 

would have placed foreign corporations operating in the 

Virgin Islands at a sharp competitive disadvantage 

relative to U.S. corporations. 
-11-

ensure that the 80-50 income tests were met. Since the 

income of the possessions corporation from sources outside 

the United States was exempt from tax until it was remitted 

to the United States through the payment of a dividend, the 

possessions corporation enjoyed the same benefits of 

deferral as did foreign firms operating in the U.S. 

possessions. 

B. Possessions Corporation Exemption under the Tax 

Reform Act of 1976. Between 1973 and 1976, the Ways and 

Means Commit tee of the House of Representatives held 

extensive hearings on the subject of tax reform. The 

Committee considered repealing the possessions corporation 

exemption on the ground that its original purpose of 

expanding U.S. trade with the Philippines and the Far East 

was no longer being served, the Philippines having ceased to 

be a U.S. possession in 1946. However, proponents of the 

exemption argued that it had become crucial to the economic 

development of another U.S. possess ion, Puerto Rico. Many 

U.S. firms had established plants in Puerto Rico after 1948, 

when Puerto Rico enacted a program of tax exemption for 

manufacturing firms. ' These tax-exempt firms were an 

important source of jobs in Puerto Rico. Proponents of 

continued U.S. tax exemption argued that the possessions 

corporation system of taxation offset the U.S. minimum wage 

requirement, the requirement to use U.S. flag vessels in 

transporting goods to the United States, and other Federally 

imposed requirements which tended to reduce Puerto Rico's 

ability to compete with neighboring countries for U.S. 

investment. Finally, it was argued that the possessions 

corporation system cost the Federal government only 

$200-$300 million a year in tax revenues, 3/ a small price 

in comparison to the $2 billion then being spent by the 

Federal government in direct grants and transfer payments to 

Puerto Rico. !/ 

ll In January 1976, the Federal revenue loss as a result of 

the possessions corporation system was estimated at $285 

million on the basis of the limited data then available. 

(See Special Anal~s Budget of the United States 

Government for Fiscal Year 1977, "Special Analysis F, 

Tax Expenditure," January 1976.) When tax return data 

on possessions corporations became available as a result 

of the filing requirement enacted in 1976, the FY 1977 

tax expenditure estimate was revised from $285 million 

to $663 million. As indicated in Table 5-5 below, the 

revised estimate (based on tax returns covering 1977) is 

$721 million. 

!I See Table 3-6 below for a tabulation of Federal direct 

aid to Puerto Rico. 
-12-

The Tax Reform Act of 1976 left intact the exemption for 

income derived by U.S. corporations from operations in a 

possession, but eliminated the exemption for income derived 

from foreign countries. These and other changes in tQe tax 

treatment of possessions corporations were effected · by 

removing possessions corporations from section 931 of the 

Internal Revenue Code and placing them in a newly created 

Code section 936. The differences between sections 931 and 

936 are: 

o Change in the scope of and method of effecting the 

tax exemption. Before 1976, a possessions corporation was exempt from the U.S. tax on all income 

derived from sources outside the United States. 

Under the Tax Reform Act of 1976, the exemption was 

limited to two kinds of income: 

Income from the active conduct of a trade or 

business in a possession, or from the sale or 

exchange of substantially all of the assets used 

by the corporation in the active conduct of such 

trade or business; and 

QPSII, which is non-business income derived from 

the possession in which the corporation has its 

trade or business 5/ and which is attributable 

to the investment - of funds derived from such 

trade or business. 

Instead of excluding this income, section 936 

provides a credit equal to (and, thus, fully offsetting) the U.S. tax on this income. The section 

936 credit is not available for other income earned 

by a possessions corporation. However, a regular 

foreign tax credit may be claimed for foreign 

(including possession) taxes paid or accrued with 

respect to income which does not qualify for the 936 

credit. 

~/ The requirement that QPSI I must be derived from the 

possession in which the corporation has its trade or 

business means that a possessions corporation with a 

trade or business in Puerto Rico cannot convert interest 

on Eurodollar deposits into possession source income by 

routing such deposits through a Guamanian bank. Such 

had been the practice prior to 1976 under section 931. 
-13-

o Exemption from U.S. tax on income remitted by a possessions corporation to its U.S. parent. Prior to 

1976, dividends paid by possessions corporations 

were fully taxable to a U.S. shareholder, but 

amounts received upon liquidation of a possessions 

corporation were exempt from tax. As a consequence, 

931 corporations accumulated substantial earnings, 

investing them in the Eurodollar market in anticipation of a tax-free liquidation. 6/ To accelerate 

the repatriation of earnings, the Tax Reform Act of 

1976 allowed U.S. parent corporations to claim a 

dividends-received deduction for dividends from a 

936 corpora ti on. If the 936 company is a wholly 

owned subsidiary (as most are), the deduction equals 

100 percent and, thus, the dividend is free of any 

U.S. tax. Because the U.S. parent qualifies for a 

dividends-received deduction, it is denied any 

foreign tax credit for taxes which may be imposed by 

Puerto Rico on or with respect to such dividends. 

o Requirement that a possessions corporation elect the 

benefits of section 936 for 10 years. Under section 

931, as construed by a court decision, 7/ a possessions corporation which suffered a loss in a given 

year could join its parent and other affiliated corporations in filing a consolidated return for such a 

year. The parent of a 931 corporation thus avoided 

taxes in profitable years but was able to offset any 

loss against other taxable income in unprofitable 

years. Under section 936, a possessions corporation 

must elect the benefits of section 936, and that 

election is irrevocable for 10 years. During this 

period, it cannot join with its parent in filing a 

consolidated return, although it can delay electing 

936 status until profitable years begin. 

In explaining the amendments made by the Tax Reform Act 

of 1976, Congress cited its desire to leave undisturbed the 

tax exemption of earnings from a trade or business in Puerto 

~/ Because the investment income was not subject to Federal 

tax as earned, the company was not subject to the U.S. 

accumulated earnings tax. 

21 Burke Concrete Accessories, Inc., et al. v. Commissioner 

of Internal Revenue, 56 Tax Ct. 588 (1971). This case 

overturned Rev. Rul. 65-293, 1965-2 C.B. 323. 
-14-

Rico or from investments made with those earnings for use in 

Puerto Rico. At the same time, Congress wished to end the 

exemption for passive income from funds invested in foreign 

cap~tal markets and to hasten their repatriation. Congr~ss 

stated that it sought to: 

assist the U.S. possessions in obtaining employmentproducing investments by U.S. corporations, while at the 

same time encouraging those corporations to bring back 

to the United States the earnings from these investments 

to the extent they cannot be reinvested productively in 

the possession. ~/ 

C. Source of Income Rules. In determining whether a 

corporation satisfies the 80-50 gross income tests of 

section 936, which are described above, it is important to 

ascertain the source of the income of the corporation. The 

income of most possessions corporations is derived from the 

sale of products manufactured by the corporations in Puerto 

Rico. Therefore, the most important source rule for 

possessions corporations deals with income from the sale or 

exchange of personal property. 

Under sections 861 through 863, the source of income 

from the sale or exchange of personal property is generally 

determined by the place where title to the personal property 

passes to the purchaser. If a possessions corporation sells 

goods produced in Puerto Rico to its U.S. parent 

corporation, with title to the goods passing in Puerto Rico, 

the income derived from the sales to the parent will be 

treated as Puerto Rican source income, even if the parent 

subsequently resells the goods in the U.S. market. 

D. Treatment of Income from Intangibles under Pre-1982 

Law. Before 1982, there were no explicit statutory 

guidelines on the allocation to a possessions corporation of 

income from intangibles, such as patents, trademarks, and 

tradenames. In a number of instances, U.S. corporations 

attempted to increase the income which was exempt from tax 

~/ Report of the Committee on Ways and Means, U.S. House of 

Representatives, on H.R. 10612, Report No. 94-658, 

November--r2,-197~P:-2ss;--aftdReport of the Committee 

on Finance, United States Senate, on H.R. 10612, Report 

No. 94-938, June 10, 1976, p. 279. 
-15-

under section 936 by transferring to an affiliated possessions corporation intangible assets created in the United 

States. These corporations generally construed the law to 

require no allocation to the U.S. parent of income generated 

by the intangibles. The view of the Internal Revenue 

Service, on the other hand, is that it can reallocate to the 

U.S. parent all or a portion of the income attributable to 

the intangibles. This issue is now before the U.S. Tax 

Court. 

The first two sections below describe the most important 

rules prior to 1982 for the tax treatment of income from 

intangibles. The chapter then describes the new rules 

applicable to possessions corporations which were added to 

the Code by the Tax Equity and Fiscal Responsibility Act of 

1982. 

1. Intercorporate Transfers of Assets. Section 351 

of the Code provides that if a U.S. corporation owns 80 

percent or more of a U.S. subsidiary, it may transfer 

appreciated property, including intangibles such as patents 

and trademarks, to the subsidiary solely in exchange for 

stock or securities of the subsidiary without the 

recognition of gain. The Code permits such tax-free 

transfers between related U.S. corporations because the 

income to which the transferred property gives rise 

generally will be taxed to the subsidiary at the time the 

income is realized. An important exception arises, however, 

if the transferee corporation is tax-exempt under section 

936. 

Although it does business in Puerto Rico, a corporation 

qualifying for the benefits of section 936 is a U.S. 

corporation. Thus, a U.S. parent corporation that 

transferred appreciated property to a 936 corporation could 

claim a dual tax benefit. First, the parent retained as an 

offset against other taxable U.S. income the costs incurred 

in developing the intangibles in the United States. Second, 

prior to 1982, it could assert that the gross income 

generated by the transferred property was exempt from tax 

under section 936. As explained below in the section on 

income allocation, the Internal Revenue Service challenged 

some of these claims. 

The tax treatment of property transferred between two 

U.S. corporations contrasts with the tax treatment of 

property transferred from a U.S. to a foreign corporation. 

The income of a foreign corporation is normally not subject 
-16-

to current U.S. taxation unless the corporation earns income 

from a U.S. trade or business or other U.S. source income. 

Therefore, provision is made in the Code to prevent a U.S. 

corporation from avoiding tax by transferring property to a 

foreign subsidiary in a non-recognition transactiQn. 

Section 367 of the Code provides that in order to obtain 

non-recognition treatment, a U.S. corporation making such a 

transfer must receive a ruling from the Internal Revenue 

Service that the transfer has not been undertaken for the 

principal purpose of avoiding U.S. tax. Guidelines issued 

under section 367 provide that the Internal Revenue Service 

may in some cases impose a ''toll charge" on the transfer of 

property to a foreign corporation. ~/ 

In the particular case of a U.S. corporation which 

transfers to a foreign corporation title to patents, 

trademarks, or other intangibles used to produce a good 

which will ultimately be sold in the United States, the U.S. 

corporation would normally be required to include in its 

gross income the excess of the value of the intangible over 

its adjusted basis. If all costs of developing the intangible have been deducted from the U.S. corporation's income, 

then its basis in the property is zero, and the total value 

of the intangible must be included in the income of the 

parent corporation. Section 367 does not apply to transfers 

of income-producing property from a U.S. parent corporation 

to its 936 subsidiary, since 936 companies are U.S., not 

foreign, corporations. 

2. Allocation of Income and Deductions. Under 

section 482 of the Code, the Internal Revenue Service may 

reallocate income, deductions, or credits among two or more 

corporations under common ownership so as to prevent evasion 

of taxes or to clearly reflect the income of any of such 

corporations. The objective is to place a controlled 

corporation on the same tax footing as an uncontrolled 

taxpayer. Section 482 reallocations of income between a 

U.S. parent and an affiliated possessions corporation have 

been a subject of controversy since 1955. The principal 

issue has been the treatment of income from patents, 

trademarks, and other intangibles developed by a U.S. parent 

corporation, but related to a product which is manufactured, 

in whole or in part, by its affiliated possessions 

corporation. 

~/ See Revenue Procedure 68-23, 1968-1 C.B. 821, and subsequent Revenue Procedures modifying Rev. Proc. 68-23. 
-17-

In a 1955 private letter ruling, the Internal Revenue 

Service ruled that income derived from sales of goods made 

by a possessions corporation to its U.S. parent constitutes 

gross possession source income of the possessions 

corporation for purposes of section 931. 10/ The ruling did 

not explicitly address the issue of the sales price charged 

by the possessions corporation. In the ruling, the taxpayer 

had represented that sales of manufactured goods from the 

possessions corporation to the U.S. parent would be priced 

so as to give to the parent only the profit margin normally 

earned by an independent distributor. Under such a pricing 

rule, the af f i 1 iated possess ions corporation would receive 

all of the income attributable to any patent, trademark, or 

customer goodwill for the product it manufactured. In 

commenting on the pricing issue, the Internal Revenue 

Service subsequently stated that the 1955 ruling: 

should not be construed to pass upon the propriety of 

the [particular pricing rule used by the taxpayer] as 

being an appropriate measure of the allocation of 

profits between [the taxpayer] and its subsidiary 

operating in Puerto Rico. 

The Internal Revenue Service noted that the proper income 

allocation rule is a factual question which the 1955 ruling 

did not address. 11/ 

In 1963, the Internal Revenue Service provided 

guidelines in Revenue Procedure 63-10 for the allocation of 

income from intangibles between a U.S. parent corporation 

and its affiliated possessions corporation. The Revenue 

Procedure was prepared after considerable discussion with, 

and review by, representatives of the Puerto Rican 

government. The guidelines state that if, under all facts 

and circumstances, intangibles "belong" to the affiliated 

possessions corporation, it is entitled to the income 

produced by the intangibles. The Revenue Procedure cautions 

that where the U.S. parent corporation is the marketing and 

servicing organization for products produced by. the 

possessions corporation, "no supportable contention could be 

made" that certain intangibles, such as "market position, 

10/ Private letter ruling, October 6, 1955 • 

.!_!_/ Private letter ruling, April 8, 1959. 
-18-

consumer acceptance, or similar factors of good will 

attributable to the distribution and product servicing 

activities in the United States" belong, as a matter of 

substance, to the possessions corporation. The Revenue 

Procedure does not specifically address the application . of 

section 482 to cases involving intangibles transferred from 

a U.S. parent corporation to an affiliated possessions 

corporation, largely because such transfers were not yet 

common. 

They [the guidelines] do not deal with other problems 

that may be involved in particular cases, including 

those which may be present in cases involving the 

transfer of income-producing intangibles from the United 

States to an affiliate located in Puerto Rico • ..!±_/ 

Shortly after the publication of Revenue Procedure 

63-10, the Internal Revenue Service also issued Manual 

Supplement 42G-86. It states that if intangibles "belong" 

to an affiliated possessions corporation, it is entitled to 

the return thereon. The Manual Supplement does not define 

the term "belong" in the case where intangibles have 

purportedly been transferred to an affiliated possessions 

corporation, except by reference to the facts and 

circumstances. In particular, it sets forth various factors 

the presence of which are evidence that there has not been a 

transfer in substance to the affiliated possessions 

corporation, such as lack of formal transfer documents, 

continued use of the intangibles by the mainland parent in 

its own operations, and retention by the mainland parent of 

protective and exploitative activites related to the 

intangibles. The Manual Supplement requires that cases in 

which there is evidence that significant income-producing 

intangibles have been transferred to an affiliated 

possessions corporation must be referred to the National 

Off ice for coordinated examination. 

In 1968, the Internal Revenue Service issued regulations 

under sectlon 482. These regulations provide detailed rules 

for the setting of transfer prices on transactions between 

related parties. Like t}1e 1963 guidelines for the allocation of income to possessions corporations, the regulations 

do not specifically address the question of whether a 

section 351 transfer of intangibles will be respected for 

purposes of the allocation of income attributable to those 

12/ Revenue Procedure 63-10, 1963-1 C.B. 490. 
-19-

intangibles. On the same day that the section 482 

regulations were issued, the Internal Revenue Service issued 

Revenue Procedure 68-22, which provides that taxpayers may 

use the guidelines set forth in Revenue Procedure 63-10 if 

the result would be more favorable to the taxpayer than the 

section 482 regulations. 

Since 1963, a number of U.S. parent corporations have 

transferred intangibles to their possessions subsidiaries 

under section 351. In computing the proper arm's-length 

price for sales of goods from a possessions corporation to 

its U.S. parent, the parent corporations have in some cases 

asserted that the possessions subsidiaries are entitled to 

all of the return on the intangibles. The Internal Revenue 

Service has contested the claimed allocation of the income 

attributable to the transferred intangibles to the 

possessions corporations, and has attempted to utilize 

section 482 to reallocate that return to the parent 

corporations. 

In Technical Advice Memorandum 8040019, issued in July 

1980, the Internal Revenue Service took the position, under 

the particular facts involved, that even though the parent 

corporation had taken all steps to legally transfer 

intangibles to its affiliated possessions corporation, the 

intangibles would not be treated as "belonging" to the 

possessions affiliate. The Service decided that the 

transfer lacked substance and was motivated solely by tax 

avoidance and that section 482 would be applied to 

reallocate all of the income produced by the intangibles to 

the parent corporation. In issuing this finding, the 

Internal Revenue Service noted that, subsequent to the 

transfer, the U.S. parent corporation continued to perform 

the same promotional, marketing, and supervisory activities, 

and also continued to conduct further research with respect 

to the patented and trademarked product. 

The effect of the position enunciated in the Technical 

Advice Memorandum was to reallocate income to the parent and 

thereby reduce the income eligible for tax exemption under 

section 936. In many instances, U.S. corporations have 

taken the position that the Internal Revenue Service actions 

are inconsistent with the law and with Revenue Procedure 

63-10; three cases concerning the transfer of intangibles 

are presently before the United States Tax Court. 
-20-

The 1980 Technical Advice Memorandum and the ongoing 

litigation have highlighted the uncertainty of the law in 

this area and may have discouraged U.S. investment in Puerto 

Rico. The chart below shows that the number of manufacturing plants beginning operations in Puerto Rico .was 

roughly constant between Puerto Rico's fiscal year ending 

June 30, 1979 and fiscal year 1982. However, there was a 

sharp drop after fiscal year 1980 in the number of new 

contractual agreements reached between the Puerto Rico 

Economic Development Administration and potential investors. 

Number of Manufacturing : Fiscal Year 

Plant Start-ups and New : 1978 1979 1980 1981 1982 Tax Exemption Agreements: 

Manufacturing plant 

start-ups 105 114 110 117 118 

Non-local investors 59 71 65 65 58 

Local investors 46 43 45 53 60 

Contractual agreements 

reached between the 

Puerto Rican Economic 

Development Administration and potential 

investors * 196 189 215 170 182 

Non-local investors 116 112 136 83 97 

Local investors 80 77 79 87 85 

Source: Puerto Rico Economic Development Administration 

* Includes agreements reached with respect to expansions 

and changes of ownership of existing plants. · Does not 

include conversions of 100 percent tax-exemption grants 

to partial tax-exemption grants under the Puerto Rican 

Industrial Incentive Act of 1978. 

E. Treatment of Income from Intangibles under the Tax 

Equity and Fiscal Responsibility Act of 1982. In order to 

limit abuses under section 936 _!l/, Congress in 1982 amended 

_!l! See Joint Committee on Taxation, General Explanation of 

!~~-~~~~~~e Provisions of the Tax ~uity and Fiscal 

Respons1b1l1ty Act of 1982, December 1982, pp. 81-83. 
-21-

section 936 to provide detailed rules for the allocation of 

intangibles income between -a possessions corporation and its 

affiliates. The Tax Equity and Fiscal Responsibility Act 

(TEFRA) adds a new section 936(h) to the Code providing, as 

a general rule, that income from intangibles is taxable to 

the U.S. shareholders of the possessions corporation. U.S. 

corporations may elect out of the general rule and choose 

between two options for allocating income to a possessions 

corporation. These two options are a "cost-sharing" option 

and a "50/50 profit split" option. Once an election to use 

either the cost-sharing or profit-split option is made, it 

will be binding unless the consent of the Commissioner of 

the Internal Revenue Service to revoke the election is 

obtained. 

1. Cost-sharing Option under TEFRA. If a possessions corporation shares, through a cost-sharing payment, in 

the annual product area research expenditures of its affiliates, it will be deemed to own manufacturing intangibles 

related to the product or service which it produces, in 

whole or in part, in a possession. The possessions corporation will be entitled to the full return · on these manufacturing intangibles. The applicable income allocation 

methods provided under section 482 will be utilized for this 

purpose. The possessions corporation cannot claim a return 

on marketing intangibles, such as trademarks, trade names, 

and brand names, under this election. The cost-sharing 

payment will be a fraction of the current year's worldwide 

direct and indirect product area research expenditures of 

the corporations affiliated with the possessions corporation. The fraction will be equal to the same proportion of 

the product area research expenditures which the gross 

receipts from sales of the product produced, in whole or in 

part, in the possess ion bears to the gross receipts from 

sales of all products in the product area by the possessions 

corporation and all affiliated companies. 

2. 50/50 Split of Combined Taxable Income under 

TEFRA. This election provides a 50/50 split of the combined 

taxable income of the possessions corporation and all U.S. 

affiliates with respect to a product or service produced, in 

whole or in part, in a possession. Fifty percent of such 

profit would be allocated to the possessions corporation. 

The remainder of the combined taxable income would be 

allocated to its U.S. affiliates. 

For purposes of computing the combined taxable income, 

all direct and indirect expenses relating to the product, 

including research and marketing expenses, will be taken 
-22-

into account. The amount of research expenditures which 

wi 11 be allocated to the product wi 11 be the greater of 

allocable research expenditures or the cost-sharing amount 

described in Option 1. 

3. Eligibility. To be eligible to elect either of 

these options with respect to a product produced, in whole 

or in part, in a possession, a possessions corporation must 

perform a significant portion of the manufacturing activity 

with respect to that product, as follows: 

o The possessions corporation must incur production 

costs (other than the cost of materials) with 

respect to the product which are not less than 25 

percent of the difference between (a) the gross 

receipts from sales of the product to unrelated 

parties by the possessions corporation or its 

affiliates, and (b) the direct costs of materials 

purchased by the possessions corporation or its 

affiliates from unrelated parties in connection with 

the manufacture of the product. This test is 

equivalent to . a 25 percent value-added requirement. 

o Alternatively, the possessions corporation must 

incur, for labor services performed in the 

possession, at least 65 percent of the total labor 

costs incurred by the possessions corporation and 

its affiliates in producing the product or service 

during the taxable year. 

o In addition, to be eligible to elect the "50/50 

profit split" option, the possessions corporation 

must substantially transform the materials it 

purchases from other parties. The substantial 

transformation test cannot be met by mere packaging, 

labelling, or minor assembly operations. 

These business presence tests need not be met until 1986 in 

the case of a product or service which was produced by a 

possessions corporation as of August 17, 1982. 

4. Other Changes under TEFRA in the Tax Treatment 

of Possessions Corporations. In addition to the new 

gu1delines-on-the-a1Tocat1on of income from intangibles, 

TEFRA made the following additional changes in the 

possessions corporation system of taxation: 
-23-

o Passive Income Limitation. The Act raises from 50 

to 65 percent the share of its gross income that a 

corporation must derive from the active conduct of a 

possessions trade or business in order to qualify 

for the section 936 credit. This increase is phased 

in so that the percentage rises to 55 percent for 

taxable years beginning in 1983, and to 60 percent 

for taxable beginning in 1984. As under prior law, 

the gross income test must be met for the three-year 

period immediately preceding the close of the 

taxable year. The greater level of required active 

business income will mean that less passive 

investment income can be earned by a corporation 

still wishing to qualify for effective tax exemption 

under section 936. 

o Transfers of Intangibles by Possessions CorporaITons.--TheAct generaTfYsUbjectsto"-tax transfers 

of intangibles abroad by a possessions corporation 

or a former possessions corporation. Under prior 

law, such a transfer would, in many instances, not 

have been subject to tax if, for example, the 

intangible was related to a product manufactured by 

a foreign corporation and sold abroad for final 

consumption outside the United States. 

II. Puerto Rican Tax Provisions 

A. Historical Background. The modern history of 

industrial tax exemption in Puerto Rico begins with the 

Industrial Tax Exemption Act of 1948. Prior to that year, 

Puerto Rico's development strategy stressed government 

ownership and operation of key industries, such as cement, 

glass, paperboard, and shoes. When the financial burden of 

such a program was recognized, Puerto Rico shifted the 

emphasis to private enterprise. .Tax exemption became the 

keystone of an industrial incentive program that also 

included providing plants at low rents, cash grants to cover 

start-up costs, and low interest loans. 

The Industrial Tax Exemption Act of 1948 offered qualified manufacturing firms and hotels exemption from tax on 

their operating income, property, and gross receipts. To 

qualify for exemption, a manufacturing firm had to produce 

an item which was not produced on a commercial scale in 

Puerto Rico prior to 1947, or certain other specified items, 

including wearing apparel and processed food products. In 

other legislation enacted in 1948, Puerto Rico exempted from 

~xcise tax all raw materials, machinery, and equipment used 

~n manufacturing for export or sold to other manufacturers 

in Puerto Rico. 
-24-

In the early 1950s, many manufacturing firms established 

plants in Puerto Rico to benefit from the tax holiday. 

Apparel was the fastest growing industry, but shoes and 

other leather goods and assembly of mechanical, electrical, 

and electronic devices were also important. Originally, 

Puerto Rico contemplated that the period of total e~emption 

would end in 1959, with the amount of exempt income falling 

to 75 percent, 50 percent, and 25 percent in 1959, 1960, and 

1961, respectively. All exemptions were to end in 1962. 

However, by 1954, the provisions for a 1959-1961 phase-out 

had reduced the incentive for new industries to establish 

operations in Puerto Rico, and the Industrial Tax Exemption 

Act was amended. 

The 1954 Act provided for a 10-year exemption for new 

applicants. Because some of the established firms in Puerto 

Rico were approaching the end of their tax holidays, but a 

new applicant could qualify for a ten-iear exemption, the 

1954 Act sought to limit the ability of an old firm to obtain a new grant. If a firm received a new grant of exemption for a product produced under an old grant, the new 

grant would be terminated if the level of output in the 

predecessor operation was reduced. In addition, plant, 

equipment, and other property that had been used in the 

production of an exempted product could not be used by 

another enterprise to produce a similar exempt product. 

Both prohibitions were weakened in 1959, and the Governor 

had the power to waive them if he deemed it to be in the 

public interest. 

Puerto Rico adopted a third tax exemption act in 1963, 

which authorized exemptions for 10, 12, 15, 17, or 25 years, 

depending on the degree of economic development of the zone 

in which the plant was located. (The number of zones was 

subsequently reduced, and the maximum exemption period was 

increased to 30 years.) In addition, a company could elect 

partial exemption for up to twice the length of the original 

grant. It could also postpone the start of the exemption 

period for up to four and a half years after its first 

payroll, which permitted it to save the exemption for 

profitable years rather than wasting it during a period of 

start-up losses. 

In 1973 and 1974, the Puerto Rican economy entered into 

recession, and the government experienced difficulty 

financing a large unexpected deficit. To encourage 

possessions corporations to reinvest a larger portion of 

their earnings in the Commonwealth, Puerto Rico added 
-25-

section 2(j) to the exemption laws of 1954 and 1963, 

extending the benefits of tax exemption to interest, rents 

and dividends earned on funds derived from tax-exempt 

manufacturing operations that were reinvested in specified 

eligible assets, principal among which were certificates of 

deposits in qualifying banking institutions. Banks 

receiving these tax-exempt deposits were in turn required to 

reinvest such funds in Puerto Rican government obligations 

and loans to Puerto Rican businesses. 

Under pre-1976 law, Puerto Rico imposed a "tollgate" tax 

on dividends distributed by an exempt company to a parent 

outside of Puerto Rico, provided that the parent was able to 

claim a foreign tax credit for the tax. But since such 

dividends were fully taxable to the parent under U.S. law in 

effect until 1976, whereas a liquidating distribution was 

free of both U.S. and Puerto Rican tax, possessions 

corporations did not ordinarily pay dividends, and the 

existence of the Puerto Rican tollgate tax was of largely 

academic interest. In the Tax Reform Act of 1976, described 

above, Congress allowed U.S. parent companies a dividendsreceived deduction, but denied a foreign tax credit for 

Puerto Rican or other taxes imposed on the dividends. Under 

pre-1976 Puerto Rican law, the denial of the foreign tax 

credit would have exempted the dividend from the tollgate 

tax. However, Puerto Rico at this time eliminated the 

exemption from the tollgate tax for dividends paid to 

"nonresident" U.S. corporations. 14/ As a result, the 

tax-free repatriation of dividends which possessions 

corporations expected to be able to make after the passage 

of the Tax Reform Act of 1976 did not take place. 

B. Present System. In 1977, the Governor of Puerto 

Rico appointed a commission to study the industrial tax 

exemption program. Out of that commission's work came the 

Industrial Incentives Act of 1978. This Act reduced the 

rate of tollgate tax on dividends paid by tax-exempt firms 

provided that they reinvested specified portions of their 

earnings in designated Puerto Rican assets. The 1978 Act 

also replaced 100 percent tax exemption for new firms with 

.!_!/ Puerto Rican tax law makes a distinction between "resident" and "nonresident" firms. Firms that are organized 

outside of Puerto Rico but conduct a business in Puerto 

Rico are classed as resident; those that have no such 

business are non-residents. 
-26-

partial exemption of income from manufacturing operations. 

The Act did not change former tax exemption commitments, but 

it provided incentives to firms operating under "old" full 

tax exemption commitments to "convert" to partial tax 

exemption under the 1978 Act. 

This section discusses, in turn, Puerto Rican taxation 

of non-exempt corporations, taxation under an old (pre-1978) 

exemption contract, taxation under a "converted" exemption 

contract, and taxation under a new exemption contract. 

1. Taxation of Non-Exempt Corporations. Although 

section 936 manufacturing corporations operating in Puerto 

Rico normally hold an exemption contract, nonmanufacturing 

corporations generally do not qualify for an exemption. 

Puerto Rico's authority to enact its own income tax 

system derives from the Organic Act of 1917, known as the 

Jones Act. In 1954, the legislature adopted its present 

income tax system, based on the U.S. Internal Revenue Code 

of 1939. In the absence of a tax exemption grant, Puerto 

Rico taxes all Puerto Rican source income earned by U.S. and 

foreign persons (including corporations), and taxes the 

worldwide income of all Puerto Rican residents and 

corporations. Corporate income tax rates are graduated, 

ranging from 22 percent for taxable income under $25,000, to 

45 percent for taxable income in excess of $300,000. Gross 

income and allowable deductions are defined in much the same 

way as under the U.S. In terna 1 Revenue Code. However, the 

Puerto Rican code contains a "flexible depreciation" 

provision which permits taxpayers to recover the cost of 

"qualifying property" in any taxable year or years chosen by 

the taxpayer, up to a limit of 50 percent of net income, 

without regard to the useful 1 ife of the property. Generally, property acquired for use in agriculture, 

construction, manufacturing, hotels, or shipping qualifies 

for flexible depreciation. 

Dividends paid out of Puerto Rican source earnings and 

profits to a U.S. parent corporation are subject to Puerto 

Rican tax. The method of taxing dividends depends on 

whether the parent corporation itself is engaged in a trade 

or business in Puerto Rico. If it is, the parent 

corporation is a "resident" of Puerto Rico subject to the 

ordinary corporate tax. The dividend income will, however, 

qualify for an 85 percent dividends-received deduction, 

thereby reducing the effective tax rate to a maximum of 6.75 

percent (i.e., 15 percent of 45 percent), if the payor of 

the dividend is a Puerto Rican corporation. If the parent 

corporation is a "nonresident" of Puerto Rico, the dividend 
-27-

will generally be subject to a 25 percent tollgate tax 

withheld at source. The rate of tollgate tax will be 

reduced to 10 percent if the dividend is paid out of income 

derived from the operation of a hotel, manufacturing, or 

shipping business. Upon liquidation, a 29 percent tollgate 

tax applies to any Puerto Rican source gain received by a 

parent corporation which is not a "resident" of Puerto Rico. 

2. Taxation under an Old Exemption Grant. In 

general, a firm which has a tax exemption grant under the 

1963 Industrial Incentive Act 15/ is 100 percent exempt from 

tax on business income and investment income from certain 

designated assets (see below). This tax-exempt income is 

called Industrial Development Income. The firm is also 100 

percent exempt from property and gross receipts taxes. The 

duration of the tax exemption grant, which depends on the 

municipality of Puerto Rico in which the firm locates its 

plant, ranges from 10 to 30 years. 

The assets which give rise to tax-exempt investment 

income -- generally known as 2{j) assets -- include Puerto 

Rican government bonds, loans for the construction of 

buildings or acquisition of equipment used by a tax-exempt 

business, mortgages insured by thePuerto Rican Housing Bank 

and Finance Agency, and certificates of deposit in certain 

banks doing business in Puerto Rico. Banks receiving these 

tax-exempt deposits are required to reinvest the funds 

within Puerto Rico, although this requirement was not 

strictly enforced until 1980 • .!.§./ 

Dividends paid out of Industrial Development Income to 

"nonresident" U.S. parent corporations are subject to a 10 

percent tollgate tax. However, the rate is reduced where 

the tax-exempt firm meets certain investment and 

disbursement conditions. These conditions and rules, 

summarized below, apply not only to firms with pre-1978 

exemption grants, but also to firms with grants issued under 

the 1978 Industrial Incentives Act: 

_!21 As of Apr i 1 1 9 8 0 , approx i mate 1 y 2 10 corpora t i on s , not 

all of them 936s, enjoyed partial tax exemption under 

the 1963 Act. These represented about 10 percent of all 

grants still in effect under that Act. 

!.§_/ Puerto Rican regulations which were in effect through 

March 31, 1980, permitted banks to "warehouse" 936 

deposits outside Puerto Rico for up to six months. 

Puerto Rican rules regarding tax-exempt financial 

investments are explained in Chapter 4, below. 
-28-

Dividends paid out of accumulated Puerto Rican 

source Industrial Development Income earned in tax 

years beginning before October 1, 1976, are subject 

to a tollgate tax of 7 percent, rather than 10 

percent, if no more than 25 percent of the balance 

at the beginning of any year is paid out and a 

matching 25 percent is reinvested for 12 months in 

Puerto Rico. 

Dividends paid out of Puerto Rican source Industrial 

Development Income earned in tax years beginning 

after September 30, 1976, are subject to a tollgate 

tax of 7 percent, rather than 10 percent, if no more 

than 75 percent of a given year's income is paid out 

and if at least 25 percent of such income is reinvested in Puerto Rico for a period of more than 

eight years. 

Dividends paid out of interest on government obligations are exempt from tollgate tax. If the government obligation is held for at least eight years, 

the principal may also be distributed exempt from 

tollgate tax. 

A credit equal to 3 percent of new investment (made 

subsequent to the later of March 31, 1977, or the 

second year of tax exemption) in buildings and other 

structures used in manufacturing is allowed against 

the tollgate tax. 

On liquidation, a firm with an old tax exemption grant 

may distribute all accumulated earnings free of the tollgate 

tax. 

3. Taxation Under an Old Exemption Grant "Converted" to the 1978 Industrial Incentives Act. The 1978 

Industrial Incentives Act does not affect the terms of 

grants or petitions for tax exemption which were made before 

June 1978, but it provides opportunities to firms operating 

under old tax exemption grants to convert to partial tax 

exemption under the new Act. The election to convert had to 

be made by December 31, 1979, and two optional conversion 

plans were available: 

Option One. During the years remaini'1g until the 

end of t;he existing grant, the exempted business will 

pay a maximum effective rate of tax from 3 percent to 12 

percent of income, with the higher rate applicable to a 

firm which has fewer years left on its original grant, 

as follows: 
-29-

Years Left on Exemption Maximum Effective 

Original Grant Percentages Tax Rate 

0-4 years 73.3% 12.0% 

5-8 years 77.7 10.0 

9-12 years 85.5 6.5 

13-16 years 90.0 4.5 

17-20 years 91.0 4.0 

More than 20 years 93.3 3.0 

After the period of original exemption has expired, the 

firm electing this option is automatically entitled to 

operate partially exempt from taxation for ten more 

years. During the first five of those ten years, 50 

percent of income wi 11 be exempt. During the second 

five years, between 35 percent and 50 percent will be 

exempt, depending on the location of the plant. 

Option Two. A company with six or more years 

remaining on its current tax exemption may make an 

alternative election. It may exclude 90 percent of its 

income from taxation, and credit two thirds of the corporate income taxes actually paid against the tollgate 

tax on dividends paid from current earnings. A company 

that elects that second option may apply for a ten-year 

extension when the current grant expires, but the 

extension is not automatic. 

As a further inducement to firms to convert to partial 

tax exemption, the 1978 Act provides that under either 

conversion option, a firm may credit tollgate taxes paid on 

distributions from pre-1978 earnings against the income 

taxes due in future years, up to 50 percent of such 

liability in any given year. In addition, dividend payments 

by "converted" firms may benefit from a reduced tollgate tax 

rate, as follows: 

Pre-1973 earnings may be distributed subject to a 4 

percent tollgate tax, provided that only 50 percent 

of such amounts are distributed in a given year, and 

not more than 10 percent of such earnings are 

distributed in each of the succeeding five years. 
- - -

-30-

Dividends paid out of income earned after 1972, but 

before 1980, are subject to a tollgate tax of 4 or 5 

percent (depending upon the year in which the income 

was earned), provided that (a) 50 percent of such 

income is invested for five years in the firm's own 

capital assets 17/ or in assets designated in sect i on 2 ( j ) of Puerto R i co ' s tax exempt i on ·acts 18 I 

and (b) not more than 10 percent of such earnings 

are distributed in each of the succeeding five 

years. 

On liquidation, pre-1978 earnings of "converted" firms 

are exempt from tollgate tax. 

4. Taxation under a New Exemption Grant. New 

grants issued-underthe-I978TndustrTar-rncentives Act 

provide 90 percent exemption from income and property tax in 

the first five years of a firm's operation,· and a gradually 

decreasing rate of exemption during each subsequent fiveyear period until the expiration of the grant, as follows: 

Percentage of Effective Tax Rate on 

Years of Exemption from Income Income Derived from 

Exemption Manufacturing 19/ 

and Property Tax Minimum Maximum 

1-5 90% 2.20% 4.50% 

6-10 75 5.50 11. 25 

11-15 65 8.75 15.75 

16-20 55 9.90 20.25 

21-25 50 11. 00 22.50 

.!_21 These are defined as investments made for the acquisition of plant or equipment used in manufacturing, or the 

payment of the outstanding principal of a debt incurred 

for the acquisition of such property (Industrial 

Incentives Act of 1978, section 4 (h) (1)). 

~/ Section 2(j) assets are listed in Section III of Chapter 

4, below. 

_!11 The minimum and maximum tax rates during a given fiveyear period are computed on the basis of the statutory 

tax rates, which vary from 2 2 percent to 4 5 percent 

depending on the firm's income. 

~ 
-31-

The duration of a firm ' s grant w i 11 vary fr om 10 to 2 5 

years, depending upon the location of its plant. 

The actual effective tax rates will be somewhat lower 

than those shown because of two additional incentives provided by the 1978 Act to encourage labor-intensive 

operations and assist small firms. All grants issued under 

the new Act allow the firm to deduct five percent of production worker payroll from its manufacturing income, up to 

50 percent of such income. As an alternative to the payroll 

deduction, a firm whose profits are less than $500,000 in 

any given year is allowed a 100 percent tax exemption on the 

first $100,000 of income. 

If a tax-exempt firm reinvests all or part of its 

earnings in Puerto Rican 2(j) assets, then the dividends, 

interest, and rents derived from those assets wi 11 be 100 

percent exempt from income tax. The intent of the tax 

exemption for 2{j) earnings is to induce 936 corporations to 

reinvest their business earnings in Puerto Rico. However, 

the main incentive to a firm to retain its earnings in the 

Commonwealth arises from the tollgate tax provisions of the 

new Industrial Incentives Act, as follows: 

Dividends paid out of income earned by a tax-exempt 

business are subject to a tollgate tax of 5 percent, 

provided that {a) 50 percent of such income is 

invested for five years in 2(j) assets or in the 

firm's own capital assets, and (b) not more than 10 

percent of the net income is distributed in each of 

the succeeding five years. The 50 percent of income 

reinvested during this period can be repatriated 

after the fifth year. 

On liquidation, undistributed earnings are subject 

to a tollgate tax of 4 percent, rather than 10 percent, provided that 50 percent of such earnings have 

been invested in the firm's own capital assets or in 

2(j) assets for a period of at least five years. 
-32-

Chapter 3 

ECONOMIC DEVELOPMENT IN PUERTO RICO 

Puerto Rico is a small, crowded island with few -natural 

resources. It shares a very close economic and political 

interdependence with the United States. Puerto Rico and the 

United States have a common currency and common external 

tariffs. There are no barriers to the free flow of goods, 

labor, or capital between the two economies. Most non-local 

sales of Puerto Rican goods are to the United States, and 

most goods which enter the island are from the United 

States. Nearly all investments in Puerto Rico by non-Puerto 

Rican firms have been made by U.S. companies. Federal 

statutes other than the internal revenue laws generally 

apply to Puerto Rico, some (such as the minimum wage legislation) with large economic impacts. Most Federal grant 

programs for State and local governments and most Federal 

income maintenance programs for individuals also apply to 

Puerto Rico. Residents of Puerto Rico participate fully in 

the Social Security and Unemployment Insurance programs. 

However, Puerto Rico, unlike the States, administers 

nutritional assistance (such as Food Stamps) under a block 

grant. In addition, the Federal contribution to Puerto 

Rico's program of Aid to Families with Dependent Children is 

subject to a ceiling, whereas Federal contributions to such 

programs in the States are not capped. 

All of the ties between Puerto Rico and the United 

States have helped shape the push for Puerto Rican industrial development that began in 1948. This chapter briefly 

surveys Puerto Rican economic growth since 1948, and the 

impact of the combined U.S. and Commonwealth tax exemptions 

in shaping that growth. 

The recent history of Puerto Rican economic development 

can be roughly divided into two periods. In the period 

1948-1972, there was a sustained rise in private investment 

which created a modern manufacturing sector. GNP and GNP 

per capita grew rapidly. In the period 1973-1981, however, 

Puerto Rican economic progress slowed. Average annual 

growth in employment in the manufacturing sector fell from 

4.4 percent in the years 1950-1972, to 1.1 percent in the 

post-1972 period, as the loss of jobs in low-technology 

industries offset much of the job increases in hightechnology industries. GNP fell sharply during the 1974-76 

recession, and despite a recovery in GNP growth, GNP per 
-33-

capita has changed little since 1974. Private investment in 

plant and equipment in 1977 (excluding private refinery construction) was only 72 percent of the peak reached in 1973; 

between 1977 and 1981, it has remained roughly constant. 

In part, the decline in Puerto Rico's economic performance is traceable to the U.S. economy, which was in recession in 1974-75 and has not grown rapidly since. Puerto 

Rican growth has also been reduced by the gradual erosion of 

the U.S.-Puerto Rican wage differential, U.S. tariff and tax 

cuts, and structural changes in the world economy. These 

developments have reduced Puerto Rico's competitiveness as a 

location for U.S. manufacturing investment. 

I. Growth Since 1948 !/ 

Puerto Rico's economic growth in the two decades after 

1948 has often been called an "economic miracle." As 

demonstrated in Figure I and Table 3-1, Puerto Rican GNP 

(expressed in constant 1972 dollars) increased at an average 

annual rate of 5.3 percent in the 1950s, and 7.0 percent in 

the 1960s. Table 3-1 also shows that emigration from Puerto 

Rico was substantial in this 20-year period, presumably in 

response to the introduction of cheap air fares and the slow· 

growth in employment opportunities in Puerto Rico relative 

to the U.S. mainland. 2/ Emigration averag~d nearly 50,000 

persons per year from l950 to 1960 (or about 2 percent of 

total population), and 20,000 per year in the following 

decade (or under 1 percent of total population). Per capita 

GNP, which reflects the emigration from Puerto Rico, rose at 

an average annual rate of 4.7 percent in the 1950s and 5.5 

percent in the 1960s. By any historical or international 

yardstick, the growth in total and per capita GNP was 

remarkable • . ~/ 

!/ Throughout this chapter, unless otherwise noted, years 

are Puerto Rican fiscal years; e.g., 1972 means the 

twelve months ending June 30, 1972. 

~/ Historical employment figures for Puerto Rico are shown 

in Table 3-2. Between 1950 and 1970, total employment 

grew by 15 percent in Puerto Rico, compared to a 35 

percent increase in ci vi 1 ian employment in the United 

States. 

ll Over the same 20 years, real GNP in the United States 

grew at an annual rate of 3.7 percent, and real GNP per 

capita at a rate of 2.2 percent. 
-34-

FIGURE I 

Total and Per Capita Gross National Product of Puerto Rico, 

1947-1981 (Constant 1972 Dollars) 

$Millions 

9,000 

8,000 

7,000 

6,000 

5,000 

4,000 

3,000 

2,000 .. ••• ............ .... 

1,000 

... 

•• •• •• • 

... ••• 

•• •• •• 

Per Capita 

(right scale) 

........... •• 

.... 

Dollars 

2,800 

2,600 

2,400 

2,200 

2,000 

1,800 

1,600 

1,400 

1,200 

1,000 

800 

600 

1947 '48 '50 '52 '54 '56 '58 '60 '62 '64 '66 '68 '70 '72 '74 '76 '78 '80 
-35-

Table 3-1 

Total and Per Capita Gross National Product of Puerto Rico, 

and Net Migration of the Resident Population 

1947-1981 

GNP GNP per Fiscal Year (millions) capita 1/ 

(constant 1972 dollars) 

1947 1,256.0 584 

1948 1,304.1 600 

1949 1,457.7 665 

1950 1,564.8 709 

1951 1,647.2 740 

1952 1,809.l 811 

1953 1,925.6 869 

1954 1,966.7 890 

1955 2,027.4 908 

1956 2,111.5 938 

1957 2,175.8 965 

1958 2,240.9 983 

1959 2,428.3 1,051 

1960 2,623.4 1,121 

1961 2,783.0 1,169 

1962 2,998.7 1,237 

1963 3,242.3 1,312 

1964 3,452.7 1,368 

1965 3,738.2 1,453 

1966 3,990.0 1,529 

1967 4,165.9 1,582 

1968 4,372.3 1,646 

1969 4,779.6 1,775 

1970 5,166.7 1,901 

1971 5,477.0 1,997 

1972 5,726.8 2,031 

1973 6,144.2 2,144 

1974 6,221.3 2,162 

1975 6,094.4 2,094 

1976 6,221.9 2 ,092 

1977 6,503.2 2,139 

1978 6,814.7 2,205 

1979 7,216.2 2,304 

1980 7,383.1 2,324 

1981 7,432.3 2,307 

!/ Based on population as of January 1. 

Estimated Net Migration of the Total Resident Population of 

Puerto Rico 

April 1, 1950-March 31, 1960 

July 1, 1960-June 30, 1970 

July 1, 1970-June 30, 1980 

July 1, 1980-June 30, 1982 

Amount 1/ 

-493,000 

-201,000 

-70,000 

-43,757 

Annual Rate 2/ 

-2.19 

-.79 

-.28 

-.67 

!/ Estimated from intercensal population change, births, and 

deaths. 

~/ Per 100 mid-period population. 

Source: Puerto Rico Planning Board, Economic Report to the 

Governor, 1980-1981, Table l; U.S. Bureau of the Census, 

Current Population Reports, Series P-25, Nos. 80, 336, 

and Puerto Rico Planning Board. 
-36-

A number of factors contributed to Puerto Rico's 

economic growth in the two decades after 1948. Exemptions 

from local taxes played a key role in inducing U.S. firms to 

locate plants in Puerto Rico. U.S. manufacturers found 

Puerto Rico attractive because of low-cost Puerto Rican 

labor. Puerto Rico also had the advantage, compared to lowwage foreign countries, that it was inside the U.S. tariff 

wall and offered a more stable political and economic 

climate than countries in Latin America or the Far East. As 

shown in Table 3-2, Puerto Rico gained 77,000 jobs in 

manufacturing industries and 49,000 jobs in construction in 

the period 1950-1970. Although the growth in manufacturing 

and construction jobs was not strong enough to off set the 

decline in agriculture, the overall unemployment rate fell 

as Puerto Ricans emigrated to the mainland and as new jobs 

opened up in the Puerto Rican government, trade, and 

services sectors. By 1970, unemployment had reached its 

lowest level in the post-war period, at 10.7 percent. 

In the period 1974-1975 and again in 1981-82, the Puerto 

Rican economy was adversely affected by the recessi9n of the 

U.S. economy and high U.S. interest rates. The Puerto Rican 

economy was in recession in 1974-1976, grew by an average 

annual rate of 5 .1 percent between 1976 and 1979, and has 

experienced slower growth since then. Real GNP grew by 2.3 

percent in 1980, and 0. 7 percent in 1981. Real GNP per 

capita has also increased since 1976, though by a lesser 

amount, as a result of natural population growth in excess 

of the net migration of Puerto Ricans from the island. GNP 

per capita grew by an average annual rate of 2.7 percent . in 

the 1976-1980 period, and fell by 0.7 percent in 1981. 

Unemployment has continued to be a problem in Puerto 

Rico. Table 3-2 shows that unemployment, after declining 

through the 1960s to just over 10 percent of the measured 

labor force, has been 17 percent or higher since 1975. With 

the current U.S. recession and the elimination in U.S. 

fiscal year 1981 of 21,173 public service jobs in Puerto 

Rico financed through the Federal Comprehensive Employment 

and Training Program (CETA), unemployment rose to 24.1 

percent in August 1982. 

II. Investment in Puerto Rico 

The basic goal of any economic development program is to 

increase real income per capita. As indicated in the 

preceding section, Puerto Rico's development program was 
Table 3-2 

Puerto Rican Unanployrnent Rate and Distribution of Employment in Selected Years, 1950 - 1981 

(in thousands) 

Unanploy- Total Govern- Total Non- Agricul- Manufac- Hane Construe- Wholesale Finance, TransportaYear ment Employ- ment .Y Government Needle- and Retail Insurance, tion and Other 

Rate ment Employment tu re turing work ti on Trade Real Estate Utilities Services 

1950 12.9% 596 45 551 214 55 51 27 90 3 28 77 

1955 14.3 539 50 489 164 66 29 34 89 n.a. n.a. 69 

1960 13.l 543 62 481 124 81 10 45 97 6 39 75 

1965 11. 7 617 82 535 107 106 6 56 109 n.a. n.a. 103 

1970 10.7 686 106 580 68 132 * 76 128 13 45 116 

1971 11.6 700 111 589 61 132 * 81 134 15 47 117 

1972 11.9 737 131 606 58 141 * 79 135 16 49 126 

1973 11.6 757 143 614 49 142 * 80 146 18 50 127 

1974 13.2 775 147 628 53 147 * 79 148 18 54 128 

1975 18.l 738 151 587 49 137 * 69 141 18 49 128 

1976 19.5 718 158 560 46 133 * 53 ' 140 18 46 121 

1977 19.9 739 168 571 41 144 * 43 145 19 49 127 

1978 18.1 780 180 600 40 156 * 44 149 21 49 138 

1979 17.0 807 190 618 38 160 * 49 155 21 50 142 

1980 17.1 827 202 625 43 157 * 49 152 23 52 149 I 

1981 19.9 833 203 630 41 155 * 49 155 25 53 150 w 

.....J 

I 

Annual growth rate 

1950-1960 -1.0% 3.3% -1.3% -5.3% 3.9% -15.0% 5.2% 0.8% 7.2% 3.4% -0.3% 

Annual growth rate 

1960-1970 2.4 5.5 1.9 -5.8 5.0 5.4 2.8 8.0 1.4 4.5 

Annual growth rate 

1970-1981 1.8 6.1 0.8 -4.5 1.5 -1.9 1.8 6.1 1.5 2.4 

Office of the Secretary 

Office of Tax Analysis 

1/ Includes only public administration. 

* Less than 2,000 

n.a. - not available 

Sources: Puerto Rico Planning Board, Economic Report to the Governor, 1980-1981, Table 24; Puerto Rico Developnent Administration, 

Economic Analysis of the Industrial Incentive Program of Puerto Rico, 1978; Institute of International Law and Economic 

Developnent, Puerto Rico Industrial Sector Study, Draft Report for the U.S. Department of Comnerce, April 1978. 
-38-

very successful in achieving this goal through the early 

1970s. Physical investment leads to an increase in income 

in two ways: by providing the necessary capital to create 

new, more productive jobs; and by increasing the productivity of those currently employed. 4/ In Puerto Rico, with 

traditionally high rates of unemployment, providing the 

necessary capital for new entrants to the labor force is 

particularly important. This fact was recognized by 

Congress in 1976. In explaining the reason for retaining 

the possessions corporation system, Congress stated that it 

wanted to "assist the U.S. possessions in obtaining 

employment-producing investments by U.S. corporations ••• "~/ 

Components of physical investment in Puerto Rico are 

illustrated in Figure II and Table 3-3 for the years 

1960-1981. Private refinery construction is excluded from 

the total because the boom in this industry between ·1970 and 

1972 was based on the large allocation to Puerto Rico of 

U.S. quotas for imported oil (which before 1973 was cheaper 

than domestic oil) rather than on low wages, locational 

advantages, or other real factors. The OPEC increase in the 

price of oil in 1973 and the consequent termination of the 

Federal quota system eliminated Puerto Rico's previous 

advantage. In March 1979, the Commonwealth Oil Refining 

Company (CORCO), the principal oil refiner and the largest 

private corporation in Puerto Rico, filed for protection 

under Federal bankruptcy laws. Private refinery construction accounted from almost one-third of total private 

investment in plant and equipment between 1970 and 1972, but 

represented only about 4 percent of the total in 1973 and 

most later years. 

It is clear from Figure II and Table 3-3 that total and 

private investment (expressed in constant 1972 dollars) grew 

rapidly in the period 1960-73, but dropped off during the 

1974-76 recession and again in the late 1970s. Annual 

private investment in industrial and commercial buildings, 

excluding refinery construction, rose from $212 mi 11 ion in 

1960 to $604 million in 1973, and then fell well below $500 

million in each year after 1975. Annual private investment 

in machinery and equipment exceeded $400 million in the 

!/ A second major contributor to economic growth is investment in human capital the formal education and 

on-the-job training of the labor force. 

~/ Joint Committee on Taxation, General Explanation of the 

Tax Reform Act of 1976, p. 274. 
-39-

FIGURE II 

Components of Real Investment in Puerto Rico, 1960-1981 

(Constant 1972 Dollars) 

$Millions 

600 

500 

400 

300 

200 

100 

0 

1960 

600 

500 

400 

300 

200 

100 

0 

1960 

600 

500 

400 

300 

200 

100 

0 

1960 

65 

65 

65 

Industrial and Commercial Buildings, Private Enterprises 

70 

70 

70 

75 

Excluding private 

refinery construction ~ 

80 85 

Machinery and Equipment, Private Enterprises 

75 80 85 

Change in Inventories 

75 80 85 
-40-

FIG URE II, Continued 

Components of Real Investment in Puerto Rico, 1960-1981 

(Constant 1972 Dollars) 

$Millions 

600 

500 

400 

300 Housing 

200 

100 

0 

1960 65 70 75 80 85 

600 

500 

400 

300 

200 Government and Public Enterprise Investment 

100 

0 

1960 65 70 75 80 85 

2000 

1750 

1500 

1250 

1000 

750 excluding private refinery construction 

500 

250 

0 

1960 65 70 75 80 85 
Ta bl e 3-3 

Compone nts o f Rea l Inve s t me nt in Pue rto Ri c o 

Fis c a l Yea r s 1960-1981 

(in mi 11 ions of 1972 doll a rs _!./) 

-----=--Total--: Pri vate- Non-ResTdenfTalFixe d - Investmenf - =-------------=---------=------------ Gove rnment 

Excluding Industrial and Cha nge 

Year Private Commercial Buildings 

Ma chinery Housing and Public 

Refinery Total, Excluding and in Enterprise 

Construe- Total Refinery Equipment Inventories Inve stme nt 

ti on Construction 2/ . . . . . . ----------- --- --- ----- ---- - --

1960 592 71 67 145 54 145 182 

1961 570 89 82 123 32 161 172 

1%2 751 129 122 158 117 190 164 

1963 789 121 114 194 111 195 176 

1964 839 115 89 235 64 227 225 

1965 1,055 173 94 248 177 292 244 

1966 1,158 155 119 264 181 351 243 

1967 1,098 222 117 289 49 380 264 

1968 1,208 221 134 262 98 407 307 

1969 1,342 197 108 340 139 423 333 

1970 1,346 391 118 411 51 396 370 

1971 1,526 422 134 431 116 441 405 

1972 1,667 332 136 426 101 472 532 

1973 1,714 193 169 434 214 437 460 

1974 1,450 203 181 338 49 398 484 

1975 1,470 186 117 298 145 323 587 

1976 1,514 152 125 338 272 295 484 

1977 1,191 93 81 354 117 249 390 

1978 1,231 81 71 390 130 291 349 

1979 1, 117 77 67 369 44 250 387 

1980 1,247 85 64 350 192 228 411 

1981 1, 196 99 86 333 190 191 395 

- - - - - ----------- -------- ------------ ----- -- --- -- - ---- --- -- -- ---- ------ ------ ------- ---------

_!./ Invest~ent expenditures in current doll a rs are transl a t e d into constant 1972 dollars on the 

basis of the impl~cit price deflators for equipment, construction, ano changes in inventories, provided in Table 20 of the source document. 

2 1 Pu e rto Rico's l~rge alloca tion of U.S. oil import quotas for foreign oil led to a boom in 

r e fine ry construction between 1970 and 1972. 

Source : Pue rto Rico Planning Board, Economic Report to the Governor, Tabl e s 2, 12, and 20; a nd 

unpublished estimates of the Office of Economic se~rch, Puerto Rico Economic 

velop~ent Administr3tion. 

I 

~ 

f-' 

I 
-42-

early 1970s, dropped to about $300 million during the 

1974-76 recession, and since then has averaged 85 percent of 

the annual level of the early 1970s. Housing construction, 

which rose almost continuously until 1972 to a peak of $472 

billion, declined in nearly every year after that. 

Figure II also shows the expansion of Puerto Rican 

government investment since 1960. Total investment by the 

Puerto Rican government plus investment by public enterprises went from $0.3 billion in 1969 to almost $0.6 billion 

in 1975. Commonwealth investment was financed largely from 

external borrowing, in the United States and elsewhere. 6/ 

In response to rising interest costs, the Commonwealth cut 

back sharply on borrowing after 1975, and the rate of new 

investment by government and public enterprises has 

generally been less than $0.4 billion since 1976. 

The last graph in Figure II combines all components of 

physical investment except private refinery construction. 

It shows that annual physical investment in Puerto Rico 

rose in nearly every year between 1960 and 1973. The annual 

rate of investment declined by 30 percent between 1973 and 

1977, from $1.7 billion to $1.2 billion. Since 1977, annual 

investment has fluctuated around $1.2 billion, roughly equal 

to annual investment levels in the period 1966-1968. 

III. Profitability and Location in Puerto Rico 

A. General Considerations. As explained in the 

previous chapter, manufacturing operations of U.S. corporations in Puerto Rico have generally been exempt from U.S. 

and Puerto Rican tax since 1948. When Puerto Rico introduced its tax exemption program in 1948, a combination of 

factors made Puerto Rico a highly competitive location for 

U.S. firms. These factors included political stability, 

protection under the U.S. tariff schedule, proximity to the 

United States, and the general application of Federal 

statutes (including basic Constitutional protections, 

banking laws, and certain commercial laws). Perhaps the 

single most important factor, however, was low unit-labor 

costs resulting from both low wages and the high produc-

~/ Of the $7.5 billion in Puerto Rican government debt 

outstanding on June 30, 1981, approximately $6.5 billion 

was held outside of Puerto Ric"O. 
-43-

tivity of Puerto Rican workers. These factors provided the 

necessary profit-making opportunities for the tax exemption 

program to work. Taken together, Puerto Rico's locational 

advantages and the tax exemption program contributed 

substantially to the rapid ~rowth of the Puerto Rican 

economy throughout the 1950s and 1960s. However, Puerto 

Rico's traditional advantages of cheap labor and tariff 

protection in the U.S. market have been undermined in the 

past quarter century. 

B. Wage Rates in Puerto Rican Manufacturing Industries. 

Table 3-4 presents average hourly wages of production 

workers in Puerto Rican and U.S. manufacturing industries in 

the period 1955-1980. The table shows that hourly wages in 

manufacturing industries in Puerto Rico rose much faster 

than on the mainland between 1955 and 1971, and rose 

slightly faster than U.S. wages in most industries after 

1971. For the industries shown in the table, Puerto Rican 

average wages rose from 30-39 percent of the U.S. level in 

1955, to 48-72 percent of the U.S. level in 1980. In the 

apparel industry, which remains the largest employer in the 

manufacturing sector despite a decline since 1973, Puerto 

Rican wages rose from 35 percent to 72 percent of the U.S. 

level between 1955 and 1980. In real terms (adjusted for 

price inflation) Puerto Rican wages in the apparel industry 

increased 260 percent between 1955 and 1980, and average 

Puerto Rican wages in all manufacturing industries increased 

280 percent. 

The increase in Puerto Rican real wage rates was due in 

part to the growth in investment and the increase in 

education and on-the-job training in the 1950s and 1960s. 

As investment increased, labor became more productive. The 

rise in Puerto Rican wages also reflects the phase-in of the 

U.S. minimum wage between 1940 and 1981 to Puerto Rico. 

The U.S. minimum wage was enacted in the Fair Labor 

Standards Act of 1938 (FLSA). The U.S. minimum of 1938 

applied to Puerto Rico, where it produced massive closing of 

farms and businesses. To moderate the impact of the minlmum 

wage in Puerto Rico, Congress amended the FLSA in 1940 to 

allow for differential minimum wages and more limited 

coverage in Puerto Rico than on the mainland. The 1940 

amendments provided for industry committees, convened by the 

U.s. Department of Labor, which would recommend minimum 

wages for a particular Puerto Rican industry or industry 

Part. The committees, which were drawn from business, 

labor, and the public and which represented both the United 

States and Puerto Rico, were instructed by Congress to 

recommend for individual industries, 
- 44-

Table 3-4 

Average Hourly Earnings 1/ of Production Workers 2/ 

in Puerto Rico and the United States, Selected Industries~ 1955-1980 

(dollars per hour) 

Food and Kindred Products 

Puerto Rican earnings 

United States earnings 

P.R. earnings as a 

percentage of U.S. 

Tobacco 

Puerto Rican earnings 

United States earnings 

P.R. earnings as a 

percentage of U.S. 

Textile Mill Products 

Puerto Rican earnings 

United States earnings 

P.R. earnings as a 

percentage of U.S. 

Apparel 

Puerto Rican earnings 

United States earnings 

P.R. earnings as a 

percentage of U.S. 

Chemicals 

Puerto Rican earnings 

United States earnings 

P.R. earnings as a 

percentage of U.S. 

Leather 

Puerto Rican earnings 

United States earnings 

P.R. earnings as a 

percentage of U.S. 

Metal Products 

Puerto Rican earnings 

United States earnings 

P.R. earnings as a 

percentage of U.S. 

1955 

.69 

1. 77 

38 

.37 

1. 25 

30 

.55 

1.41 

39 

.47 

1.36 

35 

.73 

2.01 

36 

.48 

1.42 

34 

.66 

2.02 

33 

Electrical & Electronic 

Puerto Rican earnings 

United States earnings 

P.R. earnings as a 

Equipment 

.64 

1. 90 

percentage of U.S. 

Stone, Clay & Glass 

Puerto Rican earnings 

United States earnings 

P.R. earnings as a percentage of U.S. 

34 

.69 

1. 88 

37 

Off ice of the Secretary of the Treasury 

Office of Tax Analysis 

1960 

.99 

2.18 

45 

.63 

1.62 

39 

.97 

1. 62 

60 

.86 

1. 59 

54 

1.19 

2.53 

47 

.75 

1.66 

45 

1.15 

2.47 

47 

1. 20 

2.32 

52 

1.13 

2.30 

49 

October 

1966 1971 

1. 40 

2.52 

56 

1. 05 

2.08 

50 

1. 23 

2.00 

62 

1.18 

1. 93 

61 

1. 64 

3.03 

54 

1. 08 

1.96 

55 

1. 60 

2.92 

55 

1. 4 7 

2.67 

55 

1. 69 

2.76 

61 

1. 94 

3.38 

57 

1. 56 

3.00 

52 

1. 71 

2.59 

66 

1. 70 

2.51 

68 

2.36 

4.00 

59 

1. 59 

2.64 

60 

2.17 

3.77 

58 

2.01 

3.50 

57 

2.27 

3.75 

61 

1975 

2.60 

4.65 

55 

2.21 

4.27 

52 

2.15 

3.53 

61 

2.14 

3.24 

66 

3.64 

5.50 

66 

2.02 

3.25 

62 

2.95 

5.19 

57 

2.82 

4.66 

61 

2.93 

5.02 

58 

1980 

4.08 

6.95 

59 

3.69 

7.69 

48 

3.59 

5.27 

68 

3.40 

4.73 

72 

5.43 

8.53 

64 

3.35 

4.65 

72 

4.56 

7.69 

59 

4.27 

7.18 

59 

4.30 

7.74 

56 

l/ Earnings are the actual return to the worker, including premium pay for overtime and 

late-shift work and changes in output of workers paid on an incentive plan. 

~/ Includes all nonsupervisory employees and working supervisors engaged in production or 

services closely associated with production--recordkeeping, maintenance, sales, etc. 

Source: Puerto Rican Department of Labor, Census of Manufacturing Industries, various 

years; and u.s. Department of Labor, Bureau of Labor Statistics and Employment 

Standards Administration, Employment and Earnings, various years. 
-45-

••• the highest minimum wage rate ••• which (1) will not 

substantially curtail employment in such [industry] 

classification and (2) will not give a competitive 

advantage [relative to the mainland] to any group in the 

industry. 21 · 

This system of industry-specific minimums ended in the 

1970s. In 1974 and again in 1977, Congress provided a 

schedule of annual automatic increases in the minimum wage 

rates for Puerto Rican industries until the mainland minimum 

was reached. As a result of these increases and the 

doubling between 1966 and 1976 of the number of industry 

classifications covered by the FLSA, 8/ the U.S. mainland 

minimum wage applied to virtually- all Puerto Rican 

industries by 1981. 

Actual hourly wages paid to most workers in many Puerto 

Rican industries, including apparel, food products, and 

leather goods, are at, or near, the legal minimum. Table 

3-5 illustrates the clustering of average hourly earnings 

around the minimum in the period 1975-1977. The data are 

taken from individual wage studies prepared by the U.S. 

Department of Labor for use at industry committee reviews, 

and cover those industries where the FLSA rate was below the 

mainland statutory level. The table shows, for example, 

that about 60 percent of workers in food products were paid 

not more than 20 cents per hour above the legal minimum. 

The corresponding percentages for filler tobacco processing 

were 99 percent; women's outerwear, 78 percent; leather 

belts, 81 percent; rubber and plastic footwear, 37 percent 

21 Fair Labor Standards Act of 1938, 

Congressional Act of June 26, 1940 

76th Congress). 

as amended by · the 

(Pub. Res. No. 88, 

~/ Of the 470,000 workers covered in 1976, only 210,000 

would have been covered before 1966, an additional 

100,000 would have been covered as a result amendments 

of 1966, and an additional 160,000 were covered by 

amendments of 1974. Simon Rottenberg, "Minimum Wages in 

Puerto Rico", in the Economics of Legal Minimum Wages, 

Simon Rottenberg, ed., American Enterprise Institute 

(Washington, D.C., 1981), p. 328. Rottenberg cites U.S. 

Department of Labor, Wage Structure and Fringe Benefits 

in Puerto Rico, 1979, p. 187. 
-46-

Table 3-5 

Percentage of Workers in Various Industry Classifications in Puerto Rico 'Earning Exactly the FL.SA 

Minimum and Certain Specified Rates Af:x:Ne It, 1975-77 

Fcxrl and kindred products, pre-1966 coverage: 

Milk processing and distribution 

Carrly and gum products, 1961 coverage 

Other products and activities 

Tobacco, pre-1961 coverage: 

Filler tobacco processing 

Wrapper tobacco processing 

Ma.chine threshing other products 

Other products and activities 

Textile mill products, pre-1961 coverage: 

1-boked rugs 

Other products and activities 

Gloves and mittens, pre-1%1 coverage: 

Other products and activities 

Hosiery, pre-1966 coverage: 

\bnen' s hosiery 

Other hosiery 

sweater and knit &Wil'Th'Jear 

Handkerchiefs, scarves, and art linens, 

pre-1961 coverage: 

Other products 

Wanen's outerwear, needlework and fabricated 

textile products, 1966 coverage 

Children's dress and related products, 

pre-1966 coverage: 

Other operations 

Wanen' s and children' s underwear, 

pre-1%1 coverage 

Corsets and brassieres, pre-1961 coverage 

Men's and lx>y's clothing, pre-1961 coverage: 

\brk clothing and separate trousers 

Other products and activities 

1961 coverage 

1966 coverage (trousers and 

other products) 

Furniture and fixtures and lumber 

Leather g:x:rls pre-1961 coverage: 

Belts 

Other products and activities 

Non-rubber footwear, pre-1966 coverage 

Rubber and, plastic footwear 

Stone, clay, and glass, pre-1961 coverage: 

Art p:>ttery 

Vitreous and seni.-vitreous china 

Jewelry and miscellaneous industries, 

pre-1961 coverage: 

Straw and hair products 

Other products and activities 

Survey 

date 

Ma.y 1976 

Ma.y 1976 

Ma.y 1976 

Aug 1976 

Aug 1976 

Aug 1976 

Aug 1976 

Nov 1975 

Nov 1975 

Ma.y 1977 

May 1977 

May 1977 

May 1977 

May 1977 

May 1977 

May 1975 

May 1977 

May 1977 

May 1977 

May 1977 

May 1977 

May 1977 

Aug 1976 

May 1977 

May 1977 

Nov 1975 

Nov 1975 

Aug 1976 

Aug 1976 

Aug 1976 

Aug 1976 

FL.SA 

minimum 

rate 

2.os 

2.00 

2.15 

1.56 

1.82 

2.04 

2.11 

1.57 

1. 75 

2.21 

2.18 

1.97 

2.28 

1. 70 

2.29 

1.90 

2.20 

2.28 

2.22 

2.15 

2.15 

2.22 

2.10 

2.28 

2.10 

1. 75 

1. 75 

1.67 

2.13 

1.85 

2.os 

___ P_e_r_c_e_n_ta--=g_e_o_f_wo_r_k_e_r_s_earm __ ·ng........_ ___ -;-

Average Not rrore than __;.. 

hourly Exactly 10 cents 15 cents 20 cents : 

earnings:the Fl.SA above above above 

2.37 

2.23 

2.47 

1.56 

1.93 

2.37 

2.25 

2.25 

2.18 

2.37 

2.42 

2.30 

2.49 

1. 79 

2.48 

2.08 

2.42 

2.57 

2.46 

2.39 

2.27 

2.33 

2.39 

2.43 

2.36 

2.02 

2.25 

2.16 

2.39 

1.98 

2.28 

: minimum 

37.7 

0 

32.7 

97.6 

72.8 

25.0 

40.4 

0 

20.6 

48.5 

30.0 

8.5 

50.7 

70.5 

43.8 

30.6 

39.7 

17.9 

43.3 

42.3 

74.4 

38.3 

39.0 

2.3 

38.1 

35.3 

9.5 

0 

0.4 

0 

39.1 

minimum 

47.8 

60.6 

39.4 

99.0 

78.0 

39.3 

57.5 

0 

26.2 

65.0 y 

so.a 

27.1 

64.8 

74.8 

72.9 

47.0 

47.8 

18.5 11 

50.1 6/ 

48.4 -

78.6 

86.7 §./ 

48.9 

68.9 10/ 

55.2 

42.3 

19.9 

40.0 

0.8 

67.9 

43.0 

minimum 

55.0 

60.6 

51.2 

99.0 

78.7 

39.3 

68.9 

0 

28.9 

n.a. 

55.0 

34.0 

70.0 

79.9 

77.0 

74.9 

67.8 

57.4 ~ 

55.0 7/ 

58.3 -

80.9 

88.4 ]_/ 

49.3 

79.0 11/ 

62.0 

50.6 

28.1 

45.0 

57.6 

79 .8 

64.8 

minimum__;. 

61. 7 

60.6 

58.6 

99.0 

78.7 

46.4 

78.7 

0.6 

38.7 

78.4 y 

63.0 

38.3 

12.0 

82.3 

78.0 

78.6 

70.9 

66.l ?! 

63.4 §/ 

65.0 

83.9 

90.1 '!! 

56.1 

90.6 d 

66.4 

62-0 

36.5 

45.0 

68.9 

98.l 

68.4 

Source: U.S. Department of Cannerce, Econanic Study of Puerto Rico, 1979, Vol. II, p. 619. 

1/ Within 9 cents of minimum. 

2/ Within 19 cents of minimum. 

3/ Within 2 cents of the minimum. 

4/ Within 12 cents of the minimum. 

5/ Within 22 cents of the minimum. 

§._/ Within 8 cents of the minimum. 

7/ Within 13 cents of the minimum. 

8/ Within 18 cents of the minimum. 

9/ Within 23 cents of the minimt.nTI. 

Io/ As much as 7 1/2 cents above the minimum. 

11/ As much as 12 1/2 cents above the minimum. 

12/ Estimated. 
-_.:.. 

_.:.. 

-47-

and china manufacture, 69 percent. This clustering of 

workers at or near the minimum, combined with the fact that 

the minimum wage increased more than average actual wages in 

many Puerto Rican industries between 1973 and 1977, 9/ 

indicates that changes in the minimum wage in Puerto Rico 

have tended to increase Puerto Rican wages. 

Wage rates are only one of the factors determining 

Puerto Rico's competitive position. Whether that position 

is damaged as a result of wage increases depends on the rate 

of advance in labor· productivity. A comparison of unit 

labor costs in Puerto Rico, the United States, and elsewhere 

is beyond the scope of this Report. Two factors bearing on 

this issue should, however, be noted. The percentage of 

the Puerto Rican population age group 6-18 attending school 

increased from 48 percent in 1941 to 86 percent in 1971, and 

the comparable percentage for the age group 19-22 increased 

from 3 percent to 29 percent. 10/ The high rate of increase 

in educational enrollment has--r-ended to increase the skills 

and therefore productivity of the Puerto Rican labor force. 

On the other hand, the expansion of Federal income 

maintenance programs in Puerto Rico may have increased the 

real cost of labor. 11/ Such programs may reduce work 

incentives and, by inducing higher labor turnover rates, 

raise labor-training costs. Table 3-6 provides a breakdown 

of Federal transfer payments (together with other Federal 

assistance to Puerto Rico) in selected years between 1968 

and 1981. Net Federal transfers to individuals increased 

from $64 million in 1968 to $1,793 million in 1981, a 

twelve-fold increase in real (price-deflated) terms. The 

growth in income maintenance programs was led by the food 

stamp program, which was not introduced in Puerto Rico until 

1975, but reached $860 million in 1981. 

C. Reductions in U.S. Tariffs and the Expansion of 

Industry in Developing Countries. The competitiveness of 

Puerto Rican production also has been undercut by structural 

~/ U.S. Department of Commerce, Economic Study of Puerto 

Rico, 1979, Vol II., pp. 636-637 • 

.!.QI Ibid., p. 718. 

l!_! Puerto Rico participates in most, but not all, Federal 

income maintenance programs. It does not participate in 

the Supplemental Security Income Program. In the case 

of Aid to Families with Dependent Children and, beginning in 1982, the food stamp program, payments are 

limited by a ceiling. 
-48-

Table 3-6 

Federal Grants-in-Aid and Taxes Transferred 

to Puerto Rico, Selected Fiscal Years 1968-1981 

(millions of dollars) 

1968 

Net Federal transfer payments 

individuals, total ~/ 

Food stamps 

Old age, survivors, and 

disability insurance 

Veterans benefits 

Unemployment compensation lf 

All other 

to 

64 

1 

59 

-3 

7 

Federal grants to Puerto Rican Commonwealth 

and municipal governments, total 129 

Child nutrition and special milk 

programs 5 

Human development 6 

Off ice of Education programs 

Public assistance 31 

Comnunity development block grants 15 

Low-rent public housing 11 

Employment and training programs 7 

All other 54 

Federal taxes transferred to Puerto 

Rican treasury, total 93 

Customs duties 27 

Alcoholic beverage and tobacco 

excises 66 

TOTAL 286 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

1978 1979 

1,321 1,477 

682 734 

355 386 

198 202 

33 16 

91 102 

885 1,020 

62 77 

36 64 

62 69 

38 114 

56 74 

56 56 

246 262 

329 304 

271 289 -- -- 71 76 

200 213 

2,477 2,786 

!/ 

1980 19~ 

1,697 

812 ~ 960 

401 585 

223 23l 

3 -14 

123 13l 

1,126 ~ 

1 033 

106 95 

30 50 97 80 135 106 115 96 96 79 231 304 z3B 305 

304 319 12 

76 

228 z36 

3,127 3 ,14' 

____-/ 

. 005 

Sources: U.S. Department of the Treasury, Federal Aid to States, var 1 tne 

years; U .s. Department of the Treasury, Statistical Appendix to rd' 

Secretary's Annual Report for 1968; and Puerto Rico Planning aoa 

Economic Report to the Governor, Table 19, (various years). 

.!/ 

~/ 

.~/ 

301 

In 1968, both the Federal and Puerto Rican fiscal years ended on June JO 

and therefore all data for FY 1968 is based on the same time period· ol?e! 

1976, however, the Federal fiscal year was changed, beginning on oct re"' 

1, 1976 and ending on September 30, while the Puerto Rican fiscal yeareot5 

mained unchanged. With the exception of certain Federal transfer paytn 

to individuals, data for 1979-1981 are based on the Federal fiscal yea!• 

All transfer payments are net of associated payments by or on 

current or future recipients, such as employer, employee, 

employment contributions for Social Security. 

ot 

behalf if"' 

and se 

ove! 

Revised figures. Includes the excess (if any) of withdrawals d~ }Ctetl deposits in the Federal Unemployment Trust Fund, plus Federal e 

benefits. 
r 

6 

e 

I 

p l 

-49-

changes in the ·world economy. After the Kennedy round of 

tariff negotiations in the 1960s, the United States cut its 

tariff rates by 40-50 percent on average, which exposed 

Puerto Rican (and U.S.) manufacturers to more vigorous 

import competition. Foreign competitors utilizing low-wage 

labor penetrated the U.S. market, and U.S. companies also 

started manufacturing in low-wage countries and exporting 

back to the United States. Apparel and other industries in 

Puerto Rico which have historically paid average hourly 

wages that were close to the minimum were caught in a 

wage-price squeeze as a result of increased foreign 

competition. In 1965, 30 percent of all U.S. imports of 

clothing originated in Puerto Rico, 14 percent in Hong Kong, 

1 percent in Korea, and 2 percent in Taiwan. By 1976, 

Puerto Rico's share had fallen to 9 percent, and the share 

of Hong Kong had risen to 32 percent, of Korea to 17 

percent, and of Taiwan to 16 percent. 12/ 

Other international developments have had a favorable 

effect on Puerto Rico's competitive position. Between 1977 

and 1981, the Orderly Marketing Agreements limited shoe 

exports to the United States from South Korea and Taiwan. 

Since 1973, the Multifiber Arrangement has limited textile 

and apparel exports from developing countries. The United 

States is in the process of renegotiating the agreements 

under the Multifiber Arrangement with the major apparelexporting countries, and it is expected that the~e 

agreements will be tightened. 

D. Changes in U.S. Tax Law. At the same time that 

changes were taking place in the underlying competitiveness 

of Puerto Rico, a series of changes to the U.S. Internal 

Revenue Code had an indirect effect on the relative 

profitability of locating in Puerto Rico. The top Federal 

corporate tax rate, which stood at 38 percent in 1947, ~ose 

to 52 percent in 1952 and remained at that level until 1963. 

Thereafter, with the· exception of the surtax years of 

1968-70, the top rate has been reduced in several steps to 

its current level of 46 percent. The investment tax credit 

was introduced in 1962 and has generally been in effect 

since then. Its terms have been liberalized on several 

occasions, and the rate increased from an initial 7 percent 

to the current level of 10 percent. In 1971, the asset 

.!3.1 U.S. Department of Commerce, Economic Study of Puerto 

Rico, Vol. I, p. 109. 
-50-

depreciation range (ADR), a major liberalization of the 

period over which assets could be depreciated for Federal 

tax purposes, was introduced. 

These three changes in U.S. tax law since 1962, the 

investment tax credit, lower statutory rates, and ADR, 

combined to lower significantly the overall effective tax 

rate on income earned from physical capital in the United 

States. As these U.S. effective tax rates fell, the 

attraction of tax exemption for physical investment in 

Puerto Rico diminished. The tax benefits for investment in 

Puerto Rico declined further in 1981-1982 because of the tax 

reductions for U.S.-based investments in the Economic 

Recovery Tax Act of 1981 (ERTA). The ERTA tax reductions 

include accelerated cost recovery allowances for physical '-....J 

investment, an increase in the kinds of property that ~l 

qualify for the full 10 percent investment credit, and 

liberalized leasing rules designed to secure the benefits of 

the investment incentives to businesses which do not have 

sufficient tax liability to absorb these deductions and 

credits. These benefits were curtailed, but not eliminated, 

by the Tax Equity and Fiscal Responsibility Act of 1982 (see 

Table 5-6 below) • 

In summary, many fundamental changes have taken place in 

the Puerto Rican, U.S., and world economies which have had a 

direct and substantial bearing on the competitiveness of 

Puerto Rico as a location for U.S. investment. As suggested 

above, one result of these changes has been a decline in the 

1970s in the rate of investment in Puerto Rican plant and 

equipment. A second result, which emerges from the data in 

Tables 3-7 and 3-8, is that Puerto Rican business expansion 

in the 1970s was concentrated in four high-technology industries, chemicals, scientific instruments, electrical and 

electronic equipment, and machinery. 

IV. Composition of Puerto Rican Manufacturing by Industry, ~ 

1960-1981 

Table 3-7 shows that between 1960 and 1970, the industry 

composition of Puerto Rican manufacturing income changed 

relatively little. Only the food industry lost as much as 6 

percentage points in this period; only chemicals gained as 

many as 8 percentage points. Between 1970 and 1981, 

however, the industry composit:rt>n of manufacturing income 

changed dramatically. Chemicals became the largest industry 

by far, growing from 11. 4 percent to 3 7. 3 percent of the 

total income originating in Puerto Rican manufacturing. 
-51-

Table 3-7 

Net Income Originating in Puerto Rican Manufacturing 

Fiscal Years 1960, 1970, and 1981 

(dollars in millions) 

1960 1970 1981 

Amount Percent Amount Percent Amount Percent 

of Net of of Net of of Net of 

'-----~--------------------_.:..-=-I=nc~o=m=e=-.:...._-T~o~t=a~l=-~~I~n~c~o=m=e=-=~~T~o~t=a~l~--=-~I~n~c~o=m~e-=---~T~o~ta~l~ 

~ll Manufacturing Industries 

Food and kindred products 

288.8 

66.7 

10.4 

13.9 

50.7 

100.0% 

23.1 

3.6 

4.8 

957.6 

161.3 

36.4 

41.1 

172.0 

100.0% 

16.8 

3.8 

4.3 

18.0 

2.7 

2.4 

11.4 

4,453.7 

457.0 

56.0 

47.9 

356.2 

33.5 

67.5 

1,663.3 

100. 0% 

Tobacco products 

Textile mill products 

Apparel 

Furniture and wood prodcts 

Printing and publishing 

Chemicals 

Stone, clay and 

glass products 

Machinery and metal 

Products 

8.8 

11.2 

9.8 

18.8 

54.7 

~r manufacturing 43.7 

fl.c 

~f·e of the Secretary of the Treasury 

lee of Tax Analysis 

17.6 

3.0 

3.9 

3.4 

6.5 

18.9 

15.1 

26.2 

22.6 

109.3 

49.1 

191.5 

148.0 

5.1 

19.4 

15.5 

97.6 

1,261.6 

413.1 

Puerto Rico Planning Board, Economic Report to the Governor, 1980-1981, 

Table 7. 

10.3 

1.3 

1.1 

8.0 

0.8 

1.5 

37.3 

2.2 

28.3 

9.3 
-52-

Income originating in machinery and metal products 

(including electrical and electronic equipment) grew from 

19.4 percent to 28.3 percent of the total income in Puerto 

Rican manufacturing. Major industries whose share of the 

total income declined were apparel and food products, with 

declines of 10 percentage points and 6.5 percentage points, 

respectively. 

Table 3-8, which shows the distribution of employment in 

Puerto Rican manufacturing, provides further evidence of 

Puerto Rico's shift away from traditional labor-intensive to 

high-technology industries. Between 1968 and 1981, employment declined substantially in apparel, tobacco, textiles, 

leather goods, wood products, and stone, clay and glass 

products. The combined share of these industries in total 

manufacturing employment fell from 57 percent in 1968 to 34 

percent in 1981. Their decline was offset by modest gains 

in jobs in the food-processing, paper, and plastics industries and large employment increases in four high-technology 

industries chemicals (including pharmaceuticals), 

electrical and electronic equipment, scientific instruments, 

and machinery. Taken together, these high-technology 

industries employed 58, 100 workers in 1981, which was 38 

percent of manufacturing employment (and 9 percent of total 

non-government employment) in Puerto Rico. 

Because of the shift in the composition of the Puerto 

Rican manufacturing sector, increases in the income and 

capital stock of Puerto Rican manufacturing industries have 

produced less than proportionate increases in manufacturing 

payroll and employment. Table 3-9, which is based on the 

two most recent manufacturing censuses in Puerto Rico, shows 

for various industries the share of payroll costs in total 

value-added. Value-added for a given enterprise is defined 

as the market price of goods completed less the cost of 

materials purchased from others. The chemical industry, the 

most rapidly growing Puerto Rican industry in the 1970s, had 

the lowest share of payroll in industry value-added, 11. 0 

percent in 1977. In all industries whose employment 

expanded in the 1972-1977 period, payroll represented only 

16.2 percent of value-added in 1977, or less than one-half 

the 37.4 percent share of payroll in value-added for industries with declining employment. The last column of Table 

3-9 shows that substantial decreases have also occurred in 

the share of payroll in value-added within given manufacturing industries, including tobacco, machinery, 
Table 3-8 

Distributicn of Ehployment in Puerto Rican Manufacturing, 1968 - 1981* 

Irrlustry Group 1968 1969 1970 1971 1972 1973 1974 : 1975 1976 1977 1978 1979 1980 1981 Absolute : Percentage 

Change Change 

(in t.OOusarrls) 1968-1981:1968-1981 

All Manufacturing Irrlustries 137.1 138.5 136.7 138.1 147.2 152.9 149.6 136.6 144.8 148.6 155.9 157.7 154.6 151.7 14,600 11% 

Norrlurable goods 101.7 100.8 96.5 94.6 102.5 105.1 102.9 93.9 98.3 100.6 102.2 100.4 97.4 93.2 -8,500 -8 

Fcx:d. arrl kirrlred products 20.5 20.9 20.6 21. 7 23.5 22.7 23.7 23.0 24.2 23.9 24.8 24.3 23.4 21.8 1,300 6 

Tobae<D products 1.0 6.0 6.1 5.6 5.6 5.6 5.3 5.0 4.5 3.2 2.0 2.2 2.1 1.7 -5,300 -76 

Textile mill prodtct.s 8.2 8.7 8.9 6.8 7.7 7.6 7.2 4.9 4.3 4.9 5.1 4.3 3.4 3.2 -5,000 -61 

Apparel 40.2 40.5 36.8 36.2 39.2 40.7 38.0 36.1 37.1 37.2 36.2 35.4 33.6 33.6 -6,600 -16 

Paper and allied prodtct.s, arrl 

printing and p..lblishing 3.8 3.8 4.0 4.1 4.1 4.5 4.2 3.8 4.4 4.4 4.5 4.8 5.1 4.9 1,100 29 

Chemicals 4.5 5.0 4.9 1.0 9.4 11.0 11.9 10.6 12.5 15.4 15.9 16.3 15.6 15.8 11,300 251 

Pharmaceuticals 1.4 1.8 1.7 3.0 3.5 5.0 5.4 6.0 7.3 8.4 9.8 10.0 11.0 11. 7 10,300 736 

Petrolellll refining, rubber 

prodtct.s, arrl plastics 6.2 6.8 1.0 6.8 7.0 6.5 6.5 5.4 6.4 7.0 6.7 7.1 7.7 7.0 800 13 I 

U1 

Leather arrl leather products 11.4 9.1 8.3 6.4 6.1 6.7 6.1 5.2 5.0 5.7 6.2 6.0 6.6 5.2 -6,300 -55 w 

I 

Durable <pads 35.4 37.7 40.2 43.6 44.7 47.8 46.6 42.8 46.4 47.9 53.7 57.3 57.2 58.4 23,000 65 

l.J.Jrrber arrl wocrl products arrl 

furniture and fixtures 4.9 4.9 5.1 5.1 5.0 4.9 4.2 3.9 3.7 3.6 3.9 4.1 3.6 3.4 -1,500 -31 

Stone, clay arrl glass 

prodtct.s 6.7 6.5 6.8 7.3 7.5 7.2 7.3 6.2 5.3 5.1 5.5 5.5 4.8 4.3 -2,400 -36 

Primary metal irrlustries arrl 

fabricated metal products 5.0 5.6 6.1 6.5 6.9 6.7 6.7 5.6 5.7 5.5 6.0 6.0 5.3 4.8 -200 -4 

Machinery, except electrical; arrl 

transportation e::piprent 2.0 1.8 1.9 1.9 1.9 1.9 3.8 3.5 4.7 5.3 5.9 6.6 7.9 9.4 7,400 370 

Electrical arrl electronic 

equipnent 9.1 10.5 10.7 11.8 12.3 14.8 12.5 9.9 13.3 14.1 16.2 17.3 18.0 19.8 10,700 118 

Scientific instruments 3.8 4.1 5.2 7.2 7.7 9.1 9.5 10.8 10.6 11.6 12.5 13.6 13.6 13.1 9,300 245 

Miscellaneous manufacturing 

industries 3.9 4.3 4.3 3.8 3.4 3.2 2.6 2.9 3.0 2.8 3.8 4.2 3.9 3.6 -300 -8 

Off ice of the Secretary of the Treasury 

Office of Tax Analysis 

* Data as of October of each year. 

Source: Comonwealth of Puerto Rico, Department of labor, Census of Manufacturin9 Industries of Puerto Rico, Table 4, various years. 
Table 3-9 

Enployment, Payroll and Value-Added of Puerto Rican Manufacturing Industries, 1972 and 1977* 

1972 1977 :Percentage Change in 

:Payroll as :Payroll as Payroll as Percent 

:Thployment: Payroll :Value-Added:Percent of :Enployment: Payroll :Value-Added:Percent of of Value-Added 

(000) :($Million):($ Million):Value-Added: (000) :($Million):($ Million):Value-Added: 1972 - 1977 

All Manufacturing Irrlustries 149.7 616.8 1,915.4 32.2% 146.9 997.0 4,097.4 24.3% -24.5% 

Food and kindred products 27.7 121.2 343.4 35.3 21.4 149.0 485.6 30.7 13.0 

Tobacco products 4.5 16.0 46.4 34.5 3.7 24.5 122.0 20.1 -41.7 

Textile mill products 7.8 27.9 67.1 41.6 6.0 29.5 108.9 27.1 -34.9 

Apparel arrl other textile 

products 39.6 124.1 252.5 49.1 35.3 151.8 278.9 54.4 10.8 

lumber arrl WIXX:1 products 1.2 4.5 8.3 54.2 .8 3.9 9.1 42.9 -20.8 

Furniture and fixtures 3.2 13.0 29.3 44.4 2.4 12.1 26.1 46.4 4.5 

Paper arrl allied products 1.6 8.2 17.9 45.8 1.5 11.8 21. 7 54.4 18.8 

Printing and p.lblishing 3.0 16.7 41.8 40.0 4.0 28.8 68.9 41.8 4.5 

Chemical arrl allied products 9 • .0 58.8 451.2 13.0 15.7 162.5 1,476.5 11.0 -15.4 

Petroleum and a::>al products 2.2 20.7 91. 7 22.6 2.5 36.9 143.4 25.7 13. 7 

Rubber arrl miscellaneous 

plastics products 3.5 14.0 27.4 51.1 6.0 43.4 147.6 29.4 -42.5 

Leather arrl leather products 6.6 20.4 39.3 51.9 6.2 29.3 55.7 52.6 1.3 

Stone, clay and glass products 6.3 29.0 73.1 39.7 5.0 39.8 102.7 38.8 -2.3 

Primary metal irrlustries 1.0 5.3 14.3 37.1 1.6 12.7 48.6 26.1 -29.6 

Fabricated metal products 5.2 27.6 78.2 35.3 4.7 33.7 84.2 40.0 13.3 

Machinery, except electrical 2.2 12.8 37.6 34.0 4.1 32.8 161.2 20.3 -40.3 

Electric and electronic 

equiprcent 14.7 50.4 169.6 29.7 14.8 106.9 403.1 26.5 -10.8 

Transportaticn equipment .7 3.1 6.8 45.6 1.1 8.2 28.1 29.2 -36.0 

Instruments and related 

products 6.1 29.0 84.2 34.4 6.8 52.1 257.3 20.2 -41.3 

Miscellaneous manufacturing 

industries 3.7 14.1 35.3 39.9 3.5 27.3 67.8 40.3 1.0 

Irrlustries with expanding 

employment 1/ 27.7 160.4 755.0 21.2 41.8 377.4 2, 331.6 16.2 -21. 7 

Irrlustries with declining 

employment '!:._/ 105.8 397.8 972.9 40.9 89.0 500.9 1, 341.0 37.4 -9.4 

Irrlustries with constant 

employment~ 16.3 58.6 187.5 31.3 16.3 118. 7 424.8 27.9 -22.l 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

* Revised fran last year's Annual Report on the basis of p.lblished 1977 Census figures. 

Source: U.S. Depart.rrwent of Crnmerce, 1977 Econanic Censuses of Outlying Areas, Manufactures, Puerto Rico, and 1972 Econanic Censuses of Outlying 

Areas, Manufactures, Puerto Rico. 

"'!:} Includes printing and p.iblishing, chemicals, petroleum, rubber products, prima.ry metal industries, machinery, transportation equipment, and 

instruments arrl related prcrlucts. 

?J 1..ncludes food prcrluct.s, tobacco prcrluct.s, textiles, apparel, lunber, furniture, leather prcrlucts, stone, clay, and glass products, fabricate<l 

wet.al. prooucts, ard miscellaneous wanufacturing iroustries. 

I 

U1 

.i::. 

I 
-55-

instruments, and· chemicals. The combined effect between 

If) 1972 and 1977 of the shift in the composition of industry 

~ and in the share of payroll in value-added within individual 

~ industries, was that while manufacturing value-added rose 

~ fr om $1. 9 bi 11 i on to $ 4 • 1 b i 11 ion , ( a re a 1 increase of 7 2 

~ percent), manufacturing payroll rose from $0.6 billion to f $1.0 billion (a real increase of 24 percent). 
-56-

Chapter 4 

IMPACT OF POSSESSIONS CORPORATIONS ON 

PUERTO RICAN ECONOMIC GROWTH 

Chapter 3 demonstrated that the reduced competitiveness 

of Puerto Rican labor and the fall in U.S. tariffs on 

imports from competing developing countries decreased the 

non-tax incentives for locating in Puerto Rico. Exemption 

from U.S. and Puerto Rican taxation is therefore a principal 

factor attracting firms to the Commonwealth. Since the 

advantages of a Puerto Rican location vary for different 

kinds of assets, it is useful to examine the impact of tax 

exemption on three distinct types of assets: 

Physical plant and equipment and inventories; 

Intangible assets, such as patents, trade secrets, 

trademarks, and "know-how"; and 

Financial assets, such as tax-exempt certificates of 

deposit in Puerto Rican banks. 

This chapter discusses the impact of section 936 and the 

complementary Puerto Rican tax exemption program on the 

attractiveness of a Puerto Rican location for each of these 

kinds of assets. It presents data on the relative importance of each category of assets in 936 operations, and 

evaluates the contribution which each type of asset makes to 

Puerto Rican growth. The chapter also discusses in detail 

the regulations issued by Puerto Rico to channel tax-exempt 

financial investments of 936 companies into physical assets 

in Puerto Rico, and the empirical evidence on the impact of 

these funds on the Puerto Rican economy. At year-end 1981, 

accumulated tax-exempt financial assets of possessions 

corporations amounted to approximately $7.6 billion. 

I. Operations Attracted to Puerto Rico by Tax Exemption 

The mix of physical, intangible, and financial assets in 

Puerto Rico is directly affected by the way in which the 

near total exemption from Federal and Puerto Rican tax is 

structured, and by the tax savings which exemption provides 

relative to tax benefits available in the United States and 

foreign countries. 

A. Physical Assets. The exemption provided by section 

936 gives Puerto Rico a substantial tax advantage relative 

to the United States as a location for physical assets. The 
-57-

effective U.S. tax rates for selected industries on income 

from new depreciable assets used in the United States varied 

from 29-47 percent under pre-1981 law, and will range from 

18-32 percent under law in effect after 1982 (see Table 

5-6). But Puerto Rico does not offer substantially greater 

tax savings for real investment than many low-tax deveioping 

countries. Although dividends from a 936 corporation to its 

U.S. parent are not taxable in the United States, while 

dividends from a foreign affiliate are, the U.S. tax on 

foreign earnings is generally deferred as long as the 

foreign affiliate retains its income abroad. Moreover, many 

U.S. multinationals have excess foreign tax credits that can 

be used to offset the U.S. tax on dividends from low-tax 

foreign countries. !/ 

B. Patents, Trademarks, and Know-how. Some U.S. corporations have sought to increase the attractiveness of Puerto 

Rico as an investment location by transferring patents, 

trademarks, and other intangible assets to Puerto Rico. 

Many of these transfers were made under section 351 of the 

Code. As explained in Chapter 2, that section allows 

property to be transferred from one U.S. corporation to a 

second U.S. corporation which is controlled by the first, 

without requiring a taxable gain to be recognized on the 

transfer. Under pre-1982 law, a U.S. corporation which 

transferred intangible assets to a controlled 936 corporation (also a U.S. corporation) could assert that the gross 

income earned by the assets was income of the possessions 

corporation and thus exempt from U.S. tax under section 936. 

Wh i 1 e the interpret at i on of the pr e-1 9 8 2 r u 1 es regard in g 

income from intangibles is controversial ~/, the rules have 

.!./ The amount of foreign tax credits which a corporation 

may claim under the Code is 1 imi ted to the amount of 

U.S. tax due on all foreign source income. This 

limitation is computed on an aggregate basis rather than 

a country-by-country basis, so that a taxpayer who pays 

income taxes to one or more foreign countries at an 

effective rate higher than U.S. rate and to one or more 

foreign countries at an effective rate lower than the 

U.S. rate averages the foreign tax rates. The foreign 

tax credit for taxes paid to the high-tax countries will 

shelter from U.S. tax income received from low-tax 

foreign countries. 

~/ As noted in Chapter 2, three cases are before the U.S. 

Tax Court, each involving the claim of a possessions 

corporation to income from intangibles that were 

developed by its U.S. parent and subsequently 

transferred to the possessions corporation. 
-58-

been clarified and amended by TEFRA. Effective for tax 

years beginning after December 31, 1982, the amendments 

under TEFRA provide two alternative elections under which 

certain income from intangibles that are related to products 

manufactured, in whole or in part, in Puerto Rico, shall be 

treated as income of the 936 corporation eligible for the 

possessions credit. 

While the Code allows any asset to be transferred taxfree between affiliated domestic corporations, the right to 

transfer assets free of tax to a foreign corporation is 

limited. In particular, administrative , guidelines under 

section 367 of the Code impose a toll charge on the transfer 

from a U.S. corporation to a foreign corporation of the U.S. 

rights to an intangible, e.g., a patent to produce goods 

which will ultimately be sold in the United States. Based 

on the distinction in U.S. tax law between a transfer to a 

U.S. (including a 936.) and a foreign corporation, and based 

on the amendments to section 936 under TEFRA, Puerto Rico 

still offers a significant advantage over foreign low-tax 

jurisdictions for locating patents, trademarks, and other 

intangibles. 

C. Financial Assets. Section 936 and Puerto Rican law 

provide that QPSII is free of tax. For U.S. parent 

companies, the QPSII exemption makes Puerto Rico a very 

advantageous location for financial inveitments compared to 

the United States. For many U.S. parent corporations, 

Puerto Rico is also a better location than low-tax foreign 

countries. 

If a U.S. corporation organizes a subsidiary in a lowtax foreign jurisdiction in order to receive passive investment income, such as Eurodollar interest, the parent would 

be subject to the Subpart F, foreign personal holding 

company, or foreign investment company provisions of the 

Code, with the consequence that the income derived by the 

foreign subsidiary may be required to be included in the 

gross income of the U.S. corporation, whether or not such 

amount is actually distributed. The U.S. corporation might 

be able to avoid this problem by putting the financial 

assets in an operating subsidiary located in either a 

low-tax country or in a country with a territorial tax 

system which permits foreign interest to be received taxfree. The Subpart F provisions do not, for example, cause 

passive income to be subject to U.S. taxation if the income 

is less than 10 percent of the foreign subsidiary's gross 

income. Puerto Rico is an advantageous location for 

financial assets if the U.S. company does not have an 

operating affiliate in a low-tax country or if the 10 
-59-

percent rule is limiting. The fact that 936 corporations 

have retained a large pool of financial assets in Puerto 

Rico, even when the return was at a substantial discount 

from Eurodollars, indicates that some U.S. companies do not 

have other locations available for receiving tax-free 

interest income. 

D. Asset Composition of Puerto Rican Investment. Physical, intangible, and financial assets are, of course, 

related to each other. The transfer to Puerto Rico of title 

to patents and trademarks must be accompanied by operating, 

physical investment if the income attributable to the 

intangibles is to qualify for exemption from Puerto Rican 

tax. In a sense, the ability to transfer intangibles to 

Puerto Rico increases the incentive to place physical 

capital there. Also, funds used to make financial investments in Puerto Rico must be derived initially from the 

profits of an active business there if the interest is to 

qualify for tax exemption. Notwithstanding the relationships between physical, intangible, and financial assets, 

the relative shares of the three types of assets in any 

operation can vary. As is shown below, the mix of assets in 

Puerto Rico reflects the incentives which the possessions 

corporation exemption provides relative to tax benefits 

available elsewhere. 

Table 4-1, which is based on corporate balance sheets 

filed as part of U.S. tax returns, indicates that in 1980, 

plant, equipment, and property represented 12.4 percent of 

the total book assets of 936 manufacturing corporations, 

compared to 36.6 percent for manufacturing corporations 

operating in the United States. The relatively small share 

of fixed assets in total book assets of possessions 

companies was borne out in all but one of the industry 

groups for which data are available. The one manufacturing 

group for which this pattern did not hold, rubber products, 

accounted for only 0.5 percent of the aggregate book assets 

of 936 manufacturing firms. A detailed distribution of the 

book assets of 936 manufacturing corporations shows that the 

cash assets category, by itself, exceeded physical plant and 

equipment net of depreciation (see Table 5-1 below) • 

While it is difficult to identify precisely the passive 

financial investments of 936 manufacturing corporations, 

data from various official and bank sources indicate that at 

year-end 1980 they were approximately $6 billion, and rose 

to $7.6 billion at year-end 1981. (See Table 4-4 below.) 

The $6 billion in passive inv~tments in 1980 were four 

times the value of 936 manufacturing corporations' physical 

Plant and equipment net of depreciation. New investment in 

Plant and equipment by 936 manufacturing corporations was 

approximately $300 million in tax year 1980. New investment 

in financial assets was over $1 billion. 
-60-

Table 4-1 

Possessions Corporations and Corporations Operating in the U.S. -- Net Plant, 

Equiμnent and Land as a Percentage of Total Assets, Year-end 1980 

936 Assets by 

Industry as a 

Percent of All 

936 Assets y 

Net Plant, Equipnent and Property 

as a Percent of Total Assets 

by Industry Column 2 

Industry 

All Manufacturing Industries 

Food and kindred products 

Textile mill products 

Apparel 

Paper and allied products 

Chemicals 

Pharmaceuticals 

Rubber products 

Leather products 

Stone, clay, and glass 

100.0% 

7.4 

0.9 

2.9 

0.1 

54.2 

46.4 

0.5 

0.6 

products O .1 

Fabricated metal products 1.8 

Machinery, except electrical 1.4 

Electrical and electronic 

equipnent 16.0 

Instrmnents arrl related products 2.8 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

936 

Corporations 

12.4% 

14.7 

4.0 

5.0 

27.7 

13.3 

11.5 

41.2 

3.2 

17.1 

21.1 

6.9 

4.5 

12.5 

Corporations 

Operating in 

the U.S. 

36.6% y 

34.1 

33.7 

n.a. 

54.4 

39.5 

24.9 

35.0 

n.a. 

49.2 

29.5 

29.9 

24.5 

28.7 

.;. 

Column 

33.9% 

43.1 

11.9 

50.9 

33.7 

46.2 

117.7 

34.8 

71.5 

23.1 

18.4 

43.6 

Y The percentages by industry sum to 89 percent, rather than 100 percent, since data for 

industries with fewer than three firms are not shown separately. All manufacturing 

firms are, however, included in the aggregate data shown in row 1. 

Y The average for all corporations, with no adjustment made for the differing industrial 

mix between possessions corporations and corporations operating in the U.S. 

n.a. - not available 

Source: Tax return Form 1120 filed by possessions corporations; and Federal Trade 

Comnission, Quarterly Financial Report, First Quarter, 1981. 

3 
II1 2 

n 3 

__..,, 

% 

-61-

It also is difficult to specify accurately the value of 

intangible assets of 936 corporations. Frequently, these 

assets are the result of R&D and sales promotion activities 

conducted by the U.S. parent corporations. Because R&D and 

sales promotion are expensed when performed, intangible 

assets are generally carried on the books of the U.S. parent 

or its affiliated corporation at a zero basis. Intangible 

assets are not routinely bought and sold in exchanges 

between unrelated parties and, thus, cannot be easily valued 

by reference to independent party transactions. To assess 

the value of intangible assets that have been acquired by a 

possessions corporation in a section 351 transfer, one would 

ideally compare the profit margin of the possessions 

corporation to profit margins earned by corporations 

performing similar functions but not holding intangibles 

which they had acquired pursuant to section 351. Detailed 

data of this type are not generally available. It is 

possible, however, to obtain a general indication of the 

importance of intangible assets which have been transferred 

to possessions corporations by comparing 936 profits to 

those of all U.S. mainland corporations. 

Table 4-2 does this by comparing, for possessions 

corporations and mainland firms, industry ratios of 

operating profits to operating assets. The table attempts 

to exclude both income and assets associated with financial 

investments. Columns A and B list net operating income, 

which includes the return to intangibles, as a percentage of 

operating assets, which include property, plant and equipment, inventories, and net receivables. The table indicates 

that in 1980, the before-tax return on operating assets was 

52.3 percent for possessions corporations, compared to 12.7 

percent for manufacturing operations in the United States. 

Net operating income in relation to the number of employees 

by industry, shown in columns C and D, was 5.9 times greater 

in possessions corporations than in mainland corporations. 

Several factors explain the high returns of 936 

operations relative to mainland operations. First, the 

government of Puerto Rico owns land and buildings which it 

leases to tax-exempt manufacturing firms. The Puerto Rican 

government reports that many companies in the electrical and 

electronic equipment industry, in particular, use government 

-owned buildings. In 1980, total land and buildings owned 

by the Commonwealth for lease to 936 corporations and Puerto 

Rican tax-exempt firms amounted to $346.3 million. 3/ No 

data are available on the amount of government-=owned 

Property which is under lease to 936 firms. Assuming, for 

}/ Puerto Rico Industrial Development Corporation, Annual 

Report, 1981. 
Table 4-2 

Possessions Corporations and Corporations Operating in the United States: Before-tax Operating Income in Relation to 

Operating Assets and Employment, 1980 y 

Gross Sales of Operating Income as a Percentage of Operating Income Divided by 

936 Corporations Operating Assets Number of Employees 

Industry (A) 

Amount :Percent of 936 Operations y : ($millions): Total 2/ 

All Manufacturing 

Industries 9,075 100.0% 52.3% 

Hi9h-Technolo~y Industries 

Electrical and 

electronic equipment 1,274 14.0 94.2 (75.6*) 

Household appliances 0 o.o 

Radio, TVs, communications equipment 161 1.8 ll0.2 (170.6*) 

Electronic components 329 3.6 47.2 (51.2*) 

Other 784 8.6 129.1 (77.2*) 

Chemicals 3,490 38.5 53.7 

Pharmaceuticals 2,625 28.9 73.1 

Rubber products 46 0.5 34.8 

Machinery, except 

electrical 137 1. 5 60.2 

Instruments and related 

products 253 2.8 65.7 

Low-Technolo9y Industries 

Apparel 421 4.6 38.6 (34.5*) 

Textile mill products 47 0.5 31.3 

Stone, clay and 

glass products 16 0.2 26.9 

Food and kindred 

products 789 8.7 31.2 

Fabricated metal 

products 165 1.8 30.4 

Paper and allied 

products 

Leather 102 1.1 31.3 (29.2*) 

Office of the Secretary of the Treasury, Office of Tax Analysis 

* 1979 data are reported, since 1980 data on corporations 

operating in the U.S. are not available. 

Operating income is defined as gross sales less cost of goods 

sold and less all other deductions except taxes, interest, 

and charitable contributions. Operating assets include 

property, plant and equipment, inventories, and net accounts 

receivable. 

Y The pel:centages by i.ndust-x:y sum to 14 pe-x:cent, -x:ather than 

~~~ ~el:cent, since data ~Ol: industl:ies with ~ewel: than thl:ee ~~~ ~~-ems. o~ ~o~ ~n~cn no U.S. com~a~ab~e ma~n~and data a~e 

a'Ja.~-~ a...'ci'\...e.. a"'C..e. -no~ s"'no-...i"C'\. s.e'Qa.."'C..a"t:..e.'"\..."::l -

(B) Column A (C) (D) Column c 

Mainland + 936 Operations y: Mainland + Operations Column B Operations Column D 

12.7% 4.1 $37,332 $6,352 5.9 

13.6 6.9 27,188 (29,657*) 5,041 (4,467*) 5.4 

15.1* 5,184* 

7.8* 21. 9* 26,492 (36,395*) 2,371* 15.4* 

13.1* 3.9* 22,844 (28,070*) 5,520* 5.1* 

11.1* 7.0* 29,028 (29,059*) 5,315* 5.5* 

13.1 4.1 102,998 12,342 8.3 

16.0 4.6 ll7,849 ll, 867 9.9 

8.2 4.2 25,492 2,395 10.6 

14.8 4.1 32,704 6,640 4.9 

18.5 3.6 26,594 6, 729 3.9 

13.1* 2.6* 5,903 (4,789*) 1,492* 3.2* 

11.9 2.6 8,907 2,758 3.2 

10.7 2.5 19,557 4,320 4.5 

14.4 2.2 16,601 7,475 2.2 

13.8 2.2 18,216 3,836 4.7 

23.4* 1.2* 4,523 (5,488*) 4,688* 1. 2* 

ii The data for 936 corporations include only those firms for 

which employment data are available. See Table 5-3. 

Source: Tax return Form 1120 filed by possessions corporations; 

Federal Trade Commission, Quarterly Financial Report, 

First Quarter, 1981; U.S. Department of Labor, 

Supplement to Employment and Earnings, June 1982, and 

Internal Revenue Service, Source Book, Statistics of 

Income 1979. 

I 

O'\ 

N 

I 
-63-

the sake of illustration, that three-fourths of the $346.3 

million in government-owned property was provided to 936 

firms, and treating such leased property as "936 operating 

assets," would reduce the ratio of 936 operating income to 

operating assets in all manufacturing industries from 52.3 

percent to 49.0 percent. If it is further assumed that all 

such leased property was used in the electrical and 

electronic equipment industry, then that industry's incometo-asset ratio would fall from 94.2 percent to 55.2 percent, 

compared to 13.6 percent in the United States. The 

operating assets of possessions corporation will also be 

understated by the amount of any property, plant, and 

equipment leased by a 936 firm from a non-936 firm. 

The difference in the ratios in Table 4-2 between 936 

and mainland operations may also reflect the fact that 936 

corporations generally include only those corporations which 

have passed beyond the period of start-up losses, while the 

sample of mainland firms includes companies in all stages. 

In order to offset start-up losses in Puerto Rico against 

other income subject to taxation, a U.S. parent company will 

not make a 936 election for its subsidiary until the 

subsidiary is earning net income. If all loss corporations 

are excluded from the sample of mainland corporations, then 

the ratio of U.S. operating income to operating assets is 

increased from 12.7 percent to approximately 14.4 percent.!/ 

Possessions corporations and Stateside firms also 

operate in a different economic environment and face 

different prices. Prices for utilities and transportation 

tend to be higher in Puerto Rico than in the United States. 

On the other hand, average wages within Puerto Rican 

manufacturing industries are lower. If the payroll of · 

!I Since the Federal Trade Commission, Quarterly Financial 

Report, does not separately present balance sheet and 

income statement data for corporations with net income, 

the discrepancy between profit margins of all corporations and corporations with net income was computed from 

the Internal Revenue Service, Source Book, Statistics of 

Income, Active Corporations, Income Tax Returns, July 

1979-June 1980. In accounting periods ending between 

July 1979 and June 1980, operating income as a 

percentage of operating assets for U.S. corporations 

with net income was 15.0 percent, or 13.6 percent higher 

than the comparable figure for all U.S. corporations, 

which was 13.2 percent. 
-64-

possessions corporations ~/ is increased by the same 

proportion that U.S. average hourly earnings exceed Puerto 

Rican average hourly earnings in that industry ~/, then 936 

rates of return are reduced as follows: 

Industry 

Selected Manufacturing 

Industries, listed 

below 

Electrical and 

electronic 

equipment 

Chemicals 

Textile mill products 

Stone, clay and 

glass products 

Food and kindred 

products 

Fabricated metal 

products 

Apparel 

Leather 

1980 

Before-Tax Operating Income as a 

Percentage of Operating Assets 

Adjusted for Puerto 

Actual Rican-u.s. Wage 

Differentials 

52.9% 44.4% 

94.2 67.4 

53.7 48.8 

31. 3 15.6 

26.9 2.5 

31. 2 17.1 

30.4 14.5 

38.6 16.9 

31.3 7.4 

This table shows that when 936 operating income is reduced 

to eliminate the Puerto Rican-U.S. wage differential, the 

income-to-asset ratios for the principal manufacturing 

industries, taken together, fall 8.5 percentage points. In 

low-technology industries, the income-to-asset ratios fall 

to a level comparable to or even below the U.S. mainland 

levels, listed above on Table 4-2. However, in hightechnology industries, electrical and electronic equipment 

and chemicals, the adjusted income-to-asset ratios are 67.4 

percent and 48.8 percent, respectively, which are still more 

than triple the mainland rates of return. 

~/ See Table 5-3. 

~/ See Table 3-4. 
-65-

Taken together, the impact of leasing, U.S. loss 

corporations, and lower Puerto Rican wage rates may account 

for up to one-third of the difference between 936 and 

mainland rates of return. While the rest of the difference 

cannot be attributed exclusively to the transfer of 

intangibles to possessions corporations by their mainland 

affiliates, such transfers appear to be an important factor. 

This is underscored by the fact that the difference between 

936 and mainland rates of return is much greater in hightechnology industries than in low-technology industries. 21 

Table 4-2, above, lists major industry categories in 

descending order by the size of the gap between 936 and 

mainland rates of return. The electrical and electronic 

equipment industry, the pharmaceutical industry, and other 

high-technology industries appear at the top of the table, 

with 936 rates of return from 35 to 129 percent. The lowtechnology industries appear at the bottom of the table, 

with 936 rates of return from 21 to 39 percent. In contrast 

to the skewed pattern of 936 rates of return in high- and 

low-technology industries, U.S. rates of return are 

relatively constant across all industries, with an average 

return of 12.7 percent. 

The industries in which the gap between 936 and mainland 

rates of return is largest are those where U.S. spending on 

R&D is high. According to the Federal Trade Commission, the 

U.S. industry categories with the greatest firm-financed 

R&D as a percentage of sales were prescription drugs and 

electronic computing equipment. 8/ Total expenditures on 

R&D and sales promotion in these two lines of business were 

30.6 percent of sales (for prescription drugs) and 24. 7 

percent of sales (for electronic computing equipment). 

Although precise data are not available on the 

expenditures by possessions corporations on R&D and sales 

Promotion, there are indications that possessions 

21 High-technology industries in Table 4-3 are defined as 

those industries where R&D as a percentage of capital 

spending by U.S. firms is above the average for all U.S. 

manufacturing industries. Data are for 1980, from 

Annual McGraw-Hill Survey of Business' Plans for Research and Development Expenditures, 1981-94, June 1981, 

Tables VI and VII. 

~/ Federal Trade Commission, Annual Line of Business Report, 

1976, May 1982, Table 2-5. 
-66-

corporations spend little in these areas. Of all employees 

in the Puerto Rican high-technology industries listed in 

Table 4-2, only 18 percent performed work other than 

production operations in 1977, compared to 35 percent of all 

workers in these industries in the United States. 9/ 

Another indication is that expenditures for purchased 

advertising represented .002 percent of sales for 936 pharmaceutical firms (compared to 13 percent of sales in the 

mainland pharmaceutical industry). In the electrical and 

electronic equipment industry, 9 3 6 firms' spending on 

advertising was .008 percent of sales (compared to 1 percent 

for the mainland industry) • The fact that the gap between 

936 and U.S. rates of return is largest in the electrical 

and electronic equipment, pharmaceutical, and other hightechnology industries suggests that U.S. parent corporations 

have responded to the incentives under the possessions 

corporation exemption by allocating income from U.S. 

patents, trademarks, and other intangibles to their 936 

corporations. 

II. How Does Each Asset Contribute to Puerto Rican Growth? 

The contribution to Puerto Rican growth of physical 

assets, such as plant and equipment or inventories, is 

direct and straightforward. Physical investment increases 

income in two ways: by providing the necessary capital to 

create more productive new jobs; and by providing additional 

capital to, and thereby increasing the productivity of, 

those currently employed. 

Some types of intangible assets, such as management 

techniques, contribute to Puerto Rican growth and add to 

productivity in much the same way as physical capital. With 

respect to other, product-specific types of intangibles, in 

particular, patents, trademarks, and trade names, a distinction can be drawn between the right to use the intangible 

and the ownership of the intangible. 

~/ Production workers include workers (up through the 

working foreman level) engaged in fabricating, inspect- ing~ shipping (but not delivery), maintenance, and other 

services closely associated with production operations 

at a manufacturing establishment. U.S. Department of 

Labor, Supplement to Employment and Earnings, Revised 

Establishment Data, September 1980; and U.S. Department 

of Commerce, 1977 Economic Census of Outlying Areas, 

Manufactures, Puerto Rico. 
-67-

If a U.S. parent wants to move the production of a 

patented product to Puerto Rico, it can license the 936 

corporation to produce the product, in whole or in part, 

without also giving it title to the intangible. The production license adds to the productivity of Puerto Rican 

workers because it gives them an opportunity to participate 

in the production of advanced products. The license enables 

the marginal product of labor and capital used in Puerto 

Rico to be as high as that of labor and capital used in the 

United States. 

Transferring the ownership title to an intangible may 

also benefit Puerto Rico. Provided the transfer is 

accompanied by additional investment of physical assets in 

Puerto Rico, it will increase Puerto Rican productivity and 

growth. If the income attributable to the intangible is 

treated as earned by the, 936 corporation, rather than the 

U.S. parent, the pool of tax-exempt Puerto Rican earnings 

wi 11 increase. A corporation contemplating an investment 

decision may find that the benefits of a tax-free return on 

intangibles provide sufficient incentive to make a real 

physical investment in Puerto Rico. The precise impact of 

the transfer of intangibles on Puerto Rican productivity and 

growth will be closely related to the volume of physical 

investment that accompanies the transfer of intangibles. 

Manufacturing processes differ in the extent to which the 

various stages are integrated. In some cases, it may be 

difficult to separate phases of the production process, and 

the U.S. parent corporation will have a strong incentive to 

move a substantial operation to Puerto Rico in order to 

attempt to obtain the benefits of a tax-free return on its 

intangibles. In other cases, it may be possible to move a 

relatively small part of the whole production process to 

Puerto Rico. 

The data on the modest fixed capital requirements of 936 

corporations indicate that, in general, only a relatively 

small segment of the production process of U.S. corporations 

has been moved to Puerto Rico. As shown in Table 4-1, 

above, fixed assets represent 12.4 percent of the total book 

assets of 936 manufacturing corporations, compared to 36.6 

Percent for manufacturing corporations operating in the 

United States. However, those 936 operations which have 

been established in Puerto Rico add up to a substantial 

amount of economic activity. Table 3-8 indicates that the 

high-technology industries of chemicals, electrical and 

electronic equipment, and instruments provide 32 percent of 

total employment in Puerto Rico's manufacturing sector and 

have accounted for three out of every four new jobs in 

those Puerto Rican manufacturing industries which have 

experienced an increase in employment since 1968. 
-68-

The tax benefits that U.S. parent corporations have 

claimed through the transfer of U.S. intangibles to Puerto 

Rico may eventually have another favorable, but indirect, 

effect on Puerto Rico. The increased after-tax returns in 

high-technology industries may stimulate additional R&D to 

develop new products. After the products are developed, 

their production may, at least in part, be located in Puerto 

Rico. 

The benefits to Puerto Rico of financial investment in 

Puerto Rico by 936 corporations are also much more indirect 

than the benefits from physical investment. Because of the 

complexity of the rules involving tax-exempt financial 

investment, a separate section devoted to the issue makes up 

the remainder of this chapter. 

III. The Impact of 936 Financial Assets on Puerto Rican 

Growth 

Before 1976, the United States exempted all non-U.S. 

source income of possessions corporations until the income 

was repatriated in the form of dividends, and tax could be 

avoided altogether by distributing accumulated profits upon 

the liquidation of the possessions corporation. In order to 

avoid tax, possessions corporations ordinarily did not ~ay 

dividends and instead invested their prof its in the 

Eurodollar market. By limiting the tax exemption to QPSII 

and to income effectively connected with a possession trade 

or business, the Tax Reform Act of 1976 created an incentive 

for possessions corporations operating in Puerto Rico to 

invest the large pool of funds that had been invested in the 

Eurodollar market in the Puerto Rican capital market, 

instead. 

Congress ' intent i on in 1 i mi t in g the tax exempt i on to 

QPSII was to facilitate the financing of local government 

development programs and private investment in the 

possessions. 10/ The increased pool of assets, it was 

believed, would reduce the cost of capital to investors in 

Puerto Rico, compared to the cost of funds to investors in 

the United States, thus leading to additional physical 

fnvestment in Puerto Rico. The purpose of the Puerto Rican 

and U.S. regulations relating to QPSII is to maintain a 

separation between the Puerto Rican capital market (where 

..!.QI S. Rep. No. 94-938, 94th Cong., 2d Sess. 280 (1976). 
-69-

936 corporations can earn tax-free returns) and world 

capital markets by preventing arbitrage between them. This 

section assesses whether the Puerto Rican financial market 

has been amenable to this separation and control. 

The Puerto Rican authorities have recognized the 

difficulties in directing 936 financial assets into 

additional physical investment in Puerto Rico. In early 

1980, for example, the President of the Government 

Development Bank, in announcing the new regulations to be· 

implemented on Apr i 1 1, 1980, stated that "there have been 

many loopholes, and many factors, that ·precluded the optimum 

economic impact of the 936 funds in our economy." In April 

1981, the Secretary of the Treasury of Puerto Rico circulated a letter to members of the financial community asking 

them to report on their operations and to respond to various 

possible changes in the regulations governing 936 funds. He 

commented that, 

the implementation by the banks of the pooling of funds 

and fungibili ty of money concepts have resulted in a 

reduction of accountability, to the extent that the 

exact utilization of these 936 deposits sometimes cannot 

be determined by the department. 

The concern by Puerto Rican officials that 936 funds may 

not finance new investment in Puerto Rico is reflected in 

the series of changes made in the regulations governing the 

use of 936 funds. The most recent amendments to these 

regulations were issued on December 17, 1981, and went into 

effect on February 1, 1982. 

The funds that flowed into the Puerto Rican financial 

market after the enactment of section 936 in 1976 were 

enormous by Puerto Rican standards. Before 1976, financial 

investments in Puerto Rico by possessions corporations 

amounted to no more than $200 million because income from 

offshore investments was free from both U.S. and Puerto 

Rican tax. By December 1981, however, there were $5.3 

billion in tax-exempt deposits and repurchase agreements in 

Puerto Rican banks, which was more than 30 percent of total 

commercial bank liabilities. In total, financial investments in Puerto Rico made by 936 manufacturing corporations 

(enjoying exemption from both U.S. and Puerto Rican income 

tax) amounted to about $7.6 billion at the end of 1981. The 

equivalent on the scale of the U.S. economy would exceed 

$500 billion. 
-70-

Table 4-3 presents the financial portfolios of all 936 

corporations in Puerto Rico. The financial assets listed do 

not include accounts receivable or other financial working 

capital. Table 4-4 presents the financial portfolios of 936 

corporations in manufacturing. The assets in Table 4-4 are 

the principal focus of this section because the interest and 

dividends they generate are potentially free from both U.S. 

and Puerto Rican income tax. 

The first part of this section will describe the U.S. 

provisions for QPSII and the Puerto Rican rules on the 

investment of section 936 funds. Together these determine 

the financial investments that are exempt from both U.S. and 

Puerto Rican income tax. Because interest on deposits in 

certain Puerto Rican banks qualifies for income tax 

exemption, the regulations on the banks' use of 936 funds 

are an important instrument by which Puerto Rico seeks to 

ensure that 936 funds are used within Puerto Rico. The 

second part of this section will attempt to trace the effect 

of the QPSII provisions and Puerto Rican regulations on real 

investment in Puerto Rico. 

A. Legal Background 

1. Qualified Possession Source Investment Income 

under Section 936. Section 936 grants a credit which 

offsets the Federal tax on QPSII earned by a U.S. corporation which has made a 936 election. As explained in Chapter 

2, there are three requirements for investment income to 

qualify as QPSII: (1) the income must be from sources within 

a possession in which a trade or business is conducted, 

which basically means that the payer of the investment 

income must be a resident of Puerto Rico; ( 2) the funds 

invested must be derived from the active conduct of a trade 

or business in that possession; and (3) the funds must be 

invested in the possession, for use therein. The third 

requirement goes beyond the first because a Puerto Rican 

payor of interest might not necessarily use the funds for 

investment in Puerto Rico. 

Section 936 was an important change from pre-1976 law, 

which exempted all non-U. S. source income of possessions 

corporations. To obtain the highest return on their 

financial investments, possessions corporations before 1976 

invested their funds in the Eurodollar market, either 

directly or through Guamanian banks in order to satisfy the 

80 percent possession source gross income requirement. In 

either case, the investment income was free from both U.S. 

and Puerto Rican tax. For this investment income to 

continue to be free from U.S. tax, the Tax Reform Act of 

1976 requires that the funds be invested in Puerto Rico. 
-71-

Table 4-3 

Estimated Composition of the Financial Investments 

of Possessions Corporations at Year-end 1981 

Financial Investments $ 

Total ................................... . 

Investments in Puerto Rico, total 

Deposits in Puerto Rican banks, 

including repurchase agreements 

Puerto Rican source GNMA mortgages 

Loans to other possessions 

corporations •••••••••••••••••••••••• 

Puerto Rican government 

obligations 

Repurchase-Resale agreements not 

included in bank funds •••••••••••••• 

Mortgage and real estate loans ••••••• 

Other investments in Puerto Rico ••••• 

Investments outside of Puerto Rico, 

including U.S. municipals and 

preferred stock of U.S. corporations 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

+ 

* 

Denotes approximation. 

This includes about $400 million in savings 

of the funds referred to as 936 deposits 

deposits by exempt firms which have not 

election, e.g., local exempt firms. These, 

likely to be a small part of the total. 

billions 

9.5+ 

9.0+ 

5.3* 

1. 2 

.3+ 

.4+ 

.4+ 

1. 2 

.2+ 

• 5 

banks. Some 

may include 

made a 936 

however, are 
-72-

Table 4-4 

Estimated Composition of the Financial Investments 

of Possessions Corporations in Manufacturing {enjoying 

exemptions from Puerto Rican tax) at Year-end 1981 

Financial Investments 

Total ................................... . 

Investments in Puerto Rico, total 

Deposits in Puerto Rican banks, 

including repurchase agreements 

Puerto Rican source GNMAs •••••••••••• 

Loans to other possessions corporations 

Puerto Rican government obligations 

Repurchase-Resale agreements not 

included in bank funds •••••••••••••• 

Mortgages and real estate loans •••••• 

Other investments in Puerto Rico ••••• 

Investments outside of Puerto Rico ••••• 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

+ Denotes approximation. 

$ billions 

8.1+ 

7.6 

5.3 

1. 2 

.2+ 

.3+ 

.4+ 

.l+ 

.1 

• 5 
-73-

Although the U.S. Treasury has not issued final 

comprehensive regul:.ations on QPSII, it has issued a 

regulation covering deposits by 936 corporations in Puerto 

Rican financial institutions. Under this regulation, 

interest from such deposits is exempt from U.S. tax if it 

qualifies for exemption from Puerto Rican tax under 

regulations issued by the Secretary of the Treasury of 

Puerto Rico, as in effect September 28, 1976. The Puerto 

Rican regulations are described below. 

2. Puerto Rican Tax Exemption of Investment Income. 

Under the Puerto Rican Industrial Incentive Acts of 1963 and 

1978, income derived from the investment of Industrial 

Development Income 11/ in certain specified assets is free 

of tax. The investments that generate exempt interest, 

rents, and dividends (so-called 2(j) investments) are: 

Puerto Rican Government obligations and loans to 

the Government Development Bank or other government 

agencies, 

Mortgage loans or loans guaranteed by an agency of 

the Federal or Puerto Rican government, 

Loans to other exempt businesses, 

Loans to the maritime industry, 

Loans to businesses operating in Puerto Rico which 

are guaranteed by the Puerto Rican or U.S. 

government, 

Obligations issued by the Conservation Trust of 

Puerto Rico, 

Capital obligations issued by Puerto Rican banks as 

authorized by the Puerto Rico Banking Law, 

Investments in public buildings, including schools 

and hospitals, 

Nonredeemable preferred stock of banking ins ti tut ions organized under the laws of Puerto Rico, and 

.!!I Industrial Development Income is the business income of 

a firm which holds a tax-exemption grant, and also the 

passive income to which such business income gives rise 

when it is reinvested in certain designated assets. 
-74-

Fixed-term deposits 

institutions. 

in qualifying banking 

Although this appears to be a comprehensive list, apart 

from the last item the opportunities for high-yield 

financial investments afforded to 936 companies are 

relatively limited. Puerto Rican government or agency bonds 

bear yields that are linked to the tax-free municipal market 

in the U.S. By investing in a Puerto Rican government 

obligation rather than repatriating its profits, a possessions corporation wi 11 benefit from deferred and, in some 

cases, reduced tollgate taxes. But, because interest 

received by any U.S. investor in Commonwealth bonds is 

exempt from Federal tax, the possessions corporation will 

not realize the main potential benefits of the QPSII 

exemption, i.e., the tax exemption of a yield which is high 

because it is taxable to other investors. 

Government National Mortgage Association bonds (GNMAs) , 

U.S. government-guaranteed securities backed by Puerto Rican 

mortgages, are very desirable investments for 936 firms 

because they carry a high, taxable (to others) return. 

However, new Puerto Rican GNMA issues, which have recently 

been about $100 million per year, are much smaller in dollar 

volume than the annual growth in 936 financial assets. 

Finally, the market for loans by 936 firms to other 936 

firms or local exempt companies seems to be limited because 

exempt companies can get funds for long-term fixed 

investments at a tax-free rate derived from the Puerto Rican 

version of Industrial Development Bonds. One agency that 

offers loans of this type is AFICA (the Industrial, Medical, 

and Environmental Pollution Control Facilities Financing 

Authority). 

Un ti 1 recently, the banks in Puerto Rico have had a 

strategic position as intermediaries because Puerto Rican 

rules allowed them to issue tax-exempt certificates of 

deposit to 936 companies and to use the funds to make any 

loan in Puerto Rico apart from a consumer loan. A loan made 

by a bank to a Puerto Rican importer, wholesaler or 

retailer, for example, would qualify as an eligible asset, 

even though the same loan made directly by a 936 corporation 

would not. The February 1, 1982 regulations, however, now 

specifically permit brokers to invest 936 funds in the same 

range of assets that banks can, while at the same time 

putting them under the same regulatory regime as banks. 
-75-

Before the new regulations become effective February 1, 

1982, investment bankers in Puerto Rico performed a 

significant role in arranging repurchase agreements between 

936 corporations and smaller Puerto Rican commercial and 

savings banks. In these repurchase agreements, or "repos," 

a 2(j) asset such as a Puerto Rican municipal bond was used 

as the underlying asset. The 936 company, which would 

ordinarily be reluctant to deposit funds in a small Puerto 

Rican bank, had the underlying asset as added security. The 

investment banker frequently lowered the risk even further 

by adding its guarantee to the transaction. Under the new 

regulations, investment bankers (brokers) can use any asset 

as the basis for a repurchase agreement with 936 

corporations. However, the proceeds of the repo, i.e. the 

funds received from the 936 corporation, must now be 

invested in eligible assets under rules similar to those 

imposed on banks. 

3. Rules for Banks' Investment of 936 Funds Effective from May 1, 1975 to April 1, 1980. The Secretary of 

the Treasury of Puerto Rico can declare a depository 

institution to be eligible to issue certificates of deposit 

which are 2 ( j) assets. In order to ensure that the funds 

are used for the benefit of Puerto Rico, in 1975 the 

Secretary imposed a set of constraints on the banks. The 

regulations required that the banks invest 20 percent of the 

936 funds in obligations of the Puerto Rican government or 

its agencies, although banks were permitted to use their 

existing investments to satisfy this requirement. To 

prevent banks from using the remainder of the 936 funds to 

make consumer loans or investments outside of Puerto Rico, 

the regulations provided that the increase in a bank's 

consumer loans plus investments outside of Puerto Rico could 

not exceed the increase in its non-936 funds. That ia, any 

increase in a banks' s 936 deposits had to be invested in 

eligible (i.e. nonconsumer and non-foreign) assets. The 

base period for this requirement was April 30, 1975, the 

date that exempt certificates of deposit (CDs) were 

introduced under the Industrial Incentive Acts. The 

regulations also provided that the Puerto Rican branches of 

Citibank and Chase Manhattan could not reduce their 

borrowing from outside of Puerto Rico from the leve 1 

existing on April 30, 1975. There were several features of 

the way in which the banking regulations operated before 

~pril 1, 1980, however, which diluted the impact of the 

incremental rules: 
-76-

a. Warehousing. The Puerto Rican author.i ties 

realized that the sudden influx of 936 funds in 1976 could 

not immediately be absorbed within the economy. Consequently, they gave a bank 90 days to invest 25 percent of a 

new deposit in eligible assets and 180 days to invest the 

remainder. 

b. End-of-the-month reporting. Compliance with the 

pre-April 1, 1980, rules was in terms of end-of-the-month 

levels. It was therefore possible for a bank to offer a CD 

for 29 days yielding a month's tax-exempt interest, and let 

it disappear on the last day of the month. 

c. Repos (Securities sold under repurchase agreements). A bank could sell a Puerto Rican government bond in 

its portfolio to a 936 company under a repurchase agreement 

(usually through an investment banker) • 12/ The funds 

received by the bank were not considered 936 deposits. To 

the 936 corporation, however, the Puerto Rican municipal was 

an eligible (2(j)) investment. Furthermore, the bond that 

was sold under the repurchase agreement could still count as 

one of the bank's eligible assets. 13/ 

d. Assets acquired from insolvent banks. Puerto 

Rico experienced a banking crisis in the mid-1970s. The 

most significant liquidation was Banco Credito, which was 

the second largest bank at the end of 1975, with almost $800 

12/ Under the usual terms of a repo, the seller (the bank) 

agrees to buy the security back at a fixed date. It is 

therefore in essence a short-term secured loan from the 

936 corporation to the bank. In Puerto Rican Treasury 

rulings, the character of the repo interest is the same 

as the coupon interest for purposes of the 2(j) exemption. The sale and repurchase price are therefore set 

to reflect the accruing interest during the life of the 

repo, and to make the interest equivalent to a shortterm yield. Since investment bankers in Puerto Rico are 

freqq.ently intermediaries, there are in fact two backto-back repos -- first between the bank and investment 

banking house, and then between the investment banker 

and the 936 company. 

_!ll In April 1980, the first month of the new reporting 

system, repos by all banks, including savings banks, 

amounted to $240 million, or about 7.5 percent of total 

936 funds in banks. 
-77-

million in assets. It was declared insolvent and its assets 

were taken over by other banks in Puerto Rico. Banks which 

acquired eligible assets from a liquidating bank could 

regard them as new assets under the Puerto Rican 

regulations. That is, the assets did not bring an addition 

to the bank's base-period eligible assets, nor did they 

result in a corresponding increase in 936 deposits. The 

acquiring banks could therefore report an increase in 

eligible assets, even though eligible assets in the banking 

system as a whole had not increased. 

In addition to these technical reasons for the dilution 

of the impact of the Puerto Rican regulations on banks' use 

of 936 funds, there is the possibility that the incremental 

rules, even if strictly adhered to, would not have affected 

the banks' investments. The incremental rules would have 

been effective only if the increase in 936 deposits had 

exceeded the increase in eligible investments that banks 

would have wanted to make anyway. For example, between 

April 1980 and February 1981, total 936 deposits requiring 

equivalent eligible assets grew by $572 million, while total 

eligible assets increased by $675 million. On the margin, 

there was no incentive for banks to acquire additional 

eligible assets. For the banking system as a whole, the 

incremental rules imposed no constraint. 

4. Banking Regulations Effective From April 1, 1980 

to January 31, 1982. In early 1980, the Puerto Rican 

Treasury Department announced new regulations on banks' use 

of 936 funds that were designed to deal with some of the 

problems described above. The main changes were: 

a. A virtual end to warehousing opportunities. 

Ninety-five percent of 936 funds have to be invested at all 

times in eligible assets. 

b. Compliance based on average daily balances 

during the month, rather than end-of-the-month levels. 

c. Classification of repos with 9 36 companies as 

936 deposits for the purpose of the investment regulations. 

However, it appears that when an investment banker obtains a 

2 ( j) asset from a bank under a repo and then repos it in 

turn to a 936 company, the funds are not considered to be 

936 deposits. 

d. A requirement that 10 percent of eligible funds 

be deposited with the Government Development Bank (GOB). 

This is in addition to the requirement under the earlier 
-78-

regulations that 20 percent of eligible funds be invested in 

obligations of the Puerto Rican government. Banks received 

credit for existing loans to the GOB and repos to the GOB, 

which expected a net inf low of deposits of only about $50 

million. In fact, the new deposits required were 

substantially higher. 

Most banks did not appear to have great difficulty in 

complying with the new regulations. In April 1980, the 

first month that the new regulations were in effect, 

aggregate incremental eligible assets exceeded 936 funds in 

banks by $680 million. Most of the excess eligible assets 

were concentrated in the smaller commercial banks and in the 

savings banks. The branches of U.S. and Canadian banks, and 

the large local banks, had relatively few excess eligible 

assets, but it appears that they did not have to change 

their portfolios much in order to conform to the new 

regulations. 

While the April 1, 1980 regulations attempted to limit 

the opportunites for arbitrage previously available, the 

empirical evidence presented later in this chapter indicates 

that they did not significantly increase the contribution of 

936 funds to Puerto Rican development. The fact that the 

banking system as a whole continued to have excess eligible 

assets meant that new 936 deposits could be received without 

additional investment in Puerto Rico. Furthermore, even if 

banks did expand their loans to eligible Puerto Rican 

borrowers, these borrowers might themselves turn around and 

invest the funds offshore if yields in the Eurodollar market 

exceeded the cost of borrowing in Puerto Rico. 

5. Banking Regulations Effective February 1, 1982. 

The regulations which were issued on December 17, 1981, and 

became effective February 1, 1982, are intended to correct 

the problems that remained under the April 1980 regulations. 

They represent an important tightening in the procedures for 

banks' use of 936 funds. They also expand brokers' ability 

to act as intermediaries for 936 funds while bringing them 

under a regulatory regime similar to those applying to 

~anks. The major changes are: 

a. The base for the calculation of incremental 

e 1igib1 e assets is effective 1 y moved up to Ju 1 y 1 , 19 81. 

All excess eligible assets in existence at that date are 

therefore no longer available for matching with new 936 

deposits. There are some exceptions to this rule, including 

some private placements with the Government Development 
-79-

Bank, which will preserve their character as an eligible 

assets, although only to the extent that the bank had excess 

eligible assets on July 1, 1981. These exceptions are of 

limited quantitative significance. 

b. The regulations now cover the use of funds by 

the ultimate eligible borrower. The proceeds are not to be 

used to purchase financial assets to take advantage of any 

differential between 936 interest costs and regular yields. 

The banks must be able to establish to the satisfication of 

the Puerto Rican Secretary of the Treasury that the eligible 

funds have been properly applied. Evidence of proper use 

will include, but not be limited to, a representation letter 

from the enterprise receiving the funds. The enterprise 

will be able to use 936 funds to refinance its existing 

nonfinancial assets and liabilities. The opportunites for 

refinancing existing assets such as plant and equipment 

would appear to offer substantial leeway in the ultimate use 

of 936 funds, although such refinancing would not 

necessarily increase net investment in Puerto Rico. 

c. Starting in 1983, 6 percent of a bank's total 

eligible deposits will have to be invested by the bank in 

mortgage loans to finance newly constructed housing. In 

1982 only 3 percent will be required. It will be possible 

for banks to receive relief from this ~equirement if Puerto 

Rico's Secretary of Housing certifies that sufficient 

mortgage instruments are not available in the market. 

d. Brokers will now be eligible to act as 

intermediaries for the use of 936 eligible funds. They can 

obtain the funds by offering a repo to a 936 corporation 

with any security. The underlying asset in the repo may 

therefore be other than a 2(j) asset. However, the proceeds 

of the repo have to be invested in eligible assets with 

restrictions parallel to the requirements on bank funds. 

Thirty percent of the proceeds will have to be invested in 

public debt of the Commonweal th of Puerto Rico. Rules on 

the use of the 936 funds by t he ultimate borrowing 

enterprise also are associated with the transaction. 

e. There has been some clarification of the list of 

eligible assets. For example, new automobile loans are now 

specifically eligible. 

As part of 

Treasury issued 

the eligibility 

the new regulations, the Secretary of the 

an administrative determination clarifying · 

of banks' loans to brokers operating in 
-80-

Puerto Rico. This had been an issue of some importance 

because loans to brokers had apparently been a significant 

category of eligible assets. The December 17, 1981 determination stated that loans to brokers could not be used to 

finance customers' margin debt, and could not be used to 

acquire an inventory of securities, other than 2(j) assets 

or obligations issued by firms engaged in trade or business 

in Puerto Rico for the purpose of funding their island 

operations. 

In addition to advancing the date for the purpose of 

computing incremental eligible assets, the December 17, 

1981, regulations have also changed the way in which the 

incremental rule operates. The regulations state: 

The application of the above described incremental rule 

can result in an eligible institution being able to 

receive additional eligible deposits without generating 

additional qualified assets when the eligible depository 

institution has an excess of such assets. This 

situation should not be interpreted by the eligible 

depository ins ti tut ion as allowing for the investment 

outside of Puerto Rico of the eligible funds received. 

This apparently means that an eligible institution will have 

to demonstrate that any additional 936 funds have flowed 

into new eligible assets, even if it already had excess 

incremental eligible assets. This appears to be · a 

fundamental change in the incremental rule and a reduction 

in the opportunities for arbitrage. On the other hand, it 

may simply mean that banks and other eligible institutions 

book loans after receiving 936 funds, instead of booking the 

same loans first and then bidding for funds. 

The new regulations had the immediate effect of removing 

most of the excess eligible assets from the banking system. 

In January 1982, the month before the new regulations became 

effective, there were $788 million in excess eligible assets 

in the banking system. In February 1982, there were $126 

million. Much of the decline is accounted for by the fact 

that none of savings banks elected to be eligible depository 

institutions in the new regime. However, there was a 

substantial decline in excess eligible assets in the 

commercial banks as well, from $339 mi 11 ion in January to 

$126 million in February. The updating of the base period 

to July 1, 1981, accounts for almost all of this decline, as 

it had a net impact of $186 million. The stricter rules on 

the eligibility of loans, particularly to brokers, do not as 

yet appear to have had a significant impact on total 

eligible assets. 
-81-

B. Empirical Analysis 

1. Inflow of 936 Funds and Net Capital Flows into 

Puerto Rico. One indication of whether the QPSII provision 

has been successful in increasing investment in Puerto Rico 

can be found in the capital account component of the Puerto 

Rican balance of payments. Real investment in any 

economy can be financed by (a) private domestic saving, (b) 

government saving, or (c) capital inflows from abroad. The 

QPSII provision was intended to increase the third source of 

capital, inflows from abroad. That is, the objective was to 

increase the flow into Puerto Rico of the large pool of 

funds that had been invested in the Eurodollar market. Any 

increase in this source of investment would be reflected in 

a change in net capital inflows into Puerto Rico. 

Table 4-5 presents net flows in the Puerto Rican capital 

account. It reflects both changes in foreign holdings of 

assets in Puerto Rico and changes in Puerto Rican holdings 

abroad. The data in Table 4-5 are for fiscal years ending 

June 30. Because section 936 became law on October 4, 1976, 

the main impact might be expected in fiscal year 1977 (July 

1, 1976 to June 30, 1977), although there might have been 

some capital flows into Puerto Rico in the previous year in 

anticipation of passage of the law. Regardless of whether 

fiscal year 1977 or 1976 is taken as the beginning year for 

section 936 to have an impact, the inflow of 936 funds is 

hardly visible in the net capital balance. Average inflows 

in the period 1976-1980 are almost identical to the flows in 

the prior four years, even in nominal terms. The net 

capital inflow did increase to a new high in 1981, but the 

increase was still modest in relation to the annual 

accumulation of 936 financial assets. What explains the 

failure of the large inflow of 936 financial assets to be 

reflected in the overall contribution of foreign capital to 

investment in Puerto Rico? 

The answer is given in Table 4-6, which presents 

selected components of the Puerto Rican capital account. 

The inflow of 936 funds is clearly reflected in the increase 

in direct investment, which is where it would be classified. The total for the four-year period ending June 30, 

1979 was $3. 7 billion higher than the total for the prior 

four-year period, or about the magnitude one would expect. 

This $3.7 billion increase in direct investment must 
-82-

Table 4-5 

Net Capital Inflows into Puerto Rico, 1970-1981 

(Millions of dollars) 

Year Ending Net Capital Flows June 30 

1970 891 

1971 1,156 

1972 1,323 

1973 1,266 

1974 1,329 

1975 1,838 

1976 1,695 

1977 1,459 

1978 1,478 

1979 1,234 

1980 1,513 

1981 2,071 

Source: Puerto Rico Planning Board, Bureau of Economic 

Accounts and Censuses 
Table 4-6 

Co'rponents of the Puerto Rico Capital Account, 1970-1981 

(millions of dollars) 

[(+) reflects increased investment in Puerto Rico by nonresidents and liquidation of foreign assets by Puerto 

Ricans. (-) reflects sale of Puerto Rican assets by ronresidents or Puerto Rican purchase of assets abroad.] 

YFAR ENDING 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 JUNE 30 

Direct investm:mt 

in Puerto Rioo 330 686 626 792 343 539 1,276 1,838 1,954 940 2,185 3,147 

Net short-tenn banking 

flows 182 32 -25 114 39 306 59 -544 -211 -440 -557 -1,362 

Foreign holdings of 

bank debts 45 20 102 248 227 453 48 -91 -72 197 -13 -384 

Invest.ment by PR 

banks abroad -110 79 -4 -174 -25 -168 70 -457 -197 -763 -490 -1,007 

I 

co 

External deμ:>sits in w 

Puerto Rican banks 247 -67 -123 40 -163 21 -59 4 58 133 -95 29 I 

Net foreign investment in 

long-tenn Puerto Rican 

Goverrunent d:>ligations 181 307 448 404 590 896 208 353 -195 659 470 168 

PR investment in U.S. 

Goverrunent securities -15 -20 66 15 111 14 -32 -303 128 -189 -210 98 

Net foreign investment 

in short-tenn debts of 

PR μiblic oorμ:>raticns 25 67 42 64 15 153 -37 105 - 6 -s.o 146 -42 

Short-tenn investment 

abroad by μIDlic 

corpora ti ens - 7 - 2 -15 8 -26 -96 -19 -48 -199 71 -641 8 

All other 195 86 181 -131 257 26 240 65 7 198 120 54 

Total, Net 891 1,156 1,323 1,266 1,329 1,838 1,695 1,455 1,478 1,234 1,513 2,071 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

Source: Puerto Rico Planning Board, Bureau of F.conanic Accounts arrl Censuses 
-84-

represent almost exclusively an increase in financial assets 

in Puerto Rico, since gross private investment in plant and 

equipment showed no sustained upward trend between 1971 and 

1979, and amounted in 1977 and 1978 to only one-third of the 

total direct investment inflow in those two years. (See 

Table 4-2.) The level of direct investment rose sharply in 

1980, after a drop in 1979 when the major inflow of 936 

financial assets seemed about over. It rose again in 1981 

by almost another billion dollars. The large increases in 

the flow of direct investment in 1980 and 1981 apparently 

reflect the large retained earnings of U.S. corporations. 

Table 4-2 indicates that, as in 1977 and 1978, more than 

two-thirds of the direct investment in 1981 must have 

reflected financial, not real investments • .!_!/ 

The large increases in direct investment flows were 

offset in part by changes in banking flows. The three 

short-term banking flows given in Table 4-6 are (a) changes 

in the foreign holding of non-deposit liabilities of Puerto 

Rican banks, (b) changes in short-term investments by Puerto 

Rican banks abroad, and (c) changes in foreign deposits in 

Puerto Rican banks. Increases in holdings by foreigners of 

short-term non-deposit liabilities diminished substantially 

in 1976, and turned into liquidations in four of the next 

five years. Furthermore, there have been very large 

increases in investments by Puerto Rican banks in foreign 

capital markets since 1977. Presumably, these investments 

were made up of Eurodollar or U.S. bank deposits. 

Changes in the holdings of Puerto Rican government 

obligations were another offsetting factor in the years 

immediately after the enactment of section 936. The foreign 

(largely U.S.) accumulation of Puerto Rican government 

obligations diminished substantially in 1976. In part, this 

was due to smaller total borrowing by the government. 

However, the creation of section 936 must also have played 

an important role. Some 936 corporations acquired Puerto 

Rican government debt. More significant were acquisitions 

by banks. As noted above, banks were required to invest 20 

percent of 936 deposits in government obligations according 

to rules in force before April 1, 1980, when the requirement 

_!!/ These data on direct investment flows must be treated 

with some caution. Direct investment in Puerto Rico is 

estimated by adding retained earnings of foreign 

(including U.S.) corporations to the residual from all 

the other balance of payment flows. Puerto Rico has not 

undertken a benchmark survey of actual assets of foreign 

affiliates since 1973. 
-85-

was raised to 30 percent. One source of capital outflows 

which became very significant in 1980 was short-term 

investments abroad by Puerto Rican public corporations. 

These were quite large in 1978, as well. 

The overall picture presented by these balance of 

payments statistics is that, at least between June 30, 1976 

and June 30, 1981, section 936 and the related Puerto Rican 

regulations did not lead to any substantial growth in the 

net inflow of capital into Puerto Rico. Section 936 did 

bring substantial funds back to Puerto Rico, but these 

appear to have flowed out again through the banking system, 

switches in the ownership of Puerto Rican public debt, and 

investments abroad by Puerto Rican public corporations. 

2. Overview of the Puerto Rican Capital Market. To 

what extent does the financial investment of 936 corporations in Puerto Rico contribute to real investment in Puerto 

Rico and to what extent is it used to finance real 

investment outside of Puerto Rico? In unconstrained 

markets, the after-tax rate of return to investment would 

tend to be equalized among jurisdictions. The purpose of 

the provisions related to QPSII is to interfere with this 

equalization of returns by preventing, or at least 

increasing the costs of, arbitrage between the Puerto Rican 

and world capital markets. 

Arbitrage can be engaged in at several levels, i.e., 

both by financial institutions and by Puerto Rican borrowers 

who obtain "low-cost" loans. The costs of arbitrage by 

financial institutions determine the interest rate they 

offer on 936 funds relative to the yield on funds in 

offshore markets. Similarly, the costs of arbitrage by 

private borrowers set an effective limit on the extent to 

which the cost of borrowing can fall below the yield. on 

funds in offshore markets in those circumstances where the 

costs of arbitrage for banks are high enough to create a 

substantial discount on 936 deposits. 

The costs of arbitrage for financial institutions depend 

on their portfolios. The costs are very low if they have 

excess eligible Puerto Rican assets, because they are free 

to accept additional 936 funds without having to find 

additional Puerto Rican assets. In view of their very low 

transactions costs, they are then in a position to pay 

Virtually the Eurodollar rate for deposits. If a bank does 

~ot have excess eligible assets, however, it cannot engage 

in arbitrage if it receives additional 936 deposits because 

it must match 95 percent of the new funds with additional 

Puerto Rican assets. 
-86-

At least until the new regulations effective February 1, 

1982, the Puerto Rican banking system as a whole has tended 

to have excess eligible assets. For example, in December 

1981 there were eligible assets of $6.2 billion and deposits 

requiring matching eligible assets of $5.3 billion. Most 

eligible assets were in local savings banks and smaller 

commercial banks. For example, 56 percent of the excess 

eligible assets in December 1981, were in savings banks. 

Treasurers of 936 corporations were reluctant to make direct 

deposits in these small institutions because of the risk of 

default. 

This reluctance could be overcome by additional security 

provided by repos, additional collateral, and guarantees by 

brokers. Links between the 936 corporations and the smaller 

banks were usually arranged by brokers. The cost of these 

investment banking services, including a risk premium if the 

broker's capital is at risk, set the lower 1 imi t for the 

rate on 936 funds relative to yields on non-936 deposits. 

Once the spread exceeded these costs, investment bankers in 

the pre-February 1, 1982 regime were willing to bid for 936 

funds because they were then able to offer lower cost funds 

to the smaller banks than would have been available from 

non-936 channels. 

The February 1, 1982, regulations appear to substantially reduce the opportunities for arbitrage available to 

both Puerto Rican financial intermediaries and Puerto Rican 

borrowers. The moving of the base period for computing 

incremental assets to July 1, 1981, and the choice by the 

savings banks not to be declared eligible despository 

institutions, effectively dried up the excess eligible 

assets in the system. In addition, there is a specific 

obligation on Puerto Rican borrowers to demonstrate that 

they have used the proceeds of the loans in their Puerto 

Rican operations. 

These regulations seem to have had a very significant 

effect on brokers. One indication is that several u.s.-

based brokerage firms that had recently opened up off ices in 

Puerto Rico have closed them. The requirement that the 

proceeds from repos with 936 corporations be invested in 

eligible assets has apparently caused a cutback in brokers' 

transactions in 936 funds. In addition, the requirement 

that 30 percent of the proceeds of repos be invested in 

relatively low-yield Puerto Rican government debt has 

reduced the overall return that brokers can offer to 936 

depositors. The fact that commercial paper of local Puerto 

Rican firms tends to be unrated has also hampered brokers' 

activities. New York Stock Exchange rules make it expensive 

to carry unrated debt in inventory, and 936 corporations are 

unwilling to accept the local paper as the underlying asset 

in repos. 
-87-

However, this impact of the new regulations on brokers 

may reflect mainly a short-run adjustment or timing problem. 

Brokers' activities in the past resulted from the 

opportunities provided by the excess eligible assets in the 

smaller banks. As prospective eligible assets are developed 

by the smaller banks in the future, they will presumably be 

financed directly with the proceeds from 936 repos. In 

substance, therefore, there may not be a major change in 

brokers' role as intermediaries because they will continue 

to mobilize the eligible assets in the smaller banks, 

particularly if the eligible assets in savings banks again 

become available to cover 936 funds. 

The apparently dramatic effect of the new regulations on 

savings banks may also be somewhat misleading. The new July 

1, 1981 base period was particularly burdensome to them 

because of their acquisition of substantial 936 funds in the 

second half of 1981. That was one reason they chose not to 

be eligible depository institutions for 936 funds, and 

instead preferred the status of ultimate eligible recipients 

of 936 funds from eligible banks and brokers. As ultimate 

recipients they would not be subject to the restrictions 

imposed on eligible ins ti tut ions, such as the requirement 

that 30 percent of 936 funds be invested in Puerto Rican 

government debt. They would then hope to . use the 936 funds 

to finance their financial assets. However, this requires 

that their financial assets be regarded as business 

inventories for the purpose of satisfying the Puerto Rican 

rules on the use of 936 funds by ultimate recipients. The 

Puerto Rican government has not agreed with this 

interpretation. Whatever the ultimate resolution of this 

issue, mortgages and other eligible assets generated by 

savings banks will eventually find their way back to the 936 

funds market. 

The February 1, 1982 regulations have, at least in the 

short run, substantially altered the market for 936 funds. 

The new constraints on banks, brokers, and borrowers and the 

sterilization of the eligible assets that were excess on 

July 1, 1981, have reduced the value of 936 deposits and 

have thereby significantly reduced the interest rate on 

these deposits relative to offshore financial assets. The 

longer term effect is somewhat less certain. 

In the past, the Puerto Rican financial market has been 

able to generate more eligible assets than were needed to 

match both the 936 funds accumulating each year and the 

initial large inflow in 1976 and thereafter. As long as the 

"normal" growth of eligible assets, i.e., the increase in 

eligible assets financed at stateside or Eurodollar interest 
-88-

rates, exceeds the growth in 936 funds seeking investment, 

any incremental rule wi 11 not be effective, no matter how 

rigorous. It is true that the new regulations have narrowed 

the range of eligible assets, e.g., through limitations on 

the eligibility of brokers' loans. However, this has not 

yet had a visible impact on the amount of eligible assets in 

the Puerto Rican financial market. Furthermore, the 

financing of new automobile loans and the refinancing of 

borrowers' inventory and fixed assets, which are specifically eligible uses of funds, would appear to provide 

substantial new outlets for 936 funds. 

Investment income earned in the Eurodollar market is 

subject to U.S. tax. Thus, taxes play an important role in 

the financial investment choice of a 936 corporation. 

Possessions corporations would not be willing to invest 

their funds in Puerto Rico unless they could obtain an 

after-tax return at least equal to the after-tax return in 

the Eurodollar market. The lowest that the interest rate on 

936 funds can be re la ti ve to the rate on Eurodollars can 

therefore be estimated. Assume a marginal U.S. corporate 

tax rate of 46 percent, a Puerto Rican tollgate tax of 10 

percent, and repatriation of the proceeds after one year. 

Then 90 percent of the 936 CD return would be left after 

tollgate taxes, but only 54 percent of the Eurodollar return 

would remain after Federal income taxes. Based on these 

assumptions, the 936 rate would have to be at least 60 

percent of the Eurodollar return. 15/ For longer term 

assets, the tollgate tax may be less than 10 percent and the 

minimum return could therefore be less than 60 percent. 

Until the implementation of the February 1, 1982 

regulations, the 936 CD rate has generally been substantially greater than 60 percent of the Eurodollar rate. It 

has usually been in the 70 percent to 95 percent range, and 

was very close to the top of the range from March through 

December 1981. In part this reflected the fact that, with 

the greater development of the Puerto Rican capital market, 

the costs of arbitrage were reduced. Banks and brokers 

therefore were able to offer much higher rates than the 60 

percent minimum. But as discussed in Section 5 below, the 

hew regulations have had a dramatic impact in reducing the 

936 rate to about 60 percent of the Eurodollar level. 

15/ Let R be the 936 interest rate and E be the Eurodollar 

interest rate. Then the 936 corporation is indifferent 

between the two investments if the after-tax returns are 

equal, i.e., if .9R = .54E or R = .6E. 
-89-

3. Distribution of 936 Funds among Banks in Puerto 

Rico. The banks operating in Puerto Rico are diverse in 

character. On the one hand, there are branches of stateside 

U.S. banks, Citibank, Chase Manhattan, Bank of America which 

entered in 1978, and Continental Illinois which entered in 

1981. Another group are the Puerto Rican banks, the largest 

of which by far is Banco Popular, with $2.6 billion in 

assets at the end of 1981. Even so, Banco Popular would 

only be about 50th in the size ranking of U.S. banks. A 

further category includes branches of the Canadian banks, 

the Royal Bank and Bank of Nova Scotia, which have long 

histories of operating in the Caribbean. There are also 

foreign-controlled banks which are organized as Puerto Rican 

subsidiaries and are classified as domestic Puerto Rican 

banks. These include Banco Central y Economias, Banco de 

Santander, and Scotiabank de Puerto Rico. 

Corporate treasurers who invest 936 funds in Puerto Rico 

are reputedly very conservative and are unwilling to deposit 

funds in banks with capital below some threshold. 16/ This 

high degree of risk aversion may not be surprising or 

irrational in view of the Puerto Rican bank failures in the 

mid -19 7 0 s • 1 7 / Whatever the reason , the cons er vat i v e 

financial poITcy is reflected in the concentration of 936 

funds that is evident in column 4 of Table 4-7. The Chase 

Manhattan and Citibank branches, which have their parents' 

capital behind them, alone accounted for 45 percent of all 

936 deposits and repos in banks in December 1981. Their 

share of total 936 funds was substantially greater than 

their 32 percent share of all commercial bank assets in 

Puerto Rico at the end of 1981. By contrast, the local 

!§_/ $100 million is a common threshold that is cited. Banco 

Popular crossed this level at the end of 1978 -and 

doubled its 936 deposits in the following year. 

!21 Banco Credito, the second largest local bank at year-end 

1975, was declared insolvent and its assets were distributed to other banks. Banco Economias also became 

insolvent and was eventually taken over by a Spanish 

bank. The surviving bank is Banco Central y Economias. 

In each of these two cases, there was a "purchase and 

assumption" by the Federal Deposit Insurance Corporation, with the result that no depositor lost any money. 

Finally, there were also failures of three small banks 

affiliated with unions. 

--·-·.._.._._. ·-·--~·· -· ·-
-90-

Table 4-7 

Distribution of 936 Funds, Excess Eligible Assets, and Change in 936 Funds 

{Millions of dollars) 

Bank Direct 

Deposits 

Daily Average - December 1981 

Funds Re- Total Change 

Obtained deposits 936 from 

by Repos Received Funds April 1980 

Total Excess 

Eligible 

Assets, 

April 1980 

~~~~~~~~~<~l>.__~~~<2~>~~~-..:..<3~>~~~<~4>.__~~---:<~5~>~~~---'<~6~>~---

Chase Manhattan 915 

Citibank 1,289 

Bank o~ America 341 

Continental 

Illinois 285 

Total, U.S. banks 2,829 

Banco Popular 347 

Banco de Ponce 187 

Scotiabank 35 

Central 236 

Banco de San Juan 41 

Santander 35 

Roig 7 

Comercial de 

Mayaguez 19 

Total, Local 

conunercial banks 906 

Bank of Nova 

Scotia 284 

Royal Bank 334 

Total, Canadian banks 618 

Savings banks 2 

Total, All Banks 4,354 

0 

160 

9 

1 

170 

101 

21 

0 

72 

7 

0 

20 

18 

240 

0 

0 

0 

534 

947 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

20 

1 

53 

21 

95 

0 

68 

66 

35 

29 

113 

26 

935 

1,450 

403 

307 

3,094 

449 

276 

101 

343 

77 

148 

53 

0 37 

337 1,483 

0 284 

0 334 

0 618 

7 543 

439 5,301* 

+281 

+716 

+93 

+307 

+1,396 

-3 

+37 

-3 

197 

42 

+74 

+9 

-21 

+290 

+57 

+76 

+133 

+410 

+2,027 

6 

2 

-32 

n.a. 

-24 

12 

26 

1 

34 

45 

44 

16 

16 

184 

2 

30 

32 

486 

678 

* The overall total does not include redeposits because this would count the 

same funds twice for the system as a whole. 
-s 

-91-

banks have a much smaller share of 936 funds than of total 

assets. As noted above, repos are one way in which a 936 

corporation can reduce the risk associated with putting 

funds in the smaller local banks. Repos are therefore an 

important source of 936 funds for the local banks, 

particularly the savings banks, which have a large stock of 

2{j) assets. 

Even though Citibank and Chase Manhattan st i 11 account 

for almost half of total 936 funds in banks, the competition 

for 936 deposits has substantially increased since 1978. At 

the end of 1977, the combined Citibank-Chase Manhattan share 

was almost 60 percent. In 1978, the Bank of America established a branch in Puerto Rico and acquired $403 million in 

936 funds by December 1981. In addition, the Banco Popular 

crossed the $100 in capital threshold in 1978 and bid 

agressively for deposits in 1979. The Canadian banks have 

also become more promi'nent. Their parents are large 

international banks with capital sufficient to reassure the 

treasurers of 936 companies. The Bank of Nova Scotia now 

has a Puerto Rican subsidiary (Scotiabank de Puerto Rico) , 

as well as a branch, and in 1980 the Royal Bank obtained 

approval for the acquisition of the Banco de San Juan. 

Finally, Continental Illinois entered in early 1981 and 

acquired $307 million in 936 funds by the end of the year. 

The increased ability of the local savings banks and 

smaller commercial banks to obtain 936 funds was one of the 

significant developments between the beginning of 1980 and 

February 1, 1982, the effective date of the new regulatory 

regime. As shown in Table 4-7, the savings banks tripled 

their 936 funds between April 1980 and December 1981, and 

accounted for more than 20 percent of the overall increase 

in 936 funds over that interval. These funds were obtained 

almost exclusively with repurchase agreements. Column 5 of 

Table 4-7 indicates that some of the smaller commercial 

banks were also successful in attracting substantially more 

936 funds in that period. 
-92-

4. Recent Changes in Commercial Bank Portfolios in 

Response to the Availability of 936 Funds. The U.S. Treasury 

Department's 1980 Annual Report on the Operation and Effect 

of Possessions Corporations contains a review of the changes 

in commercial bank portfolios between June 30, 1975 and 

December 31, 19 7 9, which covers the period when the 

financial assets of possessions corporations flowed into the 

Puerto Rican banking system from offshore. The Report 

indicates that the increase in bank loans was relatively 

modest compared to the large increase in funds made available by 936 corporations. Furthermore, the inflow of 936 

deposits accounted for more than 70 percent of the growth in 

total bank assets over the period. There was a modest 

increase in other sources of funds, such as regular CDs. 

From December 31, 1979 to December 31, 1980, there was a 

significant change in this pattern. Table 4-8 indicates 

that from the end of 1979 to the end of 1980, total 

commercial bank assets increased by $1,582 million, or 15.9 

percent. Deposits of 936 corporations increased by $494 

million, which is substantially less than the $880 million 

increase in the previous year, and less than one-third of 

the increase in total commercial bank liabilities. 18/ 

There were significant increases in other sources of funds, 

notably non-936 CDs which include Eurodollar borrowing. The 

increase in commercial and industrial loans almost exactly 

matched the increase in 936 deposits. One trend that did 

continue was a large increase in balances due from other 

banks, which are largely deposits in the U.S. or Eurodollar 

money market, although some deposits with the GOB may also 

be included. 

The earlier pattern seems to have been reestablished in 

calendar year 1981. Deposits by 936 corporations grew by 

$1,244 million and accounted for more than half of the 

increase in total assets. Non-936 CDs also increased 

rapidly, as in 1980, presumably to compensate for the 

decline in demand and savings deposits. However, commercial 

and industrial loans increased at only about one-half the 

1980 pace. Finally, there was a very large jump in balances 

due from other banks. In fact, the increase in these 

balances, largely offshore deposits, exceeded the growth in 

~/ These data, based on consolidated reports to the Puerto 

Rico Government Development Bank, do not include repos 

in CDs. Their inclusion would not change the pattern 

significantly because most of the increase in repos has 

been in the savings banks. 

~ 

D 
-93-

Table 4-8 

Selected Assets and Liabilities of all Commercial 

Banks in Puerto Rico - year-end 1979 to year-end 1981 

(Dollar amounts in millions) 

(Percent change from previous year in brackets) 

~ Dec. 31, 1979 Dec. 31, 1980 : Dec. 31, 1981 ~-t-a-l~A--s_s_e_t_s~~--~--~~~~~9_;_,9 __ 2_2~~~--~-1-1-,-5~0-4~~--~--~~1~3-,~7~9~1~-

~lances due from 

1 other banks 

~otal obligations of 

Commonwealth of 

Puerto Rico and 

political subdivisions* 

'l'otal loans and discounts 

Demand and savings deposits 

'l'ota1 deposits 

9

36 deposits 

Deposits due to other 

banks 

ta1 non-936 deposits 

Conunercial and industrial 

loans 

Loans to individuals 

1,931 

1,039 

5,454 

2,632 

8,344 

2,862 

537 

1,122 

5,482 

2,297 

1,320 

Off· ~c7 of the Secretary of the Treasury 

fice of Tax Analysis 

( 15 .9) (19.9) 

2,483 

(35.6) 

1,391 

(33.9) 

6,056 

(11.0) 

2,858 

(8.6) 

9,663 

(15.8) 

3,356 

(17.3) 

815 

(51.7) 

1,675 

(49.3) 

6,307 

(15.0) 

2,762 

(20.2) 

1,404 

(6.4) 

3,885 

(56.5) 

1,614 

(16.0) 

6,880 

(13.6) 

2,749 

(-3.8) 

11,761 

(21.7) 

4,600 

(37.1) 

426 

(-47.7) 

2,999 

(79.0) 

7,161 

(13.5) 

3,025 

(9.5) 

1,476 

(5.1) 

This item includes assets in savings banks. 
-94-

deposits by 936 corporations. This large increase of 

balances with other banks is consistent with information on 

offshore investments by Puerto Rican banks in Table 4-6. 

The February 1982 regulations appear to have resulted in 

a somewhat more rapid growth of commercial loans. Data 

provided by the Government Development Bank indicate that 

commercial loans increased by $350 million from February to 

May 1982, which exceeds the increase in all of 1981. 

5. The Interest Rate Differential Between 936 

Deposits and Eurodollar Deposits. The analysis of the 

interest rate differential ro--the 1980 Annual Report on 

possessions corporations indicated that the 936 CD rate fell 

in relation to the Eurodollar or regular CD interest rates 

whenever the amount of 936 deposits rose more rapidly than 

eligible assets. This occurred because the costs of 

arbitrage increase when the amount of eligible assets rises 

less rapidly than the level of 936 deposits. Conversely, 

the costs of arbritrage are very low when there is a 

substantial surplus of eligible assets. For example, the 

936 rate almost reached parity with Eurodollar rates in 

early 1979 because of the very small growth of 936 deposits 

in the previous year. It then fell throughout 1979 and into 

early 1980 because of the large increase in 936 deposits 

compared to the continuing moderate increase in loans. 

The movement of the differential since early 1980 has 

generally been consistent with this pattern. As noted 

above, 936 CDs in commercial banks increased by $494 million 

in calendar year 1980, which was just over half the increase 

in 1979. The modest growth in 936 funds in banks, coupled 

with somewhat faster growth in loans and eligible assets, 

contributed to the narrowing differential at the end of 1980 

and its virtual elimination in the spring of 1981, both of 

which are evident in Table 4-9. The growth in eligible 

assets meant that banks could place new 936 funds in 

offshore markets and still comply with the regulations. The 

increased competition for 936 funds noted above probably 

also played a significant role in keeping 936 interest rates 

high. The increased competition was in part due to the 

'greater ability of the savings banks and smaller commercial 

banks to attract funds, which increased the amount of 

effective eligible assets in the system, i.e., the assets 

that could be used to bid for deposits. 
* 

-95-

Table 4-9 

Comparison of Interest Rates on 936 and Eurodollar 

Deposits, Selected Months from January 1980-April 1982* 

Month and Year 

1980 

January 

April 

July 

September 

December 

1981 

January 

March 

July 

December 

1982 

January 

February 

March 

April 

936 Rate as a Percent of 

Eurodollar Interest Rate 

70 

58 

78 

82 

82 

74 

87 

87 

82 

76 

81 

59 

61 

The differential is based on the monthly average rate 

for 30 day deposits. It is calculated from information 

provided by Citibank of Puerto Rico, the Puerto Rican 

Treasury, and from data in World Financial Markets 

published by Morgan Guaranty Trust. 
-96-

In calendar year 1981, 936 funds in the banking system 

increased more rapidly than in 1980, but eligible assets 

grew at an even faster rate. For purposes of this 

comparison, it is useful to look at recent information 

provided by the Puerto Rican Government on all 936 funds 

(including repos) and incremental eligible assets. These 

data, in Table 4-10, indicate that total 936 funds in the 

banking system grew by $1,066 million between ~ecember 1980 

and December 1981. (This is broadly consistent with the 

growth of 936 deposits in commercial banks, shown in Table 

4-8.) Total eligible assets grew even faster, by $1,426 

million, despite the modest growth in the industrial and 

commercial loan category (shown in Table 4-8). The growth 

in eligible assets was large enough to absorb the inflow of 

936 deposits and enable banks to continue to offer high 

interest rates on new deposits. As a result, the interest 

rate on 936 deposits remained close to the rate on 

Eurodollar deposits in the last 10 months of 1981. 

Table 4-9 reveals the dramatic impact that the February 

1982 regulations have had on the 936 interest differential. 

In March and April 1982, the interest paid on 936 deposits 

was about 60 percent of the rate on Eurodollars, which, as 

noted earlier, is about as far as it can fall without 

inducing a shift of funds to the Eurodollar market. When 

the differential is at this level, the after-tax return on 

936 deposits and Eurodollars are approximately equal. 

6. The Puerto Rico Government and the Mort~~~~ 

Market as Beneficiaries of 936 Funds 

a. Commonwealth of Puerto Rico Obligations. The 

passage of the Tax Reform Act of 1976 led to a shift in the 

ownership of Puerto Rican government obligations from 

foreign to local investors. Banks in Puerto Rico increased 

their holdings of Puerto Rican government obligations by 

more than $800 million between June 30, 1975 and December 

31, 19.80. Possessions corporations have also made some 

direct purchases of Commonwealth obligations. 

This increased demand for Commonweal th of Puerto Rico 

obligations does not, however, appear to have resulted in a 

significant reduction in net interest costs on public 

issues. Table 4-11 compares, for the period 1975-1981, net 

interest costs on Puerto Rican public offerings and on taxfree U.S. municipals (the latter as reported in the Bond 

Buyer index on the date of each Puerto Rican public 
-97-

Table 4-10 

Change in Total 936 Funds and Eligible 

Assets from December 1980 to December 1981 

(monthly average in millions) 

December 1980 December 1981 Change 

Total 936 funds 

Total incremental 

elibible assets 

3,288 

,4, 7 7 6 

4,354 

6,202 

Source: Puerto Rico Government Development Bank 

1,066 

1,426 
1975 

1976 

1977 

1978 

1979 

1980 

1981 

Table 4-11 

Interest Costs on Puerto Rican Bond Issues Sold 

1975 - 1981 

Agency 

Commonwealth of P.R. 

PR Urban Research & Housing Corp. 

PR Telephone Authority 

Commonwealth of PR 

PR Highway Authority 

PR Water Resources 

PR Highway Authority 

PR Telephone Authority 

University of Puerto Rico 

PR Water Resources 

PR Aqueduct & Sewer 

PR Highway Authority 

Commonwealth of Puerto Rico 

PR Highway Authority 

Puerto Rico Ports 

PR Public Buildings 

PR Industrial Dev. Co. 

PR Telephone Authority 

PR Water Resources 

PR Telephone Authority 

Commonwealth of Puerto Rico 

PR Public Buildings 

PR Telephone Authority 

PR Water Resources Authority 

PR Telephone Authority 

Commonwealth of Puerto Rico 

PR Public Buildings 

PR Telephone Authority 

PR Electricity Authority 

PR Electricity Authority 

(1) 

Amount 

80,000,000 

67,000,000 

75,000,000 

75,000,000 

50,000,000 

50,000,000 

35,000,000 

50,000,000 

22,650,000 

60,000,000 

35,000,000 

62,500,000 

300,000,000 

75,000,000 

29,500,000 

110, 000, 000 

40,000,000 

100,000,000 

125,000,000 

25,000,000 

100,000,000 

125,000,000 

110, 000, 000 

100,000,000 

50,000,000 

300,000,000 

100,000,000 

75,000,000 

75,000,000 

100,000,000 

( 2) 

Date 

1-29-75 

2-26-75 

4-17-75 

5-22-75 

7-18-75 

11-13-75 

2-27-76 

5-13-76 

8-18-76 

10-13-76 

12-10-76 

2-18-77 

4-14-77 

8-10-77 

11-17-77 

2-14-78 

3-31-78 

6-29-78 

9-26-78 

11-15-78 

11-17-78 

4-05-79 

6-06-79 

10-18-79 

1-24-80 

5-7-80 

8-07-80 

3-12-81 

6-11-81 

7-30-81 

(3) (4) 

:Net Interest: Bond 

Cost on 

P.R. Bonds 

8.00 

7.98 

9.13 

9.00 

9.42 

9.92 

9.96 

8.99 

9.15 

8.23 

7.88 

7.61 

7.89 

6.99 

7.33 

7.72 

7.98 

7.99 

7.70 

7.56 

7.98 

7.90 

7.56 

9.07 

8.95 

9.37 

10.31 

11. 20 

11.97 

12.35 

BUYer 

Index 

6.54 

6.40 

6.86 

7.09 

6.98 

7.43 

6.98 

6.71 

6.60 

6.33 

5.96 

5.86 

5.70 

5.63 

5.45 

5.61 

5.69 

6.31 

6.12 

6.11 

6.11 

6.28 

6.09 

7.18 

7.33 

7.96 

8.59 

10.40 

10.59 

11. 34 

Source: Government Development Bank for Puerto Rico 

Column 3 

Less 

Column 4 

1. 46 

1. 58 

2.27 

1. 91 

2.44 

2.49 

2.98 

2.28 

2.55 

1.90 

1.92 

1. 75 

2.19 

1. 36 

1. 88 

2.11 

2.29 

1.68 

1. 58 

1. 45 

1. 87 

1. 62 

1.47 

1.89 

1. 62 

1. 41 

1. 72 

.80 

1. 38 

1.01 

I 

l.O 

co 

I 
-99-

offering). The table shows that since the enactment of the 

QPSII provision in 1976, there has been a moderace decline 

in the differential between net interest costs on Puerto 

Rican issues and the Bond Buyer index. The differential in 

the nine issues in 1979-81 was about .60 percentage points 

lower than in 1975 or 1976. This decline may, however, have 

been due largely to the widespread perception of Puerto 

Rico's improved financial management. 

The reason for this small effect on interest costs on 

Puerto Rican bonds is that the QPSI I provision in section 

936 did not affect the relative desirablity of Puerto Rican 

publicly issued debt, since it was already exempt from U.S. 

tax. Puerto Rican debt therefore differs from the case of 

GNMAs discussed in the following section. 

b. GNMAs -- Mortgage-Backed Securities Guaranteed 

by the U.S. Government. GNMAs are securities issued by 

mortgage lenders which are backed by a pool of mortgages and 

whose interest and principal are guaranteed by the U .s. 

government. The mortgages in the pool have to be 

government-insured. The securities are issued with a coupon 

50 basis points (. 5 percentage points) below the FHA 

mortgage rate. The price of any GNMA at issue depends on 

market rates and the special features of any particular 

pool, e.g., the rate of principal repayments. 

Section 936 greatly increases the desirability of Puerto 

Rican source GNMAs from the point of view of 936 

corporations because it makes their yield tax-free. Section 

936 corporations are willing to take a lower return on 

Puerto Rican source GNMAs than on taxable U.S. obligations. 

Puerto Rican GNMAs now sell at a substantially higher price 

than U.S. GNMAs with same coupon. In June 1981, for 

example, Puerto Rican GNMAs sold at a four- to five-point 

premium over recent U.S. GNMAs with the same coupon and 

maturity. This implies a yield differential of about one 

Percentage point. 

This lower interest rate on Puerto Rican source GNMA's 

is probably passed on, at least in part, to Puerto Rican 

homebuyers who qualify for insurance. There are a large 

number of potential GNMA issuers, including mortgage 

companies, commercial banks, and savings banks. It also 

appears that a significant portion of Puerto Rican home 

mortgages would fit under the FHA size limits and could 

therefore qualify for insurance. However, interest r&tes on 

conventional mortgages do not seem significantly lower in 
-100-

Puerto Rico than in the United States. According to the 

Government Development Bank, the interest rate on conventional mortgages in June 1981, varied from 16 to 17 percent, 

which seems to be close to the range in the United States. 

It is difficult to know whether any reduction in 

mortgage costs that may have taken place has had an impact 

on home building. The dollar level of investment in private 

dwellings was very stable from 1972 through 1981. In the 

years immediately following the enactment of section 936, 

GNMA issues were as high as $250 million per year. In the 

depressed housing market of recent years, they have amounted 

to only about $100 million per year. 
-101-

Chapter 5 

CHARACTERISTICS OF POSSESSIONS CORPORATIONS 

AND REVENUE EFFECT OF SECTION 936 

The preceding chapter assessed the impact ·of the 

possessions corporation system of taxation on real 

investment in Puerto Rico. This chapter describes the 

characteristics, by industry, of possessions corporations, 

their physical and financial assets, income, tax benefits, 

employment, and payroll. It also explains the method used 

in estimating section 936 tax benefits. The tax benefits 

provided by the possessions corporation system were $1, 278 

million in fiscal year 1981, and are estimated at $1,373 

million in fiscal year 1982. As a result of the amendments 

to section 936 under tl:te Tax Equity and Fiscal Responsibility Act of 1982 1/, the tax benefits are projected to 

fall to $1,352 million and $1,074 million in fiscal years 

1983 and 1984, respectively. As explained in more detail 

below, the tax benefits are computed by applying to the 

qualified possession income of possessions corporations the 

U.S. tax rate which would have applied in the absence of 

section 936. '!:_/ 

I. Characteristics of Possessions Corporations 

A. Assets and Income in 1980. Tables 5-1 and 5-2, 

based on U.S. income tax returns filed for tax year 1980 by 

possessions corporations, show year-end balance sheet 

figures, income statement data, and estimated tax benefits 

{or tax savings) by industry. The figures are based on all 

631 corporations which had filed as 936 corporations for tax 

year 1980 no later than January 31, 1982. ll Tax year 1980 

!I See above, Chapter 2, Section I.D. 

~/ This rate takes into account the investment tax credit, 

accelerated depreciation, and the foreign tax credit for 

income taxes paid to Puerto Rico. 

ll Between February and June 1982, 60 additional possessions corporations with combined net income of $360 

million filed for tax year 1980. Possessions corporations included in Tables 5-1 and 5-2 below account for 

90 percent of the income of all 936 corporations which 

filed for tax year 1980 as of June 1982. 
-102-

includes accounting periods ending between July 1, 1980, and 

June 30, 1981. Because most possessions corporations have 

calendar year accounting periods, tax year 1980 corresponds 

closely to calendar year 1980. 

1. Assets. Only physical and financial assets are 

directly observable from balance sheets because intangible 

assets, which are usually the result of R&D and sales 

promotion activities which have been expensed, are generally 

carried on the books at a zero basis. Table 5-1 shows that 

the total assets reported on the balance sheets of 

possessions corporations were $16.2 billion at year-end 

1980. Seventy-five percent of the total assets was held by 

manufacturing companies, which benefit from total or partial 

exemption from Puerto Rican taxes. (Non-manufacturing firms 

generally do not benefit from Puerto Rican tax exemption.) 

Net plant and equipment of 936 manufacturing firms (shown as 

"net depreciable assets" on Table 5-1} amounted to $1.5 

billion, of which $624 million, or 43 percent, was owned by 

pharmaceutical corporations. Non-pharmaceutical chemical 

companies accounted for an additional 16 percent of the 

total. Other manufacturing industries with substantial 

amounts of plant and equipment in Puerto Rico were food 

products, with 9 percent of the total, and electrical and 

electronic equipment, with 6 percent of the total. 

Relative to corporations operating in the United States, 

possessions corporations have a disproportionately small 

share of their assets in real fixed assets. Net plant and 

equipment and land 4/ represented 12.4 percent of all assets 

held by 936 manufacturing firms. As shown in Table 4-1, the 

comparable ratio for manufacturing corporations in the 

United States was 36.6 percent. On an industry basis, 936 

companies' percentage of fixed real assets to total assets 

was generally one-fourth to one-half the percentage for U.S. 

mainland firms. This difference is only slightly reduced 

when account is taken of Puerto Rican government-owned land 

and buildings which are leased to 936 corporations. ~/ 

!/ 

~/ 

The value of land reported by 936 manufacturing corporations, not separately shown in Table 5-1, was $41 

million. 

As noted in Chapter 4, Section I. D, the Commonweal th 

government owns land and buildings which it leases to 

private investors (936 firms and Puerto Rican-chartered 

firms). Not all of the property, valued at $346.3 

million in 1980, is under lease at any given time. 

~ssuming that three-fourths of the government-owned 

property was under lease to 936 firms in 1980, and 

treating this property as 936 fixed assets, increases 

the ratio of 936 fixed assets to total assets from 12.4 

percent to 14.6 percent. 
Table 5-1 

Selected Balance Sheet Information by Industry, 1980 

(D?llar amounts in thousands) 

All Manufacturi~ Industries 

Industries Manufacturing Food & Kindred Textile Mill Apparel Paper Chemicals 

'Ibtal Products Products 'lb ta I :Pfiarmaceut1cais: 1\II rn::Fier 

Number of corporations 631 445 18 9 82 4 86 58 28 

Total Assets 16,226,607 12,098,355 892,184 109,162 353,626 9,394 6,554,995 5,6ll,093 943,901 

Cash 2,172, 229 1,967,779 270,824 965 33,242 355 1,000,100 978,185 21,914 

Accounts receivable 2,833,371 2,361,249 159,323 37,495 141,389 1,262 l,ll8,295 752,926 365,368 

Inventories 1,436,476 1,196, 713 141,620 5,063 59,056 2,294 477,516 331,688 145,828 

U.S. Government obligations 245,075 236,972 0 0 1,652 0 172,887 172,141 746 

State and local obligations 135,289 135,289 0 511 4,316 0 106,037 74,572 31,464 

Other current assets 772,481 701,342 42,205 50 3,942 2,334 382,601 361, 284 21,316 I 

Mortgage & real estate loans 1,872,775 143,013 0 0 2,733 0 37,250 37,250 0 t-' 

0 

Other investments 3,517,504 3,248,921 39,687 60,167 73,196 549 2,037,278 1,982,916 54,361 w 

I 

Depreciable Assets 3,565,009 2,271,196 172,246 10,136 34,737 3,394 1,318,162 818,503 499,659 

Less: Accumulated depreciation 1,120,218 806,874 45,196 5,752 18,162 1,022 467,369 194,647 272, 722 

Net depreciable assets 2,444,790 1,464,322 127 ,050 4,383 16,575 2,371 850,793 623,855 226,937 

Other assets 796,069 642,748 lll,472 525 17,520 225 372,235 296,270 75,964 

Total Liabilities and Stockholders' F.quity 

Accounts payable 1,055,596 642,820 68,491 1,088 49,226 1,487 243,016 165,018 77,998 

Notes payable in less than 1 year 238,371 ll8,233 26,409 134 1,463 0 68,537 61,615 6,921 

Other current liabilities 2,178,685 289,151 57,837 819 10,423 466 137,503 129,421 8,082 

Mortgages more than 1 year 668,597 214,968 24,284 36 2,846 0 141,668 140,554 l,ll3 

Other liabilities 652,802 469,517 4,072 7 4,148 623 414,449 388,724 25,724 

Capital stock 1,748,300 990,138 44,761 3,124 15,136 1,302 591,718 362,645 229,072 

Retained earnings, total 9,684,250 9,373,527 666,326 103,952 270,382 5,514 4,958,102 4,363,ll3 594,989 

Appropriated 127, 766 71,863 0 0 28,357 0 298 298 0 

Unappropriated 9,556,483 9,301,663 666,326 103,952 242,024 5,514 4,957,803 4,362,814 594,989 
Table 5-1 - continued 

Manufactur mg Industries - continued 

Rubber Leather and Stone, Clay, & Fabricated Machinery, Electrical and Instruments All Other 

Products Leather Glass Products Metal Products Except Electronic and Related Manufacturing Products Electrical F.quipnent Products 

Number of corporations 8 13 6 25 12 100 34 48 

Total Assets 57,079 77,635 16,447 213,877 169,719 1,932,960 334,310 1,376,962 

Cash 1,244 11,965 137 55,090 18,966 463,966 22,032 88,887 

Accounts receivable 11,944 26,254 3,356 36,974 29,912 274,976 85,284 434,779 

Inventory 7,296 13,847 2,384 38,963 20,323 182,265 32,303 213,776 

U.S. Government obligations 0 1,372 0 0 0 25,893 30,716 4,448 

State and local obligations 0 9,803 0 0 4,422 8,199 0 2,000 

Other current assets 231 1,969 55 12,741 7,686 143,206 9,399 94,918 

r-t>rtgage & real estate loans 0 0 0 4,559 1,185 97,284 0 0 I 

Other investments 12,791 9,752 7,441 19,528 74,990 612,683 85,790 215,063 I-' 

0 

~ 

I 

Depreciable assets 26,424 5,959 7,839 57,462 15,950 138,604 53,819 426,457 

Less: Accumulated depreciation 4,086 3,414 5,007 16,350 4,582 53,045 14,228 168,655 

Net depreciable assets 22,337 2,545 2,832 41,112 11,367 85,559 39,590 257,801 

Other assets 1,232 125 239 4,907 864 38,922 29,192 65,285 

Total Liabilities and Stockholders' F.quit;r: 

Accounts payable 9,142 9,160 976 32,538 5,812 85,561 22,448 113,871 

Notes payable in les.s than 1 year 0 2,322 315 845 0 9,969 7,026 1,208 

Other current liabilities 2,555 1,824 565 6,288 2,733 38,382 13,872 15,879 

Mortgages more than 1 year 5,000 159 32 3,167 0 3,940 3,852 29,981 

Other liabilities 6 437 10 257 8,093 26,604 8,203 2,602 

Capital stock 7,497 607 2,795 8,543 4,859 43,188 16,391 250,210 

Retained earnings, total 32,877 63,125 11,751 162,235 148,220 1,725,314 262,515 963,208 

Appropriated 0 0 1,688 0 0 36,750 3,678 1,090 

Una~ropriated 32,877 63,125 10,062 162,235 148,220 1,688,564 258,837 962,118 
Table 5-1 - continued 

Norunanufacturi~ Industries 

Norunanu Transportation Finance, Services and 

facturing Construction Corrrnunications Wholesale Trade Retail Trade Insurance, Industry Not 

Total and Utilities Real Estate Reported 

NLUnber of oorporations 186 9 6 27 63 31 50 

Total Assets 4,128,251 19,280 818,597 82,151 412,992 2,696,213 99,016 

Cash 204,449 3,803 3,095 4,036 35,831 152,398 5,283 

Accounts receivable 472,121 7,329 38,543 27,457 53,563 320, 738 24,489 

Inventory 239,762 447 23,899 18,644 109,490 81,965 5,313 

U.S. Government obligations 8,103 0 0 27 0 8,076 0 

State and local obligations 0 0 0 0 0 0 0 

Other current assets 71,138 1,146 6,832 _1,493 15,143 44,293 2,228 

l'brtgage & real estate loans 1,729,762 0 0 8 0 1, 729, 724 29 I 

Other investments 268,583 434 7,650 1,756 27,368 226,800 4,573 I-' 

0 

U1 

Depreciable assets 1,293,812 6,450 904,695 32,465 214,923 75,044 60,233 I 

Less: AccLUnulated depreciation 313,344 2,865 183,420 ll,035 88,lll 12,360 15,550 

Net depreciable assets 980,468 3,584 721,274 21,429 126,812 62,683 44,682 

Other assets 153,320 2,534 17 ,300 7 ,292 44,782 68,996 12,414 

Total Liabilities and Stockholders' Equity 

Accounts payable 412,775 2,815 23,702 20, 193 75,437 275,443 15,182 

Notes payable in less than 1 year 120,137 286 5,629 2,534 29,556 68,478 13,652 

Other current liabilities 1,889,534 2,987 43,008 6,ll9 55,075 1,773,487 8,856 

Mortgages more than 1 year 453,629 9 lll, 718 670 68,901 267,583 4,745 

Other liabilities 183,285 61 40 3,337 4,971 169,741 5,133 

Capital stock 758,162 5,946 626,709 18,005 65,882 13,523 28,095 

Retained earnings, total 310,722 7,173 7,789 31,290 ll3,167 127 ,952 23,349 

Appropriated 55,902 362 6, 793 0 5,521 42,404 820 

Unappropriated 254,8200 6,8ll 995 31,290 107,645 85,547 22,529 

Office of the Secretary 

Office of Tax Analysis 
-106-

Table 5-1 shows that total financial assets of 936 

manufacturing firms -- cash, net accounts receivables, CDs, 

and other financial investments 6/, were $9.4 billion. The 

cash assets category, which may 1nclude short-term CDs, was 

nearly $2 billion, or 34 percent larger than total net plant 

and equipment. As explained in Chapter 4, the QPSII 

exemption makes Puerto Rico a very advantageous location for 

financial investments compared to both the United States and 

foreign countries. The only limit on the amount of passive 

financial investments which a possessions corporation can 

make is that no more than 50 percent of its gross income can 

come from such investments for the three-year period immediately preceding the close of its taxable year. (This limit 

is reduced under the Tax Equity and Fiscal Responsibility 

Act to 45 percent for tax years beginning in 1983, 40 

percent for tax years beginning in 1984, and 35 percent 

thereafter.) 

In principle, the distinction between financial 

investment and physical (or real) investment should not be 

important. By providing the funds that permit businesses 

and individuals to purchase plant and equipment, build 

homes, and hold inventories, financial investments lead to 

real investments. However, the data presented in Chapter 4 

suggest that 936 financial investments in the Puerto Rican 

capital market have made only a small contribution to the 

financing of physical investment in Puerto Rico. At least 

through 1981, the large inflows of 936 funds tended to flow 

out again through the banking system or to result in shifts 

in the ownership of Puerto Rican government debt and 

investment abroad by Puerto Rican government corporations. 

2. Retained Earnings. Table 5-1 also shows the 

incentive-£0r--g36--manufacturing companies to retain 

earnings. At the end of tax year 1980, these companies 

listed $9.4 billion of retained earnings on their balance 

sheets. Forty-seven percent of these retained earnings, or 

$4.4 billion, were held by pharmaceuticals. Slightly less 

than one-f i ft h of the re ta in ed earnings , or $1. 7 bi 11 i on , 

were held by the electrical and electronics industry. 

Retained earnings represented 77 percent of total 

liabilities and stockholders' equity of 936 manufacturing 

corporations. The comparable figure for all U.S. manufacturing corporations in 1979 (the latest year in which 

complete U.S. tax return information is available) was 29.l 

~/ See Table 4-4A for the composition of these financial 

investments. 
-107-

percent. 21 The high level of 936 retained earnings is a 

response to limited opportunities under the Internal Revenue 

Code for tax-free, financial investment and to Puerto Rico's 

tollgate tax on repatriated profits. As explained in 

Chapter 2, the rate of tollgate tax is reduced from 10 

percent to 4 or 5 percent if a company operating in Puerto 

Rico meets certain reinvestment conditions. 

3. Total Receipts. Table 5-2 shows that total 

receipts of 936 manufacturing corporations were $9. 6 

b i llion, of which $9.l billion was attributable to business 

receipts. Most of the remainder, or $0.4 billion, was 

attributable to interest on nongovernment securities, such 

as 936 CDs in Puerto Rican banks. Interest on Puerto Rican, 

State, and local government securities is excluded from 

gross income for Federal tax purposes, and therefore is not 

included in the total receipts shown in Table 5--2. The 

amount of such exempt interest income reported by all 936 

firms for tax year 1980 was $25 million. 

The pharmaceutical industry accounted for 29 percent of 

the business receipts of all 936 manufacturing companies. 

After pharmaceuticals, the manufacturing industries with the 

greatest business receipts were electrical and electronic 

equipment, chemicals other than pharmaceuticals, and food 

products. 

21 Data for all U.S. corporations are from Internal Revenue 

Service, Source Book, Statistics of Income, 1979: 

c 0 r po ration-Income-Tax Re turns-;-19 81~--Some-Ofth is 

difference can be attrfbuted to-differences between the 

industry mix of possessions corporations and that of. all 

U.S. manufacturing corporations. To correct for the 

differing industrial mix, the total assets of the sample 

of U.S. corporations were distributed among industries, 

as defined by two digits of the Standard Industrial 

Classification Code, in the same manner as are the 

assets of 936 corporations. The U.S. ratio of retained 

earnings to total liabilities and stockholders' equity 

was then multiplied by those industry asset figures to 

obtain an industry-mix-corrected amount of retained 

earnings. Taking the ratio of this industry-mixcorrected amount to total liabilities and stockholders' 

equity of U.S. manufacturing firms gives 31.4 as the 

p~rcentage of retained earnings to total liabilities and 

stockholders' equity. 
Table 5-2 

Selected Incane Statement Information and Tax Benefits by Industry, 1980 

(Dollar amounts in thousands) 

All Manufacturing Industries 

Industries Total Food & Kindred Textile Apparel Paper Chemicals 

Products Mill Products Total :Pharmaceuticals: All Other 

Number of corporations 631 445 18 9 82 4 86 58 28 

Total receipts 11,575,860 9,573,482 825,515 49,652 434,426 17,210 3,757,136 2,882,484 874,652 

Business receipts 10,798,879 9,074,605 789,008 46,688 420,891 17,129 3,489,801 2,625,lll 864,690 I 

Nongovernrnent interest 590,105 413,381 25,205 2,893 7,468 6 229,752 220,432 9,410 f--' 

Other receipts 186,875 85,494 ll,301 70 6,065 74 37,582 37,030 552 0 

co 

I 

Total dedu::tions 8,431,990 6,607,958 644,506 36,355 351,620 15,975 2,149,724 1,449,325 700,398 

Cost of sales 6,422,525 5,347,310 543,463 29,860 323,302 15,101 1,424,757 823,196 601,560 

Depreciation 190,338 111,835 7,412 683 1,919 186 62,782 43,305 19,476 

All other deductions 1,819,125 1,148,812 93,631 5,811 26,398 686 662,185 582,823 79,361 

Estimated net incane per return 3,143,872 2,965,523 181,008 13,297 82,806 1,235 1,607,412 1,433,158 174,253 

Estimated net inccrne per books 2,794,924 2,692,332 187,960 12,797 76,608 1,050 1,432,578 1,274,596 157,982 

Reduction in U.S. tax liability 1,244,536 1,244,536 69,372 5,602 36,865 524 663,827 590,708 73,118 

Distributions 1,284,500 1,215,380 160,319 86 5,981 150 798,753 758,468 40,284 
Table 5-2 - continued 

Manufacturing Industries - continued 

Rubber Leather and Stone, Clay Fabricated Machinery, Electrical and Instruments All Other 

Products Leather and Glass Metal . Except Electronic and Related 

Products Products Products Electrical F.qui{Xnent Products Manufacturing 

Number of corporations 8 13 6 25 12 100 34 48 

Total receipts 49,221 103,406 17,735 171,705 143,602 1,370,682 263,662 2,369,524 

Business receipts 46,389 101,560 16,482 165,414 137,000 1,273,810 253,232 2,317,197 

Nongovernment interest 1,054 1,090 27 5,422 5,833 88,305 9,893 36,426 I 

Other receipts .L, 777 755 1,226 868 768 8,566 536 15,899 I-' 

0 

l.O 

Total deductions 31,136 93,005 13,978 133,160 102,109 853,763 152,867 2,029,756 I 

Cost of sales 25,682 83,505 10,857 112,821 88,399 725,840 115,379 1,848,339 

Depreciation 1,202 346 668 3,686 1,429 11,082 4,316 16,119 

All other deductions 4,251 9,153 2,452 16,652 12,280 116,840 33,171 165,297 

Estimated net income per return 18,085 10,401 3,757 38,544 41,493 516,918 110,794 339,767 

Estimated net income per books 18,011 10,493 3,025 37,364 42,079 507,358 96,038 266,965 

Reduction in U.S. tax liabilitl 7,993 4,851 1,583 17,674 18,025 229,528 48,054 140,633 

Distributions 1,748 760 90 1,472 10,983 44,233 36,519 154,280 
Table 5-2 - continued 

Nonmanufacturing Industries 

Non-Manu- Transportation Finance, Services and 

facturing Construction Comnunications Wholesale Trade Retail Trade Insurance, Industry Not 

and Utilities Real Estate Reported 

Number of corporations 186 9 6 27 63 31 50 

Total Receipts 2,002,378 75,147 253,117 216,084 1,115,486 224,345 118,196 

Business receipts 1,724,274 74,132 251,272 213,819 1,055,964 21,416 107,668 

Nongovernment interest 176,723 23 585 693 2,118 172,851 453 I 

Other receipts 101,380 991 1,260 1,571 57,404 30,078 10,074 ....... 

....... 

0 

I 

Total Deductions 1,824,031 40,734 198,672 186,523 1,068,898 220,821 108,379 

Cost of sales 1,075,214 25,615 94,712 139,383 743,899 147 71,456 

Depreciation 78,503 582 56,145 1,274 13,260 3,232 4,007 

All other deductions 670,313 14,537 47,815 45,865 311,737 217,440 32,915 

Estimated net income per return 178,349 34,415 54,444 29,560 46,587 3,523 9,816 

Estimated net income per books 102,592 565 54,126 27,292 12,255 1,298 7,054 

Reduction in U.S. tax liability 0 0 0 0 0 0 0 

Distributions 69,120 825 53,79 14,115 6 226 156 

Office of the Secretary 

Office of Tax Analysis 
-111-

4. Net Income per Tax Return. Net income per 

return (totaY-recefptsminus-total-deductions on Table 5-2, 

or taxable income on the U.S. corporation income tax return) 

amounted to almost $ 3. 0 bi 11 ion for al 1 936 manufacturing 

corporations. The industry with the greatest amount of net 

income was pharmaceuticals, with 48 percent of the total. 

The electrical and electronic equipment industry accounted 

for 17 percent of the combined net income of 936 manufacturing firms, and food products and chemicals other than 

pharmaceuticals each accounted for 6 percent of the total. 

5 • Red~£ t i on__!_~__!!~ s . __!~~~i_~E.i..!.i.~Y • Tab 1 e 5 - 2 

shows that U.S. tax liabilities were reduced by $1,245 

million in tax year 1980 by the possessions corporation 

system. The reduction in Federal tax liabilities under 

section 936 was estimated by applying to possessions 

corporations in manufact~ring the same U.S. tax rules which 

applied to corporations operating within the United States 

in 1980, and then subtracting income and tollgate taxes paid 

by 936 corporations to Puerto Rico. Possessions corporations in non-manufacturing industries were assumed to pay an 

effective rate of income tax to Puerto Rico at least equal 

to the U.S. rate, and thus they did not give rise to any 

Federal revenue loss. The pharmaceutical industry accounted 

for 4 7 percent of the total Federal tax savings provided 

under section 936. Eighteen percent of the tax savings was 

attributable to the electrical and electronic equipment 

industry. 

6. Distributions. The final line in Table 5-2 

shows that 936 manufacturing corporations reported $1, 215 

million of distributions, which was 41 percent of their net 

income in tax year 1980. This represented an increase over 

the 1979 level of distributions, which was $899 million, or 

one-third of net income. Fifty-five percent of total 

distributions by manufacturing corporations in these two 

Years was attributable to the pharmaceutical industry. 

B. Payroll and Employment in 1980. In enacting section 

936 in 1976, Congress sought to assist Puerto Rico in 

obtaining employment-producing investments. Matching 936 

corporations' U.S. income tax returns with payroll and 

~mployment data from the companies' Federal unemployment 

insurance tax returns provides one indication of the extent 

to which this objective has been attained. Table 5-3 

Presents, by industry, 936 tax benefits per employee and as 

a percent of labor compensation. The actual tax benefits 

received by a possessions corporation depend, of course, on 
Table 5-3 

Tax Benefits, Employment, and Compensation of Employees by Industry, 1980 

Qualified: Tax Benefits &npl Compensation Number of :Possession: oyees of Employees 2/ Tax Benefits 

Average 

Employee 

Compensation 

($) 

:Corporations: Net Income :_Am_o_u_n_t_:_P_e_r_ce_n_t_o_f_: _____ :_P_e_r __ ce_n_t_o_f __ Am_ou_n_t-=-:-P ..... e_r_c_e_n--'t'-o-f- per Employee 

: ($000) 1/: ($000) : Total Number Total ($000) : Total ($) 

All Manufacturing Industries 

Food and kindred products 

Textile mill products 

Apparel 

Men's and boys' 

W<xnen's and children's 

Hats, caps, etc. 

All other 

Chemicals 

Industrial chemicals, 

plastics 

Pharmaceuticals 

Soaps, cleaners, etc. 

All other 

Rubber and plastics 

Leather 

Footwear 

All other 

Stone, clay, and glass 

Fabricated metal products 

Metal cans and containers 

Cutlery, hand tools, 

screws, bolts 

All other 

Machinery, except electrical 

Electrical and electronic 

equipnent 

Radio, "N, comnunication 

Electronic components 

All other 

282 

10 

6 

52 

14 

32 

3 

3 

52 

7 

34 

4 

7 

6 

8 

5 

3 

3 

17 

5 

3 

9 

5 

74 

7 

19 

48 

Transportation equipnent 5 

Instruments and related 

products 

Scientific instruments 

All other 

All other manufacturing 

23 

6 

17 

4/ 21 

Office of the Secretary of 

Office of Tax Analysis 

* Less than 0.5%. 

the Treasury 

2,234,383 

85,983 

5,594 

70,906 

29,233 

37,635 

2,212 

1,828 

1,234,178 

105,705 

1,092,059 

31,300 

5,114 

15,376 

10,957 

8,189 

2,408 

1,580 

27,033 

6,040 

9,270 

ll, 723 

29,998 

411,569 

58,245 

69,438 

283,886 

13,568 

77,246 

6,109 

71,137 

250,755 

961,693 

33,174 

2,687 

32,809 

13,346 

17,707 

939 

817 

523,260 

44,471 

462,664 

13,828 

2,297 

6,830 

4,777 

3,674 

1,103 

621 

12,584 

2,800 

4,236 

5,548 

13,207 

185,959 

26,ll2 

31,086 

128,761 

6,ll6 

33,376 

3,153 

30,223 

106,293 

100.0 

3.4 

* 

3.4 

1.4 

1.8 

* 

* 54.4 

4.6 

48.l 

1.4 

* 

* 

* 

* 

.7 

.5 

1.3 

* 

* 

.6 

1.4 

19.3 

2.7 

3.2 

13.4 

.6 

3.5 

* 

3.1 

ll.l 

y Equals net income from the active conduct of a trade or 

business in a possession plus net qualified possession source 

investment income. 

y Compensation of employees was computed by multiplying 1.232 

times payroll. The 23. 2 percent reflects the employer-paid 

portion of Social Security, unemployment insurance, and other 

non-payroll costs. The 23. 2 percent is the average for all 

U.S. manufacturing iooustries in l.980. Source: Un-published 

es\:iroa\:es of the U.S. Depat:tn'en\: of Conmet:ce. 

54,202 

5,355 

507 

ll,361 

3,952 

6,433 

439 

537 

10,347 

1,863 

7,876 

413 

195 

528 

2,412 

2,154 

258 

79 

1,335 

579 

251 

505 

785 

12,712 

1,893 

3,012 

7,807 

761 

2,759 

158 

2,601 

5,261 

100.0 

9.9 

.9 

21.0 

7.3 

ll.9 

.8 

1.0 

19.1 

3.4 

14.5 

.8 

* 

1.0 

4.5 

4.0 

.5 

.1 

2.5 

1.1 

.5 

.9 

1.4 

23.5 

3.5 

5.6 

14.4 

1.4 

5.1 

.3 

4.8 

9.7 

645,948 

57,794 

4,832 

97,084 

34,667 

54,410 

3,447 

4,560 

174,172 

42,780 

123,217 

5,062 

3,ll3 

6,410 

21,402 

19,136 

2,266 

1,786 

18,295 

9,076 

2,382 

6,837 

9,809 

142,844 

19,844 

31,108 

91,892 

8,423 

31,263 

1,718 

29,545 

71,834 

100.0 

8.9 

.7 

15.0 

5.4 

8.4 

.5 

.7 

27.0 

6.6 

19.l 

.8 

.5 

1.0 

3.3 

3.0 

* 

* 2.8 

1.4 

.4 

1.1 

1.5 

22.1 

3.1 

4.8 

14.2 

1.3 

4.8 

* 

4.6 

11.1 

17,186 y 

6,194 

5,299 

2,887 

3,377 

2,752 

2,138 

1,521 

50,571 

23,870 

58,743 

33,481 

ll, 779 

12,935 

1,980 

1,705 

4,275 

7,860 

9,426 

4,835 

16,876 

10,986 

16,824 

14,628 

13,793 

10,320 

16,493 

8,036 

12,097 

19.955 

ll,619 

20,203 

ll,915 y 

10,792 

9,530 

8,545 

8,772 

8,457 

7,851 

8,491 

16,833 

22,962 

15,644 

12,256 

15,964 

12,140 

8,873 

8,883 

8,782 

22,607 

13,704 

15,675 

9,490 

13,538 

12,495 

ll,236 

10,482 

10,328 

ll, 770 

ll,068 

ll,331 

10,873 

ll,359 

13,654 

y Compensation of employees and number of employees used to 

ccmpute these amounts were weighted, by industry, by using the 

ratio of income in Table 5-2 and income in this Table. The 

unweighted figures are the following: tax benefits per 

employee, $17,742; tax benefits as a percent of compensation, 

148.9%; average employee compensation, $11,917. 

!f Includes manufacturing industries where data were available 

for fewer than 3 corporations. 

Tax Benefits 

as a Percent of 

Compensation 

of Employees 

144.2 y 

57.4 

55.6 

33.8 

38.5 

32.5 

27.2 

17.9 

300.4 

104.0 

375.5 

273.2 

73.8 

106.6 

22.3 

19.2 

48.7 

34.8 

68.8 

30.9 

177.8 

81.l 

134.6 

130.2 

131.6 

99.9 

140.l 

72.6 

106.8 

183.5 

102.3 

148.0 

I 

...... 

...... 

N 

I 
-113-

the amount of income which it earns, not on the number of 

workers it employs. Table 5-3 is based on all 936 firms in 

the manufacturing sector for which 1980 employment and payroll data could be obtained. The 282 corporations included 

in the table represent 63 percent of the number of 

manufacturing companies included in Tables 5-1 and 5-2; the 

combined qualified possession net income of $2.2 billion 

represents 75 percent of the net income of all manufacturing 

possessions corporations. 

Table 5-J shows that for all manufacturing industries, 

the Federal tax benefits per Puerto Rican employee averaged 

$17,186. Tax benefits per employee, or as a percentage of 

total employee compensation, varied substantially from 

industry to industry. In the pharmaceutical industry, for 

example, the average Federal tax benefits amounted to 

$58, 743 per employee or close to four times the average 

compensation of the comparatively well-paid Puerto Rican 

pharmaceutical employee. In the electrical and electronics 

industry, the average tax savings amounted to $14, 628 per 

employee or 130 percent of average compensation. In the 

apparel industry, in contrast, the average tax savings per 

employee were $2,887, or 34 percent of employee 

compensation. 

The variation in tax benefits in relation to number of 

employees and average compensation is illustrated in Figure 

III. The chemical industry (including pharmaceuticals) 

provided slightly less than one-fifth of the employment of 

all 936 manufacturing companies (as indicated by the width 

of the bars), but accounted for more than half of the total 

section 936 tax savings (indicated by the area of the shaded 

bars). The food, apparel, and textile industries provided 

one-third of all employment in 936 manufacturing firms, and 

accounted for less than one-tenth of the total section . 936 

tax savings. 

The industries in which tax benefits per employee were 

the highest (pharmaceuticals, machinery, instruments, and 

electrical and electronic equipment) tended to be the same 

industries in which total Puerto Rican employment has been 

growing during the past decade. Conversely, industries in 

Which average tax savings per employee were the lowest 

(tobacco products, textiles, apparel, leather products) 

~ended to be those whose employment was declining. As shown 

in Table 3-8, above, the high-technology industries of 

Pharmaceuticals, machinery, instruments, and •electrical and 

electronic equipment have provided nine out of every ten new 
$55,000 

50,000 

45,000 

40,000 

35,000 

30,000 

25,000 

20,000 

15,000 

10,000 

5,000 

FIGURE Ill 

Tax Benefits Per Employee and Average 

Employee Compensation, Selected 

Manufacturing Industry Groups, 1980 

50,571 

16,833 

14,628 

No. of ~ 10,347 ~ Employees ~ 12,712 ~ 

Chemicals Electrical & 

Electronic 

Equipment 

-114-

~ Tax Benefits per Employee 

.__ __ __,,Average Employee Compensation 

13, 144 

~II~ 3,544 

Instruments & 

Machinery 

(except electrical) 

9,273 

3,987 

~ 17,223 ~ 

Food Products, 

Apparel, and 

Textiles 

~10,37+..­

All Other . g 

Manufacturin 

Note: The height of the bars indicates the tax benefits per employee and the average compensation per employee. 

Because the width of the bars indicates the number of employees, the area indicates total tax benefits and 

total compensation. 
-115-

jobs in those Puerto Rican manufacturing industries which 

have experienced an increase in employment since 1968. In 

1980, these industries accounted for 36 percent of total 

employment in Puerto Rico's manufacturing sector. 

Table 5-3A is based on the same 282 possessions corporations shown in Table 5-3, but ranked according to the 

Federal tax benefits per employee. At the top of the 

ranking are 10 companies for which the U.S. tax benefits 

represented more than $100,000 per employee in Puerto Rico. 

At the low end are the companies which incurred losses and 

thus derived no immediate tax benefit from section 936. The 

top 10 possessions corporations accounted for 24.5 percent 

of the tax benefits but provided only 2. 6 percent of the 

employment of the 282 manufacturing companies. The top 32 

possessions corporations, those for which tax savings per 

employee equalled or ex~eeded $50,000 in 1980, collectively 

accounted for 48.2 percent of the total tax benefits and 8.2 

percent of total employment. 

c. Summary Data for 1973-1980. Table 5-4 presents data 

for the period 1973-1980 on the number of possessions 

corporations, their net income, estimated tax benefits, and 

tax benefits in relation to payroll and employment. The 

table reveals a number of trends: 

0 

0 

0 

After declining from 399 to 374 between 1974 and 

1978, the number of possessions corporations in 

manufacturing increased to 445 firms by 1980. Onefourth of the new firms were in the electrical and 

electronics industry. 

Net income of manufacturing possessions corporations 

rose from $813 million in 1974, to almost $3 biilion 

in 1980. In real terms, this represented an 

increase of 141 percent. The percentage of the total 

net income earned by the pharmaceutical industry 

stood at approximately 50 percent throughout this 

period, while the share of the electrical and 

electronics industry varied between 15 percent and 

20 percent. 

As the net income of possessions corporations has 

grown, the tax benefits of possessions corporations 

have increased roughly in proportion, from $397 

million in tax year 1974, to $1,245 million in tax 

year 1980. 
Table 5-3A 

Tax Benefits, Employment, and Canpensation of Employees by 

Size of Tax Benefits Per Employee, 1980 

: Qualified Tax Benefits Employees Total Canpensat1on Average 

Number of :Possession of Employees 2/ Tax Benefits Employee 

Returns :Net Income Amount :Percent of: Number :Percent of Amount :Percent of per Employee Canpensation : ($000) 1/ ($000) Total Total ($000) : Total ($) ($) 

All Manufacturing 

Corporations 282 2,234,383 961,693 100.0 54,202 100.0 645,948 100.0 17 ,186 y 11,915 y 

$100,000 or more 10 553,228 235,411 24.5 1,399 2.6 28,151 4.4 168,270 20,122 

$ 50,000 under $100,000 22 518,967 227,853 23.7 3,061 5.6 47,995 7.4 74,437 15,679 

$ 10,000 under $ 50,000 96 863,061 370,892 38.6 16,798 31.0 241,154 37.3 22,079 14,356 

$ 5,000 under $ 10,000 40 152,758 64,670 6.7 9,014 16.6 100,983 . 15.6 7,174 11,202 

$ 1,000 under $ 5,000 78 147,600 61,848 6.4 19,687 36.3 186,452 28.9 3,141 9,470 

$ 500 under $ 1,000 10 1,125 445 * 626 1.2 7,020 1.1 710 11,214 

$ 1 under $ 500 10 1,385 574 * 1,633 3.0 14,167 2.2 352 8,675 

No tax benefits 16 -3,726 0 0 1,984 3.7 20,026 3.1 0 10,093 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

* Less than 0.1 percent. 

!/ F.quals net income from the active conduct of a trade or business in a possession plus net qualified possession source investment 

income. 

~ Canpensation of anployees was computed by multiplying 1.232 times payroll. The 23.2 percent reflects the anployer-paid portion of 

social security, unanployment insurance, and other non-payroll costs. The 23.2 percent is the average for all U.S. manufacturing 

industries in 1980. 

y Canpensation of anployees and number of anployees used to compute these amounts were weighted, by industry, by using the ratio of 

incane in Table 5-2 to incane in Table 5-3. 

: Tax Benefits 

:as a Percent of 

Canpensation 

of Employees 

144.2 y 

836.2 

474.7 

153.8 

64.0 

33.2 I 

..... 

..... 

6.3 (J\ 

I 

4.1 

0 
Table 5-4 

Summary Data on Possessions Corporations, 1973-1980 

1974 1975 

Number of corporations, all industries 596 595 

Manufacturing industries 399 394 

Pharmaceuticals 44 47 

Electrical and electronic equipment 76 76 

All other manufacturing 279 271 

Nonmanufacturing industries 197 201 

Net income, all industries ($000) 852,058 1,108,881 

Manufacturing industries 813,057 1,055,060 

Pharmaceuticals 405,355 547,060 

Electrical and electronic equipment 167,389 195,593 

All other manufacturing 240,313 312,407 

Nonmanufacturing industries 39,002 54,059 

Estimated tax benefits ($000) y 

Manufacturing industries 397,021 478,367 

Pharmaceuticals 181,508 245,486 

Electrical and electronic equipment 75,231 89,106 

All other manufacturing 140,282 143,819 

Tax benefits per employee ($) 

Manufacturing industries y 6,310 8,512 

Pharmaceuticals 38,129 39,031 

Electrical and electronic equipment 6,237 9,488 

All other manufacturing 3,479 3,987 

Tax benefits as a percent of com pensat ion of employees 

Manufacturing industries y 91. 7 ll6 .1 

Pharmaceuticals 425.5 389.1 

Electrical and electronic equipment 93.5 126.0 

All other manufacturing 52.7 55.8 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

~/ Preliminary. As noted on page 101, figures for 1980 are based on corporations which filed as possessions 

corporations for tax year 1980 no later than January 31, 

1982, that is, within 7 months of the end of the tax 

year. Figures for years prior to 1980 have been revised 

to include corporations which filed as possessions 

corporation within 12 months of the end of of the tax 

year. 

1976 1977 1978 1979 1980 P7 

528 519 637 672 631 

395 385 460 502 445 

52 53 58 65 58 

81 80 90 ll2 100 

262 252 312 325 287 

133 134 177 170 186 

1,627,213 1,800,313 2,484,572 3,088,304 3,152,766 

1,551,677 1,714,321 2,361,446 2,798,156 2,965,523 

779,954 876,576 1,053,252 1,325,309 1,433,158 

323,249 231,475 417,629 . 543,195 516,918 

448,474 606,270 890,565 929,652 1,015,447 

75,536 85,992 123,126 290,148 187,243 

698,839 771,444 998,120 1,167,529 1,244,535 

350,941 394,459 438,695 552,020 590,708 

145,575 104,164 184,501 219,771 229,528 

202,322 272,821 374,924 395,738 424,299 

ll,454 ll,217 14, 250 15,690 17,186 

47,166 39,337 48,669 51,417 58,743 

10,816 ll,315 11,988 15,439 14,628 

5,300 4,432 9,639 8,415 9, 314 

143.3 135.9 133.2 135.4 144. 2 

428.1 327.5 357.3 343.8 375.5 

129.2 126.6 122.6 138.9 130.2 

72. 3 62.2 94.6 77. 7 82.4 

.~/ The estimated tax benefits shown here differ from the 

corresponding years shown in Table 5-5 because that 

table is based on calendar and Federal fiscal years, 

whereas the data above are based on the taxable years of 

possessions corporations, as explained in pages 101-102. 

±I These figures are weighted averages based on only those 

returns for which employment and compensation of 

employees were available. See Table 5-3 for details. 

I 

t-' 

t-' 

-i 

I 
0 

0 

-118-

U.S. tax savings under the possessions corporation 

provisions in relation to the number of employees in 

936 companies rose from $6,310 per employee in 1974, 

to $17 ,186 per employee in 1980. This increase 

reflects the fact that the tax-exempt income of 

possessions corporations grew more than twice as 

fast as employment in this period. 

While tax benefits per employee have increased 

rapidly, compensation per employee in 936 companies 

has also increased (from $6, 973 in 1974 to $11, 915 

in 1980). Total U.S. tax benefits under the 

possessions corporation provisions have stood at 

about 138 percent of 936 employee compensation since 

1976. 

II. Estimates of Linkages 

The preceding sections related the tax benefits of the 

possessions corporation system of taxation to the employment 

and payroll of 936 companies. In addition to creating jobs 

directly, the industry development encouraged by this system 

of taxation may bring indirect benefits to Puerto Rico. The 

development of one industry may encourage the growth o f 

other industries that are users of the products which it 

manufactures, a phenomenon called ''forward linkages." Manufacturing also gives rise to "backward (supplier) linkages." 

Production requires raw materials, intermediate goods, and 

services, a portion of which are supplied by the local 

economy; and investment in plant in Puerto Rico creates jobs 

in the construction industry. 

A. Forward Linkages 

"Forward linkages" are usually evaluated by examining 

the percentage of total sales to various types of customers. 

When one industry sells a substantial part of its output to 

another local industry, it is plausible that forward 

linkages have occurred. Conversely, where an industry 

produces a consumer good (e.g., apparel) or where it sells 

most of its output abroad, it is unlikely that the industry 

,is an important stimulant to the development of local 

"downstream" (customer) industries. 

The latest year for which Census data on the destination 

of Puerto Rican shipments are available is 1977. Table 5-5 

shows the percentages of manufacturing industries' shipments 

in 1977 to Puerto Rico, the United States, and foreign 
-119-

countries, respectively, but does not distinguish between 

sales to individual consumers and sales to manufacturers. 

For manufacturing as a whole, 33.4 percent of direct 

shipments went to Puerto Rico, 59.2 percent to buyers 

(including parent companies) in the United States, and 7. 4 

percent to foreign purchasers. If indirect shipments 

outside of Puerto Rico (i.e., goods sold to other Puerto 

Rican manufacturers who, in turn, sold them to the United 

States or foreign countries) could be estimated separately, 

Puerto Rico's sales to the U.S. and foreign markets would 

appear larger than Table 5-5 indicates. 

Table 5-5 shows that some industries' forward linkages 

with other sectors of the Puerto Rican economy are stronger 

than others. The lumber and wood industry sells its limited 

output to Puerto Rican users, and its primary customers --

the furniture and paper industries also sell almost 

exclusively to the local market. By contrast, the chemical 

industry and electrical and electronic equipment industry 

sold 9.2 percent and 7.3 percent respectively, of their 

total production to Puerto Rican buyers. These two 

industries, together with the consumer good industries, 

apparel and food products, account for two-thirds of the 

business receipts of all 936 manufacturing firms. The 

evidence of Table 5-5 would therefore suggest that 

possessioins corporations are not generally an important 

stimulant to the development of "downstream" industries. 

B. Backward Linkages 

Backward linkages refer to the generation of income and 

employment in "upstream" (supplier) industries as a result 

of an industry's purchases of local goods and services. The 

1978 Annual Report on possessions corporations estimated 

that in most Puerto Rican manufacturing industries, onethird to one-half of all materials were purchased from 

Puerto Rican sources. The usefulness of this data is 

limited, however, because it is based on import coefficients 

for 1963 and because it does not distinguish between 

purchases of materials from 936 manufacturing companies 

(whose investment and employment are included in Tables 5-1 

to 5-3 as direct benefits to Puerto Rico) and all other 

companies. 

The Puerto Rican government views the electronics 

industry as the centerpiece for a growing locally-owned 

electronics and metal products industry. There is evidence 
Industry 

Group 

-120-

Table 5-5 

Destination of Shipments by Puerto Rican 

Manufacturing Industries, 1977 

(Percentage of total) 

Puerto United 

Rico States 1/: 

Foreign 

Countries 

All Manufacturing Industries 33.4 59.2 7.4 

Food and kindred products 55.1 39.2 5.8 

Tobacco products 45.3 54.7 * Textile mill products 27.8 72.2 * 

Apparel 18.6 76.3 * Lumber and wood products 100.0 

Furniture and fixtures 87.1 12.2 * Paper and allied products 87.6 4.0 8.2 

Printing and publishing 53.8 44.4 1. 7 

Chemicals 9.2 74.2 16.6 

Drugs 1.6 71.2 27.2 

Petroleum refining 68.9 28.7 2.4 

Rubber products 20.0 79.8 .5 

Leather and leather products 2.5 97.2 .1 

Stone, clay and glass products 83.8 15.3 .8 

Primary metal industries 49.1 34.0 16.9 

Fabricated metal products 76.5 20.9 2.5 

Machinery except electrical 27.8 71. 7 .5 

Electrical and electronic equipment 7.3 84.8 .8 

Transportation equipment 9.1 84.6 6.2 

Instruments and related products .4 95.4 4.1 

Miscellaneous manufacturing 

industries 3.4 95.2 1.1 

Off ice of the Secretary 

Off ice of Tax Analysis 

Source: U.S. Department of Commerce, 1977 Economic Censuses of 

Outlyin~ Areas, Manufactures, Puerto Rico, November 1980, 

Chapter 2, Table 3. 

.!/ 

* 

Figures for shipments to the United States represent direct 

exports by Puerto Rican manufacturing establishments to the 

United States and the U.S. Virgin Islands. 

Less than 0.05 percent. 
-121-

that some locally owned firms are currently supplying 

materials to 936 electronics firms. In addition, a 

substantial service sector in Puerto Rico provides banking, 

transportation, and utilities to 936 manufacturing firms. 

Employment in these "supplier" industries is not included in 

employment figures reported in Table 5-3, above. 

III. Revenue Impact of Section 936 

A. Projections and Estimating Procedure 

Table 5-6 presents the estimated U.S. tax benefits 

provided by the possessions corporation system on the basis 

of fiscal and calendar years 1973-1980, and projected tax 

benefits for 1981-1988. Adjusting the income of possessions 

corporations to a fiscal year basis requires apportioning 

the income reported on all possessions corporatons' returns 

filed for tax years which overlap the fiscal year. This 

results in an estimate of $1, 195 million in tax benefits 

under section 936 for fiscal year 1980. 

For accounting periods beginning after December 31, 

1982, possessions corporations are subject to the provisions 

of TEFRA. As explained in Chapter 2, TEFRA provides that 

only certain income from intangibles developed by a U.S. 

corporation may be allocated to an affiliated possessions 

corporation. The remainder of the income from such 

intangibles must be allocated to the U.S. parent and be 

subject to U.S. tax. It is estimated that the intangibles 

income provision in TEFRA will reduce the tax benefits under 

section 936 by about 30 percent in 1984 and subsequent years 

(see column (3)). The estimated revenue effect of TEFRA is 

based on the assumption that, absent TEFRA, some U.S. 

mainland corporations would continue to transfer to . 936 

subsidiaries title to patents, trademarks, and other 

intangibles and to claim the benefits of tax exemption on 

the income attributable to such intangibles. 

In addition to providing rules relating to income from 

~ntangibles, TEFRA reduces the amount of passive investment 

income which a corporation can receive if it wishes to 

qualify for the possessions tax credit. Under current law, 

~ possessions corporation may receive up to 50 percent of 

its gross income in passive investment income. This will be 

teduced to 45 percent for tax years beginning in 1983, 40 

Percent for tax years beginning in 1984, and 35 percent 

thereafter. These reductions wi 11 affect only those 

corporations which currently earn passive income in amounts 
-122-

Table 5-6 

Federal Revenue Cost Estimates and Projections, 

Possessions Corporation Provisions, 1973-1988 

(millions of dollars) 

Fiscal Year Receipts Forgone 

TEFRA Cost Reductions 

. 0 l Reduct10 

Year : Pre-TEFRA !/: Intangibles Passive Calendar 

Year Ta~ Income Income 

Provisions Limitation 

Post-TEFRA Liabil~ 

1973 

1974 

1975 

1976 

1977 

1978 

1979 

1980 

1981 

1982 

1983 

1984 

1985 

1986 

1987 

1988 

254 

325 

429 

572 

724 

864 

1,121 

1,195 

1,278 

1,373 

1,479 

1,566 

1,666 

1,825 

2,026 

2,251 

112 

471 

501 

549 

610 

678 

Off ice of the Secretary of the Treasury 

Office of Tax Analysis 

15 

21 

30 

37 

43 

50 

1,352 

1,074 

1,135 

1,239 

1,373 

1,523 

!/ Estimates for 1973 through 1975 are based on the original 

possessions corporation provisions enacted in the Revenue Act 

of 1921. Estimates for 1976 and all subsequent years are 

based on the section 936 provisions of the Tax Reform Act of 

1976. 

'!:._/ Estimates for 1973 through 1982 are computed on the same 

basis as described in footnote 1. Estimates for 1983 and 

subsequent years are based on the amendments to section 936 

in the Tax Equity and Fiscal Responsibility Act of 1982 

(TEFRA) • 

Source: The 1973 through 1975 figures are based on book income 

data taken primarily from 936 election forms filed for 

1976 (Form 5712) • The 1976 and 1977 estimates are based 

on net income data taken primarily from Federal income 

tax forms (Form 1120). The figures for 1978-1980 are 

based on qualified possession taxable income taken from 

possessions credit computation forms (Form 5735). 

Figures for 1981 and subsequent years are projections 

which reflect an assumed 10 percent annual growth in 

qualified possession taxable income. 

269 

393 

473 

692 

763 

988 

1,156 

1,233 

1,323 

1,424 

1,165 

1,091 

1,177 

1,300 

1,446 

1, 601____./ 
-123-

close to the current limit. Because the passive investment 

income earned by most possessions corporations is well below 

50 percent of their gross income (the passive income of all 

936 manufacturing companies represented approximately 15 

percent of their combined gross income in 1980 8/), the 

revenue effect of the new passive income limitation under 

TEFRA is expected to be relatively small. Column (4) of the 

table shows that the new passive income limitation is 

projected to reduce section 936 tax benefits by $15 million 

in fiscal year 1983, and by $50 million in 1988. 

In past Annual Reports on possessions corporations, the 

U.S. tax benefits under section 936 were estimated by 

applying the average effective U.S. corporate tax rate to 

the qualified possession income of 936 corporations (except 

those in nonmanu- facturing industries) ~/ and then 

~/ A rough measure of income from financial assets in . 1980 

may be obtained by summing the nongovernment interest 

($413.4 million) and the government interest ($25 

million) reported by possessions manufacturing corporations in tax year 1980. The total of $438 million in 

gross interest income represented 14. 8 percent of the 

net income of 936 manufacturing corporations. This 

estimate does not take into account the overhead or 

other expenses of earning financial income, nor does it 

take into account non-interest income on financial 

investments. The proportion of financial income in 

total 936 income is estimated to rise after 1980 because 

of the rise in interest rates and the reinvestment of 

interest i·ncome. 

2/ It is assumed that 936 companies in nonmanufacturing 

industries do not qualify for a Puerto Rican tax exemption grant and that the taxes which they pay to Puerto 

Rico offset 100 percent of their U.S. tax liability. 

While the Puerto Rican Industrial Incentive Acts do 

provide exemptions to designated nonmanufacturing industries, in particular, hotels, medical laboratories, 

movie production, and, after 1978, various services 

produced for export, the total possession income of 936 

firms in these industries was negligible in 1980. 

Moreover, a sample of the 1978 Puerto Rican tax returns 

filed by 936 firms in all nonmanufacturing industries 

suggests that the average effective Puerto Rican tax 

rate for such companies was roughly 40 percent. 
-124-

subtracting income and tollgate taxes paid to Puerto Rico. 

The Treasury used 40 percent as the effective U.S. tax rate 

for years through 1978, and 38 percent as the effective U.S. 

tax rate for later years. These figures were based on the 

average effective tax rate paid by U.S. corporations. 10/ 

Use of the average effective U.S. tax rate to estimate the 

tax benefits of the possessions corporation system 

implicitly assumes that the amount of 936 assets which, in 

the absence of the possessions corporation provisions, would 

have been eligible for accelerated depreciation and the 

investment tax credit, bears the same relationship to 936 

income as eligible U.S. assets bear to the income of U.S. 

corporations as a whole. Since 936 corporations have only 

one-eighth as much property, plant, and equipment in 

relation to their income as do corporations operating in the 

United States, such an assumption results in an 

underestimate of the revenue impact of section 936. 11/ 

Accordingly, this Report does not apply the average U.S. 

effective tax rate to the qualified income of possession 

corporations. Instead, it estimates the 936 tax benefits by 

(1) subtracting from the qualified income of possession corporations the additional depreciation deductions which these 

corporations would have enjoyed had they been eligible for 

the accelerated cost recovery system, and (2) applying the 

U.S. statutory tax rate to the adjusted qualified income. 

The revenue estimate which is thereby obtained is then 

reduced by the amount of the investment tax credit which 

would have been available had the corporations been 

operating in the United States, and by the tollgate and 

income taxes paid to Puerto Rico. 12/ 

The $1,245 million estimated revenue impact of section 

936 in tax year 1980 (shown in Table 5-2) is less than the 

936 credits claimed by manufacturing firms in that period 

10/ See Department of the Treasury, Effective Income Tax 

Rates Paid by U.S. Corporations in 1972, May 1978. 

~l/ At the end of tax year 1980, possessions corporations' 

net property, plant, and equipment was equal to 51 

percent of their net income per return. For U.S. 

mainland corporations, net property, plant and equipment 

was equal to 419 percent of their before-tax income. 

See Tables 5-1 and 5-2 and Federal Trade Commission, 

Quarterly Financial Report, First Quarter 1981~ 1982. 

~/ In 1980, Puerto Rican tollgate and income taxes on 

possessions corporations in manufacturing were 

approximately 3.5 percent of their qualified possession 

source net income. See Chapter 6. 
-125-

($1,404 million), because the credit is based on tax 

liability computed without regard to accelerated depreciation, the investment tax credit, and the foreign tax credit. 

Whether the elimination of the possessions corporation 

exemption would result in a gain to the U.S. Treasury of the 

tax benefits provided under section 936 depends on the taxsaving alternatives available to possessions corporations 

and on the induced effect on the aggregate level of 

investment by U.S. persons. This is the subject of the 

remainder of this chapter. 

B. Alternative Tax-saving Routes 

1. Physical Assets. As explained in Chapter 4, the 

tax-saving alternatives to investment through a 936 firm 

differ significantly for physical assets, financial assets, 

and intangible assets. Table 5-7 shows for selected 

manufacturing industries the effective U.S. tax rates on 

income from new plant and equipment under law in effect in 

the period 1979-81, during 1981-82, and after 1982. The 

accelerated cost recovery schedule and the safe harbor 

leasing rules enacted in ERTA reduced the effective tax rate 

on plant and equipment in the industries shown by roughly 

one-half. TEFRA retained ERTA' s cost recovery schedule 

applicable to depreciable property placed in service in 1981 

or 1982, but tightened the leasing provisions and reduced 

the basis of depreciable property by one-half of the amount 

of the investment tax credit. The effect of TEFRA will be 

to increase the U.S. effective tax rate for years after 1982 

by 6-10 percentage points in the industries shown. 

To obtain the benefit of 100 percent U.S. tax exemption 

on current income from physical assets, a possessions 

corporation could elect to remain in Puerto Rico as a Puerto 

Rican-chartered corporation, or it could move to a foreign 

country. The United States generally does not tax the 

current foreign earnings of a corporation chartered outside 

the United States until the earnings are repatriated. 

Moreover, Federal income tax can be avoided altogether where 

a U.S. parent corporation has excess foreign tax credits 

that can be used to offset the Federal tax on dividends from 

a foreign affiliate. 

If a possessions corporation derives most of its income 

fr~m investment in physical assets, then it might elect to 

reincorporate in Puerto Rico or in a foreign country if 

section 936 were repealed. With respect to firms that took 
-126-

Table 5-7 

Effective U.S. Tax Rates on New Depreciable 

Assets, Selected Industries 

Industry :1979-1981: 1981-82 : Post-1982 

Law :Law (ERTA) :Law (TEFRA) 

Food 43.5 20.4 26.7 

Apparel 40.6 23.1 28.9 

Chemicals 28.6 8.5 17.7 

Fabricated metals 47.3 24.7 32.2 

Machinery and instruments 38.2 18.6 25.7 

Electrical and electronic 

equipment 31.9 15.8 25.7 

Note: Effective tax rates are based on investment patterns 

by corporations in the United States, and assume a 4 

percent real after-tax rate of return and 6 percent 

inflation. The source of these figures is unpublished statistics based on the Treasury Department 

depreciation tax model. 
-127-

this course, the repeal of the possessions corporation 

credit would not result in a large gain to the U.S. Treasury 

of the tax benefits provided under section 936. Those 

possessions corporations with the largest percentage of 

their income attributable to physical assets are in the lowtechnology industries. In 1980, the combined income of 

possessions companies in low-technology industries 

represented only 11.2 percent of the income of all 936 

manufacturing corporations. ~/ 

2. Financial Assets. For income from financial 

assets, there are very few tax-saving alternatives to 

section 936. If a U.S. corporation invests through a 

foreign corporation, the return on financial investments 

will generally av.oid U.S. tax only if the income is less 

than 10 percent of the foreign subsidiary's gross income. 

In the absence of the QPSII provision of section 936, the 

assets currently placed in the Puerto Rican capital market 

could be redirected into other assets, including taxable 

financial assets and physical assets in the U.S. and abroad; 

the funds could also be used to pay higher dividends to U.S. 

individual shareholders. It may therefore be reasonable to 

assume that a substantial part of the income from these 

currently tax-exempt assets would become taxable by the 

United States. 14/ Income from financial assets represented 

approximately 15 percent of total 936 income in 1980, and 

will rise somewhat in later years. 15/ 

3. Intangible Assets. Income from intangible 

assets generally means income derived from patents, knowhow, trademarks, brand names, access to established 

marketing and distribution channels, and goodwill with 

customers. In many cases, U.S. parent corporations have 

!ii See Tables 4-2 and 5-2. If those possessions corporations in the "all other manufacturing" category in Table 

5-2 are counted as firms in low-technology industries, 

then the percentage which these industries represent in 

the income of all 936 manufacturing firms rises from 

11.2 percent to 22.7 percent • 

.!._!! A 1 though a U • S • corpora t i on can of f set d i v id ends 

received from a wholly owned U.S. subsidiary (including 

a 936 subsidiary) with a 100 percent dividends-received 

deduction, which frees the dividend from Federal tax, 

dividends paid by a U.S. corporation to individual 

shareholders are taxable to the individuals at the time 

they are rece.i ved • 

.!2_! See footnote 8 above. 
-128-

transferred {tax-free) to affiliated 936 corporations the 

U.S. rights to certain intangibles, and the 936 affiliates 

have claimed as part of their income the gross return 

attributable to the intangibles. In the absence of section 

936, taxpayers could not claim the benefits of tax exemption 

for this return. If a possessions corporation reincorporated in Puerto Rico or a foreign country, the transfer of 

the U.S. rights to intangibles from the possessions company 

to the foreign-organized company would generally be subject 

to Federal tax on the gain {i.e., the fair market value of 

the intangible less the adjusted basis in the hands of the 

transferor, which would normally be zero). 

Although it is difficult to measure precisely the amount 

of 936 income which is attributable to intangibles, Table 

4-3 implies that in 1980, roughly 50 percent of the income 

of 936 manufacturing corporations may be a return on 

intangibles. .!.§_/ The income derived by 936 firms from 

16/ In the absence of "shifting" of items of income or 

expense between related corporations in order to reflect 

greater amounts of income in one of the corporations, it 

would be expected that the average before-tax return to 

u.s.-owned operating assets in Puerto Rico would be less 

than the return on such assets in the U.S., s i nee the 

Puerto Rican income is not taxable, while the U.S. 

income is. In fact, Table 4-2 shows that for hightechnology industries {which account for about 80 

percent of the income of 936 manufacturing firms), 936 

income-to-asset ratios are, on average, 4. 8 times 

greater than comparable U.S. profit margins. When 936 

margins are adjusted for Puerto Rican-u.s. wage 

differentials, 936 margins in high-technology industries 

still remain about 4 times larger than U.S. profit 

margins. The unexpectedly high 936 pre-tax profit 

margins would suggest that the 936 margins include a 

large return to intangible assets developed in the 

United States or to management or other services 

provided by the U.S. parent at little or no charge to 

the 936 subsidiary. The difference in rates of return 

implies that income from activities performed by the 

U.S. parent corporations, including R&D and marketing, 

constitutes at least three-fourths (i.e., 1 - 1/4 = 3/4) 

of the operating income of 936 high-technology firms, or 

about 50 percent of the total income of all 936 

manufacturing firms in 1980 (i.e., .75 X .85 (operating 

income as a share of all 936 income) X .80 (income of 

high-technology firms as a share of all 936 income)). 
-129-

intangibles is earned predominantly on sales to the U.S. 

market. 17/ If section 936 were eliminated, the income 

earned on--U.s. rights to intangibles would become taxable by 

the United States. 

In the long run, however, there may be other adjustments 

by U.S. parent companies which may substantially reduce the 

revenue pick-up from repealing section 936. For example, 

U.S. high-technology companies, which have been enjoying a 

much higher after-tax return because of 936 benefits, would 

tend both to reduce their total R&D effort and to shift some 

of their R&D from the United States to foreign locations. 

If U.S. firms reduced their total R&D effort or shifted some 

of their R&D from the United States to foreign locations, 

the effect of the repeal of section 936 would be to . reduce 

the income of high-technology U.S. firms. If such an effect 

occurred by 1986, then ' the estimated $1. 2 billion revenue 

impact of section 936 for the year would overestimate the 

gain to the U.S. Treasury from the repeal of section 936 • 

.!2_/ The United States is the principal market for hightechnology products, as well as for apparel, made in 

Puerto Rico. For example, in 1977, 84 percent of the 

pharmaceutical preparations made in Puerto Rico were 

shipped to the U.S.; 85 percent of the output of the 

Puerto Rican electrical and electronics industry was 

shipped to the U.S.; 95 percent of the scientific 

instruments made in Puerto Rico were shipped to the 

U.S.; 75 percent of Puerto Rican apparel shipments were 

to the U.S. (U.S. Department of Commerce, 1977 Economic 

Census of Outlying Areas, Manufactures, Puerto Rico, 

1980.) 
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Chapter 6 

IMPACT OF CHANGING FROM SECTION 931 TO SECTION 936 AND 

OF CHANGES IN THE PUERTO RICAN TOLLGATE TAX AND 

INDUSTRIAL INCENTIVES PROGRAM 

As explained in Chapter 2, the possessions corporation 

system was modified in the period 1976-1978 by the 1976 Tax 

Reform Act, the new Puerto Rican tollgate tax rules, and the 

1978 Industrial Incentives Act. Because all three sets of 

legislative changes were made within a relatively short 

period, their effects are difficult, if not impossible, to 

disentangle from one another. The principal effect of these 

changes was to induce possessions corporations to bring back 

to Puerto Rico the large pool of funds that had been 

invested abroad (as explained in Section III of Chapter 4> 

and to increase 936 dividend repatriations and Puerto Rican 

tax revenues (described below). 

I. Dividend Repatriation 

Under section 931, possessions corporations had a strong 

incentive to liquidate at the end of the Puerto Rican 

exemption period; that was the only way for them to 

repatriate earnings to their U.S. parent free of U.S. tax. 

The adoption of section 936 reduced the incentive to 

liquidate by eliminating the Federal tax on dividend 

distributions. 

There has been a clear response in the repatriation of 

earnings. Before 1977, possessions corporations paid 

virtually no dividends to their U.S. parents. In tax years 

1978 to 1980, however, possessions corporations in 

manufacturing distributed dividends of $885 million, $905 

million, and $1,215 million, respectively. The 1980 

dividends represented 13 percent of the companies' $9.4 

billion in retained earnings, and 41 percent of current 

earnings. 

Thus, while possessions corporations have repatriated 

substantial dividends since 1976, they continue to 

accumulate more than half of their current earnings in the 

possessions corporation. QPSII is effectively exempt from 

Federal and Puerto Rican tax, whereas income on comparable 

investments made by the U.S. parent is not. Both U.S. and 

Puerto Rican law, moreover, exempt possessions corporations 

from the accumulated earnings tax. In addition, the Puerto 
-131-

Rican tollgate tax can be reduced by reinvesting earnings in 

Puerto Rican assets and can be avoided al together in many 

cases by a liquidation. !/ 

II. Impact on Federal and Puerto Rican Tax Revenues 

If the changes in U.S. and Puerto Rican law between 1976 

and 1978 made the possessions corporation system more 

attractive to U.S. firms and thereby resulted in the 

shifting of some U.S. investment to Puerto Rico, the Federal 

revenue loss under the possessions corporation exemption 

would have increased. If, on balance, the changes in the 

law reduced the after-tax return to investment in Puerto 

Rico and led to a shifting of U.S. investment away from 

Puerto Rico, the U.S. revenue loss would have decreased. In 

addition, any income and tollgate taxes paid to Puerto Rico 

under the new Puerto Rican laws reduce the tax benefits 

received by possessions corporations. 

It is not clear from an examination of the changes in 

the U.S. and Puerto Rican laws whether the possessions 

corporation system provides more or less of an attraction to 

U.S. firms than it did before 1976. The adoption of section 

936 in place· of section 931 may have discouraged location in 

·Puerto Rico by restricting U.S. tax exemption on investment 

income to QPSII, and by requiring firms to make binding 

10-year elections which carry a prohibition from joining in 

a consolidated return. But it may have encouraged investment in Puerto Rico by allowing U.S. parent corporations a 

100 percent dividends-received deduction for dividends from 

a possessions corporation, and not just a tax-free 

liquidation. 

Table 6-1 presents data on the number of companies that 

have made an election under section 936. As of June 1980, 

750 corporations had filed a section 936 election form. 

Taken together, these companies accounted for over 99 

Percent of the income excludable under section 931 in 1975. 

There were 19 additional elections under section 936 in the 

Year ending June 1981, and 38 new elections in the year 

ending June 1982. Most of the new electors were in 

manufacturing industries. Over the two-year period ending 

June 1982, eleven of the new electors were in the electrical 

!/ As explained in Chapter 2, the tollgate tax does not 

apply to liquidating distributions by companies with 

"old" exemption grants or to 1 iqu ida ting distributions 

paid out of pre-1978 earnings by "converted" firms. 
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Table 6-1 

Elections under Section 936 

Total as of New Total as of Industry June 1980* Elections June 1982 

-- All Industries 750 57 807 

All Manufacturing Industries 575 44 619 

Apparel 124 5 129 

Chemicals 100 8 108 

Fabricated metal products 37 4 41 

Electrical and electronic 

equipment 115 11 126 

All other manufacturing 199 16 215 

Non-manufacturing Industries 175 13 188 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

* To alleviate hardship caused by the filing deadline set by 

temporary section 936 regulations, the final regulations 

allowed a corporation which had made its election before 

April 9, 1980, to revoke that election for the first taxable 

year to which the election applied. No adjustment has been 

made to reflect cases in which corporations revoked prior 

elections. A~ least six corporations filed revocations, but 

several of these simultaneously filed new elections for later 

tax years. 

----
-

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and electronic equipment industry, 8 electors were chemical 

firms, and 5 electors were apparel firms. These electors 

were reacting to changes in Puerto Rican law and to 

underlying Puerto Rican locational advantages, as well as to 

the adoption of section 936. No implication can be drawn as 

to whether the number of firms electing possessions 

corporation status was higher or lower than it would have 

been under section 931. 

For some firms, the 1978 Puerto Rican Industrial Incentives Act offers incentives not available under prior law. 

In particular, export-oriented service industries, which had 

been fully taxable under prior law, can qualify for 50 

percent tax exemption under the new Act. Also, firms with 

existing grants which elected to convert to a new, partially 

taxable status before December 31, 1979, received a 

guarantee of an automatic 10-year extension of the grant, ~/ 

whereas under prior law ~xtensions (or the availability of a 

new grant) were not guaranteed. Firms in the textile, 

apparel, and shoe industries whose grants are scheduled to 

expire before 1983 are also to be allowed an additional 

five-year exemption on 90 percent of their income. 

The main result of the complex changes made in Puerto 

Rican law, both the tollgate tax and the new Industrial 

Incentives Act, was to impose additional taxes on possessions corporations. Total tax revenues generated by the new 

Puerto Rican tax provisions are estimated to be $111 million 

in Puerto Rico's fiscal year 1980, and $106 million in 

fiscal year 1981. Because the effective rate of tax, at 

least initially, is very low for most firms, these new taxes 

may provide little disincentive to investment in Puerto 

Rico. 

Collections under the tollgate tax amounted to -$65. 0 

million in the year ending June 30, 1979, $81 million in 

fiscal year 1980, and $56 million in fiscal year 1981. 

These tollgate taxes represented an effective tax rate of 

about 8 percent on repatriated dividends in calendar year 

1979, and 6 percent in calendar year 1980. The drop in the 

effective tollgate tax reflects in part the pre-payment of 

tollgate taxes by a number of 936 firms in 1979. It also 

reflects the fact that income taxes can offset two-thirds of 

~/ As explained in Chapter 2 above, the 10-year automatic 

extension provides exemption from 50 percent of income 

tax during the initial five-year period, and between 35 

and 45 percent during the second five-year period. 
-134-

tollgate taxes owed by a firm which has converted its 100 

percent tax exemption grant to a grant of partial tax 

exemption under the Puerto Rican Industrial Incentives Act 

of 1978. 

In addition to tollgate tax collections, Puerto Rico 

receives income tax revenues from companies operating under 

the new Industrial Incentives Act, which provides for only a 

partial exemption from income tax for new or "converted" 

firms. Total income taxes paid by all firms with partial 

tax exemption grants are estimated to be $30 million in the 

year ending June 1980, and $50 million in the year ending 

June 1981. 

Combining the above estimates of Puerto Rican tax collections from the tollgate tax and income tax, it appears 

that in calendar year 1980, they amounted to approximately 

3.5 percent of the net income of all manufacturing possessions corporations in that year. Because new tax exemption 

grants issued under the Industrial Incentives Act of 1978 

provide that the rate of exemption decreases after the first 

five years of the grant's duration, the Puerto Rican effective tax rate will rise somewhat after 1983. Accordingly, 

the projected Federal tax benefits under the possessions 

corporation system, shown in Table 5-5 above, have been 

reduced to reflect tax payments to Puerto Rico of 3.5 

percent of pre-tax income in calendar years 1981 through 

1983, and 5 percent of pre-tax income for the period 1984 

through 1987. 
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Appendix A 

Operation of the Possessions Corporation System 

of Taxation in American Samoa, Guam, and 

the V1rg1n Islands 

The term "possession" as used in section 936 of the 

Internal Revenue Code includes not only Puerto Rico, but 

also American Samoa, Guam, the Panama Canal Zone (before 

October 1, 1979) 1/, and other smaller U.S. territories. 2/ 

It does not include the Virgin Islands. U.S. corporations 

operating in American Samoa or Guam qualify for special tax 

treatment under section 936 in the same manner as U.S. 

corporations operating in Puerto Rico. Moreover, American 

Samoa and Guam, like Puerto Rico, provide exemptions from, 

or rebates of, their ' local possession income tax to 

complement the exemption from Federal tax under section 936. 

The first part of this Appendix describes the income tax 

laws of American Samoa and Guam and the characteristics of 

possessions corporations operating in these islands. It is 

estimated that possessions corporations operating in Guam 

were subject to an effective Guam income tax rate of 10 

percent; possessions corporations operating in American 

Samoa or the Canal Zone were generally subject to no 

possession income tax. The reduction in U.S. Federal tax 

provided under section 936 to all possessions corporations 

operating outside of Puerto Rico was approximately $2.4 

million in tax year 1980. The $2.4 million in Federal tax 

benefits is estimated by computing the U.S. tax liability 

which these corporations would have owed in the absence of 

section 936, and then subtracting the estimated income taxes 

paid or accrued to the host possession. 

The second part of the Appendix describes the tax 

treatment accorded to corporations operating in the Virgin 

Islands. Under the Revised Organic Act of 1954, section 

28 (a) l/, all "inhabitants" of the Virgin Islands satisfy 

_!_/ Pursuant to the Panama Canal Treaties of 1977, the 

United States ceased to have jurisdiction over the 

Panama Canal Zone on October 1, 1979. 

3/ Other territories to which section 936 benefits 

apply are the Northern Mariana Islands and Wake and 

Midway Islands. 

/ 48 u.s.c. 1642. 
-136-

their liability for U.S. tax by paying tax on their worldwide income to the Virgin Islands. The Virgin Islands is 

required by the Naval Appropriations Act of 1922 4/ to 

administer the U.S. income tax laws as the Virgin Islands 

territorial income tax, but may rebate the tax which it 

collects on Virgin Islands source income earned by U.S. or 

V.I.-chartered corporations operating primarily in the 

Virgin Islands. In 1980, the amount of income tax subject 

to a rebate under the Virgin Islands tax-incentive program 

i s estimated at $ 4 0 • 6 mi 11 ion , of which $ 3 7 • 5 mi 11 i on i s 

attributable to Virgin Islands subsidiaries of U.S. 

corporations. 

I. American Samoa, Guam, and the Panama Canal Zone 

A. Federal and Possession Taxation 

American Samoa and Guam, 1 ike Puerto Rico, constitute 

income tax jurisdictions separate from that of the United 

States. American Samoa and Guam have primary jurisdiction 

to tax U.S. corporations operating there, and the United 

States has secondary jurisdiction. 

In 1963, the legislature of American Samoa adopted the 

"Samoan Income Tax Act," which provides that: 

The income tax and the income tax rules in force in the 

United States of America and those which may hereafter 

be enacted or adopted, where not clearly inapplicable or 

incompatible with the intent of this section, are 

adopted by American Samoa, and shall be deemed to impose 

a separate territorial income tax, payable to the 

government. 

American Samoa generally applies the U.S. Internal Revenue 

Code as the American Samoan Income Tax by substituting 

"American Samoa" for "United States," where appropriate in 

order to give the income tax law proper effect in American 

Samoa. 

The legislature of American Samoa has from time to time 

amended the locally applicable U.S. income tax laws. 

American Samoa also provides exemptions from tax on American 

Samoan source income to businesses whose investments are 

deemed to promote Samoan economic development. In order to 

qualify for tax exemption, a corporation, partnership, or 

sole proprietorship must employ a work force at least 75 

percent of which consists of American Samoan residents. For 

purposes of the 75 percent work force rule, a resident means 

any person who has continuously resided in American Samoa 

!/ 48 u.s.c. 1397. 
-137-

for at least five years. Tax exemption grants generally 

last 10 years and are subject to renewal. However, the 

period of tax exemption may be made to terminate early if 

the cumulative amount of all taxes forgiven under the grant 

equals 200 percent of the business's total investment in 

American Samoa. 

Guam, unlike American Samoa and Puerto Rico, does not 

have the authority to adopt its own income tax system, and 

the income tax system which Congress provided for it is 

closely integrated with the income tax jurisdiction of the 

United States. The Organic Act of 1950 5/ requires that 

Guam administer the income tax laws in force in the United 

States as the Guam territorial income tax, the so-called 

Guam "mirror" tax. The U.S. Internal Revenue Code is 

generally applied as the Guam territorial income tax by 

substituting "Guam" for "United States," where appropriate 

in order to give the income tax law proper effect in Guam. 

Section 935 of Internal Revenue Code provides that 

individuals who are residents of Guam but derive income from 

the United States file a single income tax return with Guam; 

individuals who are residents of the United States but 

derive income from Guam file a single return with the United 

States. In addition, Code section 881 (b) provides that 

interest, dividends, and other passive investment income 

received from U.S. sources by corporations chartered in Guam 

is exempt from the U.S. tax withheld at source on such gross 

amounts. Similarly, passive investment income received from 

Guam sources by corporations chartered in the United States 

is exempt from the Guam tax withheld at source on such gross 

amounts. 

No Federal provision explicitly limits the authority of 

Guam to provide income tax relief through rebates. Under 

the tax-incentive program of Guam, the Guam Economic 

Development Authority provides rebates of up to 100 percent 

of Guam income taxes to corporations that meet minimum 

investment and certain other requirements (such as 

increasi~g employment, replacing imports, or creating needed 

facilities). The rebate is allowed for up to 20 years. 

Most possessions corporations operating in Guam in 1980 

were entitled to a rebate of 75 percent of Guam income 

taxes. Given the effective exemption from U.S. tax under 

section 936, these corporations paid an over-all effective 

tax rate of about 10 percent on income from the active 

~/ 48 u.s.c. 142li. 
-138-

conduct of a trade or business in Guam and on QPSII (i.e., 

Guam source income derived from the reinvestment of income 

from the Guam trade or business) • Many of these 936 

corporations enjoyed, in addition, exemption from the Guam 

real property tax. Dividends paid by certain tax-exempt 

corporations to individual shareholders were also eligible 

for a rebate of 75 percent of the Guam shareholder level 

income tax. 

The Panama Canal Zone, which ceased to be a possession 

for purposes of section 936 on October 1, 1979, imposed no 

local territorial income tax. Before October 1979, a 

Federal agency (the Panama Canal Company) administered the 

Canal Zone and financed agency expenditures through toll 

collections. Possessions corporations operating in the 

Canal · Zone were effectively exempt from any tax on income 

derived from operations in the Panama Canal Zone. 

B. Characteristics of Possessions Corporations Operating Outside of Puerto Rico 

Table A-1 shows that in tax year 1980, there were 13 

active 936 corporations operating in possessions other than 

Puerto Rico. Three of these corporations claimed the 

section 936 credit for operations in the Panama Canal Zone, 

even though the Canal Zone ceased to be eligible for the 

benefits of section 936 as of October 1, 1979. 

The qualified possession net income of the 13 corporations shown in Table A-1 was $6.4 million, of which 42 

percent was attributable to possessions corporations 

operating in Guam. These 13 corporations claimed tax 

savings of $2.4 million under section 936. 

The comparable data for tax year 1979 are a total of 11 

possessions corporations operating outside of Puerto Rico, 

with qualified income of $2.1 million and tax savings under 

section 936 of $0.9 million. 

II. Virgin Islands 

A. Taxation of Corporations Operating in the Virgin 

Islands 

The Virgin Islands is not treated as a possession for 

purposes of section 936. However, corporations operating in 

the Virgin Islands receive benefits similar to those 

provided to 936 corporations. 
-139-

Table A-1 

Possessions Corporations Outside of Puerto Rico -

Income and Estimated Tax Benefits, 1980 

Qualified Number 

of 936 Possession 

Possession Net Income ~Corporations~ ( $000) 

Guam 5 2,650 

Panama Canal Zone 3 176 

Other U.S. possessions, except 

Puerto Rico 5 3,557 

Total 13 6,383 

Off ice of the Secretary of the Treasury 

Office of Tax Analysis 

. . Estimated 

. Tax Benefits . 

. . ($000) 

835 

74 

1,494 

2,403 
-140-

The Naval Appropriations Act of 1922 requires the Virgin 

Islands to administer the income tax laws in force in the 

United States as the Virgin Islands territorial income tax, 

the so-called Virgin Islands "mirror" tax. In 1954, 

Congress enacted section 28(a) of the Revised Organic Act in 

order to allocate taxing responsiblities with respect to 

persons who were "inhabitants" of the Virgin Islands and to 

transfer additional revenues to the Virgin Islands. Section 

28(a) provides that: 

[inhabitants of the Virgin Islands] shall satisfy their 

income tax obligations under the taxing laws of the 

United States by paying their tax on income from all 

sources both within and without the Virgin Islands into 

the Treasury of the Virgin Islands. 

In other words, Virgin Islands "inhabitants" are subject to 

Virgin Islands tax on their worldwide income and generally 

pay no tax to the United States, even on U.S. source income. 

"Inhabitants" of the Virgin Islands include U.S. citizens 

who are resident in the Virgin Islands as of the last day of 

their taxable year, corporations chartered in the Virgin 

Islands, and certain U.S. corporations which operate 

primarily in the Virgin Islands. 

Section 934 (a), added to the Internal Revenue Code in 

1960, prohibits the Virgin Islands from granting relief, 

directly or indirectly, from Virgin Islands income tax. 

However, an exception is made under section 934 (b) with 

respect to non-U.S. source income of U.S. or Virgin Islands 

corporations that have derived at least 80 percent of their 

gross income from Virgin Islands sources and at least 50 

percent of their gross income from the active conduct of a 

trade or business in the Virgin Islands during the threeyear period preceding the close of the taxable year (or 

applicable part of such period). The Tax Equity and Fiscal 

Responsibility Act of 1982 increases the SO-percent active 

trade or business test to 65 percent for taxable years 

beginning after December 31, 1984. The provision is phased 

in so that the required percentage of active trade of 

business income rises to 55 percent for taxable years 

beginning in 1983, and to 60 percent for taxable years 

beginning in 1984. 

The Virgin Islands has established an industrial incentive program which provides tax rebates for corporations 

which meet the gross income tests of section 934 (b) and 

certain further criteria. The principal requirements are 

that the corporation: 
-141-

(1) invest at least $50,000, exclusive of inventory, in 

a Virgin Islands industry or business; 

(2) agree in writing to give preference 

and contracting to Virgin Islands 

V.I. corporations; 

in employment 

residents and 

(3) obtain approval from the Commissioner of Labor for 

the hiring of any nonresident workers; and 

(4) conform to ecological standards established by 

Federal or local law. 

In addition to these specific requirements, which must 

be met by an applicant for Virgin Islands tax relief, the 

Virgin Islands considers applications in light of the 

following general guidelines: 

(1) the extent to which the proposed enterprise may 

pollute the environment; 

(2) the applicant's requirements for utilities, social 

services, and other resources; 

(3) the applicant's capacity to employ Virgin Islands 

resident labor; and 

(4) the proposed industry's compatibility with existing 

businesses in the Virgin Islands. 

Corporations which are beneficiaries of the V.I. Industri al Development Program generally receive rebates of 7 5 

percent or 90 percent of income taxes paid, rebates of 90 

percent of customs duties, and/or 100 percent exemptions 

from the V.I. real property tax, gross receipts tax and/or 

excise tax. Rebates of income tax do not, however, apply to 

corporate tax on interest income, capital gains, and certain 

types of rental income. Any particular package of benefits 

is negotiated between the applicant and the Virgin Islands 

Industrial Development Commission. 

In general, the duration of a tax exemption grant is 10 

years. A firm is allowed the option of determining when the 

tax benefits commence, provided they are initiated at some 

Point during the first five years of business operations. 

An additional five years of benefits (or up to 10 years at 

no more than 50 percent of the benefits) are granted to 
- - - - - -- ~~~- - ~-

-142-

corporations which locate their plants in certain economically depressed areas. Moreover, any beneficiary under the 

Industrial Development Program may be granted a renewal of 

those benefits subject to approval of the Governor of the 

Virgin Islands. A corporation which is deemed to be an 

"inhabitant" of the Virgin Islands within the meaning of 

section 28(a) of the Revised Organic Act and which qualifies 

under Code section 934 (b) and the Industrial Development 

Program for a rebate of 75 percent of income taxes, pays an 

average effective corporate income tax rate in the Virgin 

Islands of approximately 10 percent. 

B. Taxation of Dividends Received from Corporations 

Operating in the Virgin Islands 

U.S. law generally imposes a 30 percent tax on the gross 

amount of dividends, interest, and certain other passive 

investment income paid by U.S. persons to nonresident aliens 

and foreign corporations when that income is not effectively 

connected with the conduct of a U.S. trade or business by 

the foreign person. This 30 percent tax is often reduced or 

eliminated by income tax treaties, but the Virgin Islands is 

not a party to U.S. income tax treaties. The Government of 

the Virgin Islands and the U.S. Internal Revenue Service 

take the position that the mirror system imposes a similar 

30 percent tax withheld at source on the gross amount of 

passive investment income paid from Virgin Islands sources 

to non-Virgin Islands persons, including U.S. persons. 5/ A 

U.S. recipient of passive investment income from the vTrgin 

Islands can take a foreign tax credit for any such tax 

against its U.S. tax liability, but the amount of the credit 

is limited to the U.S. tax liability on foreign source net 

income. Therefore, the 30 percent tax on V.I. source gross 

passive investment income frequently results in such income 

being taxed at a higher rate than similar income earned by 

U.S. persons in the United States or foreign treaty 

countries. The Virgin Islands cannot rebate this tax under 

section 934(b) since the tax is upon the U.S. recipient and 

not upon the corporations operating in the Virgin Islands. 

~/ The U.S. Court of Appeals for the Third Circuit cast 

doubt on this interpretation of the mirror system. 

Viteo v. Government of the Virgin Islands, 560 F. 2nd 

180 (3rd Cir. 1977), cert. denied, 435 U.S. 180 (1978). 

However, the Report of the Committee on Ways and Means 

on H.R. 7093 (Public Law 97-455), an Act to reduce the 

rate of the Virgin Islands tax from 30 percent to 10 

percent on payments to U.S. persons, states that, "The 

bill makes clear the Virgin Islands right both to impose 

the tax and to collect it by requiring withholding." 

H.R. Rep No. 833, 97th Congress 2nd Sess~ 4 (1982). 
-143-

To remove this disincentive to investment by U.S. 

persons in the Virgin Islands, Congress in December 1982 

passed legislation adding a new section 934A to the Internal 

Revenue Code. This section reduces from 30 percent to 10 

percent the rate of Virgin Islands tax imposed on payments 

of Virgin Islands source passive investment income to U.S. 

corporations, citizens and resident aliens. 6/ The Act 

allows the Virgin Islands, at its discretion, to use rebates 

to further reduce or eliminate this 10 percent rate. 

However, the Act continues the 30 percent rate for dividends 

paid to U.S. persons out of earnings and profits accumulated 

during taxable years beginning before January 12, 1983. The 

Act treats dividends as first coming out of earnings and 

profits accumulated during taxable years beginning before 

January 12, 1983, so that the 10 percent tax rate on 

dividends received by U.S. persons will apply only after a 

corporation operating in the Virgin Islands has distributed 

all pre-1983 earnings and profits. 

Dividends received from a U.S. subsidiary operating in 

the Virgin Islands are eligible for the dividends-received 

deduction under section 243 of the Code. However, the 

· United States does not allow a U.S. parent to take a 

dividends-received deduction for dividends paid by a 

subsidiary incorporated in the Virgin Islands. ]_/ Thus, 

~/ Public Law 97-455, section 1 (1983). 

]_/ This follows from the treatment of _Virgin Islandschartered corporations as foreign corporations for 

purposes of U.S. income taxation. The general rule with 

respect to foreign corporations is that a U.S. corporate 

shareholder is allowed the dividends-received deduction 

only if 50 percent or more of the foreign corporation's 

income has been derived, for the 36 months (or lesser 

period that the corporation has been in existence) 

ending with the close of the taxable year in which the 

dividends are paid, from a U.S. trade or business, and 

in that case, only to the extent of the corporation's 

U.S. effectively connected income. A corporation which 

met the so-called "80-50 gross income tests" required to 

be eligible for V.I. relief tax relief would not qualify 

for the deduction even with respect to dividends 

attributable to U.S. source income (Code section 

245(a)). 
-144-

even though the profits of a 934(b) Virgin Islands 

subsidiary may be 75 percent or 90 percent tax-free in the 

Virgin Islands, the profits will be subject to the normal 

U.S. corporate rate of income tax once they are repatriated. 

In 1980, the Internal Revenue Service ruled that a U.S.-

chartered corporation which satisif ied the 80-50 gross 

income tests under section 934(b), conducted all significant 

business operations in the Virgin Islands, held all 

shareholder meetings in the Virgin Islands, and all of whose 

officers where Virgin Islands residents, constituted an 

"inhabitant" of the Virgin Islands. 8/ The ruling does not 

make clear whether all these conditions must be satisfied to 

constitute an "inhabitant" of the Virgin Islands, and most 

U.S. investors in the Virgin Islands continue to operate 

through Virgin Islands-chartered corporations. Thus, their 

income from the Virgin Islands becomes subject to U.S. tax 

at the time it is repatriated in the form of dividends, and 

a foreign tax credit is allowed (subject to the general 

foreign tax credit limitation) for taxes paid to the Virgin 

Islands. 

C. Allocation of Income Attributable to Intangibles 

The Tax Equity and Fiscal Responsibility Act of 1982 

(TEFRA) provides rules for the allocation of income from 

intangibles between a U.S. parent corporation and an 

affiliated U.S. 934 (b) corporation to conform the tax 

benefits available to such corporations with those available 

to possessions corporations. As explained in Chapter 2 

above, these rules permit a 936 corporation or a U.S. 934(b) 

co~poration to compute its business income with respect to a 

product or type of service under the R&D cost-sharing method 

or the 50/50 profit split method. To qualify for either of 

these income allocation methods, the 936 or 934(b) 

corporation must meet a significant business presence test 

in a possession with respect to the product or service. 

These provisions are generally effective for taxable years 

beginning after December 31, 1982. 

D. Characteristics of Corporations, Partnerships, and 

Sole Proprietorships Eligible for Virgin Islands Tax 

Rebates 

Tables A-2 to A-4 present data on assets, income, tax 

rebates, and employment for corporations and other entities 

~/ Revenue Ruling 80-40, 1980-2 C.B. 175. 
-145-

which qualified in 1980 for income tax rebates under Code 

section 934 (b) and the Virgin Islands Industrial Incentive 

Program (hereinafter referred to as 934 (b) entities). The 

tables cover accounting periods ending in calendar year 

1980, and are based on income tax returns filed with the 

Virgin Islands. Tables A-2 and A-3 are based on the 48 

active 934(b) entities for which both balance sheet and 

income statement data are available. It is estimated that 

these 48 corporations accounted for over 95 percent of the 

assets and income of the active 934(b) entities in 1980, and 

90 percent of the total number of active 934(b) entities. 

1. Assets, Income, and Income Tax Benefits by Type 

of Entity 

Table A-2 presents data on the assets, income, and 

income tax benefits of 934 (b) entities by type of entity. 

Of the 48 active 934(b) entities for which data are available, 15 were Virgin Islands-chartered subsidiaries of U.S. 

corporations, and 26 were Virgin Islands corporations with 

no parent, partnerships, or sole proprietorships. The 

remaining seven 934(b) corporations were either foreigncontrolled V.I. corporations or u.s.-chartered corporations. 

The 48 entities had assets of $1,965 million. Ninetyfive percent of these assets, or $1,860 million, were held 

by Virgin Islands subsidiaries of U.S. corporations. 

Locally controlled Virgin Islands corporations, partnerships, and sole proprietorships accounted for an additional 

$41 million, or 2 percent, of the total assets of 934 (b) 

entities; and the remainder, or 3 percent, was owned by 

foreign controlled or u.s.-chartered companies. 

Net plant and equipment of 934 (b) entities (shown in 

Table A-2 as net depreciable assets) were $435 millirin, or 

22.1 percent of total assets. The share of net depreciable 

assets in total assets was almost twice as large in 934(b) 

entities as in 936 manufacturing corporations. The 

comparable figure for 936 manufacturing corporations was 

12.1 percent, as shown in Table 5-1, above. 

Ninety-six percent of the net plant and equipment of 

934 (b) entities belonged to Virgin Islands subsidiaries of 

U.S. companies. Virgin Islands subsidiaries of U.S. 

companies also accounted for most {approximately 99 percent) 

of the $5.1 billion in 934(b) total receipts. 
Table A-2 

934(b) Corporations in the Virgin Islands - Selected Balance Sheet and Income Statement 

Items and Tax Benefits by Type of Corporation, 1980 

Number of corporations 

Total assets 

Inventories 

Depreciable assets 

Accumulated depreciation 

Net depreciable assets 

Total receipts 

Business receipts 

All other receipts 

Total deductions 

Cost of sales and operations 

All other deductions 

Taxable income 

Virgin Islands income tax subsidy 

Office of the Secretary of the Treasury 

Office of Tax Analysis 

(Dollar amounts in thousands) 

All v. I. Corporations 

Entities with a U.S. Parent 

48 15 

1,964,908 1,859,600 

629,903 615,924 

813,579 786,963 

378,818 370,057 

434,735 416,898 

5,106,356 5,038,136 

5,081,955 5,017,670 

24,401 20,466 

4,984,462 4,920,909 

4,734,643 4,694,636 

249,819 226,273 

114,668 115, 707 

40,590 37,543 

: V.I. Corporations V.I. Corporations with No Parent, : . th F . 

:V.I. Partnerships & :wi a ore1gn Parent 

:Sole Proprietorships: & U.S. Corporations 

26 7 

41,421 63,887 

10,585 3,394 

20,355 6,261 

7,048 1, 713 

13,291 4,546 

44,888 23,332 

41,669 22,616 

3,219 716 

44,244 19,309 

26,410 13, 597 

17,834 5,712 

-3,820 2,781 

1,336 1,711 

I 

...... 

"""" °' I 
-147-

Business reciepts provided 99. 5 percent of the gross 

receipts of 934 (b) entities. Information on nongovernment 

interest and other investment income of 934(b) corporations 

is not available, but the high share of business receipts in 

total receipts suggests that passive investment income 

represents a relatively insignificant share of the income of 

934 (b) entities. As noted above, the Virgin Islands 

Industrial Development Program, unlike the Puerto Rican 

Industrial Incentive Acts, does not provide relief from tax 

on interest and certain other kinds of passive investment 

income. 

Taxable income equals the difference between total 

receipts and total (current) deductions, less net operating 

loss carryovers and certain special deductions for dividends 

received. The combined taxable income of the 48 entities 

shown in the table amounted to $115 million. Virgin Islands 

subsidiaries of U.S. corporations reported income of almost 

$116 million, foreign-controlled V.I. firms and u.s.-

chartered firms had income of almost $3 million, and 

locally-controlled V.I. entities had combined net losses of 

$4 million. 

Virgin Islands income tax rebates due, which represented 

in most cases 75 or 90 percent of income taxes paid, were 

estimated to be about $41 million. u.s.-controlled Virgin 

Islands firms accrued somewhat less than $38 million in tax 

rebates for 1980, while Virgin Islands entities with no 

parent accrued approximately $1 million in tax rebates. 

2. Assets, Income, and Tax Rebates by Industry 

Table A-3 

presents the 

industry. 

covers 

asset, 

the same entities as Table A-2, 

income, and tax benefit data 

but 

by 

Four corporations in the petroleum refining, alumina 

processing, and concrete products industries accounted for 

78 percent of all net plant and equipment and 93 percent of 

the combined net income of 934(b) entities. These 4 

corporations accrued tax rebates of slightly less than $36 

million, or 88 percent of the Virgin Islands income tax 

rebates for all industries. 

Other 934(b) firms with substantial plant and equipment 

were hotels, with almost $25 million in net depreciable 

assets. Most of the fourteen 934(b) hotels reported losses 

for tax purposes. As a result, this industry accrued less 

than $0.5 million in income tax rebates in 1980. 
Table A-3 

934(b) Corporations in the Virgin Islands - Selected Balance Sheet and Income Statement Items 

and Tax Benefits by Industry, 1980 

Number of Corporations 

Total Assets 

Inventories 

Depreciable assets 

Accumulated depreciation 

Net depreciable assets 

Total Receipts 

Business receipts 

All other receipts 

Total Deductions 

Cost of sales and 

operations 

All other deductions 

Taxable income 

v. I. income tax subsidy 

All 

~Industries 

48 

1,964,908 

629,903 

813,579 

378,818 

434,735 

5,106,356 

5,081,955 

24,401 

4,984,462 

4,734,643 

249,819 

ll4,668 

40,590 

Off ice of the Secretary of the Treasury 

Off ice of Tax Analysis 

(Dollar amounts in thousands) 

Petroleum 

Chemicals Watches Refin~ng, Other 

Alumina : f . : Hotels 

P . Manu actur1ng rocess1ng,: : 

& Concrete 

5 14 4 6 13 

10,687 26,221 1,766,459 63,574 30,984 

1,818 5,516 611,321 3,838 365 

3,028 3,752 669,546 4,990 33,774 

863 1,832 332,369 1,542 9,201 

2,160 1,914 337,175 3,446 24,565 

15,961 33,671 4,972,950 17,705 26, 925 

15,816 33,672 4,953,644 17,642 24,275 

145 -1 19,306 63 2,650 

13,899 32,517 4,866,739 12,240 25,875 

ll,435 29·, 889 4,679,738 8,897 5,003 

2,464 3,628 187,001 3,343 20,872 

2,062 -364 106,173 5,460 -252 

749 773 35,627 2,125 490 

Other 

Services 

6 

66,983 

7,045 

98,489 

33,0ll 

65,475 

39,144 

36,906 

2,238 

33,192 

681 

32,511 

1,553 

825 

I 

f--' 

~ 

co 

I 
-149-

The manufacturing category with the largest number of 

934 (b) firms in 1980 was watches. The 14 Virgin Islands 

watch manufacturers reported $2 million in net plant and 

equipment, earned almost $34 million in business receipts, 

and accrued $0.8 million in income tax rebates. The 

industry as a whole reported losses for tax purposes of $0.4 

million. 

3. Employment 

To obtain a more complete picture of the operations of 

934 (b) entities, the Virgin Islands Finance Department 

matched employment and payroll information with tax return 

information for these entities. The employment and payroll 

information was obtained from Form W-3, "Transmittal of 

Income and Tax Statements," used by employers to transmit to 

the Virgin Islands Finance Department statements of compensation and withheld tax for employees in the Virgin Islands. 

The 37 entities for which such information was available 

accounted for 80 percent of the income of the entities 

covered in Tables A-2 and A-3. These entities had a total 

of 5,402 full-and part-time employees in calendar year 1980. 

Table A-4 ranks the 37 entities according to the size of 

the Virgin Islands income tax bnefits per employee. At the 

top of the ranking were four companies for which the Virgin 

Islands tax benefits represented, on average, $19, 533 per 

employee; at the low end were 18 entities which incurred 

losses and thus derived no immediate tax benefits under 

section 934 (b). The top four corporations in terms of tax 

benefits per employee accounted for 94 percent of the total 

income tax benefits, 29 percent of the total employment, and 

59 percent of total compensation of firms covered in Table 

A-4. The average compensation of all full- and part_.time 

employees in these firms was $24,569, several times higher 

than average compensation in most other 934 (b) firms. The 

bottom 24 entities, receiving tax benefits per employee of 

less than $500, accounted for 1.6 percent of the total 

income tax benefits, 62 percent of the total employment, and 

36 percent of the total comensation. Average employee 

compensation of all full- and part-time workers employees in 

these 24 firms was $7,131. 
Table A-4 

934(b) Corporations in the Virgin Islands - Tax Benefits, Employment, and Compensation of Employees by 

Size of Tax Benefits per Employee, 1980 

Size of tax Number Taxable Tax benefits Employees Compensation Tax benefits Average 

benefits of incane of employees 1/ 

per employee employee 

per employee corporations ($000) Amount Percent Number : Percent Amount Percent ($) compensation y ($000) :of total :of total ($000) of total: ($) 

All entities 37 92,243 32,835 100.0 5,402 100.0 65,913 100.0 6,078 12,201 

$10,000 or more 4 96,465 30,922 94.2 1,583 29.3 38,893 59.0 19,533 24,569 

$5,000 under $10,000 3 1,970 770 2.3 120 2.2 1,139 1. 7 6,416 9,491 

$1,000 under $5,000 3 1,047 534 1.6 262 4.9 1,418 2.2 2,038 5,412 

$ 500 under $1,000 3 276 78 .2 94 1.7 625 .9 712 6,648 

$ 1 under $500 6 3,888 542 1.6 1,821 33.7 14,338 21.8 298 7,875 

Entities with losses 18 -ll,403 0 0 1,522 28.2 9,500 14.4 0 6,241 

Office of the Secretary of the Treasury 

Off ice of Tax Analysis 

: Tax benefits 

: as a percent 

:of compensation 

of employees 

49.8 

79.5 

67.6 

37.7 

10.7 

3.8 

0 

.!f Compensation of employees is canputed by multiplying 1.232 times payroll. The 23.2 percent reflects the employer-paid portion of Social Security, 

unemployment insurance, and other non-payroll costs. The 23.2 percent is the average for all U.S. manufacturing industries in 1980. Source: 

unpublished estimates of U.S. Depart:Irent of Comnerce. 

y Total (.'()['({>ellsation divided by total number of employees in calendar year 1980. Because part-year and part-time employees are included in the total 

number of employees, the average employee canpensation is not comparable to that reported in Tables 5-3, 5-4, B-3, and B-4, which are based on the 

number of full-time equivalent employees during the year. See Appendix c. 

I 

t-"' 

Vl 

0 

I 
-151-

Appendix B 

Possessions Corporations in Tax Year 1979 

This appendix presents data on the assets, income, tax 

benefits, and employment of possessions corporations in tax 

year 1979, which includes accounting periods ending between 

July 1, 1979, and June 30, 1980. Tax year 1979 corresponds 

closely to the calendar year because most possessions 

corporations have calendar year accounting periods. Tables 

B-1 through B-3 are similar to T~bles 5-1 through 5-3, 

above, covering tax year 1980. 

I. Assets and Income in 1979 

Tables B-1 and B-2 are based on the 546 possessions 

corporations which filed a corporate income tax return for 

tax year 1979 no later than February 1981. Between February 

and June 1981, 126 additional possessions corporations with 

comibined net income of $253 filed. Possessions 

corporations included in Tables B-1 and B-2 account for 92 

percent of the income of all possessions corporations which 

had filed for tax year 1979 as of June 1981. 

A. Assets. Table B-1 shows that the total assets of 

possessions corporations were $13.4 billion at year-end 

1979, with 77 percent of the assets held by manufacturing 

companies. Net plant and equipment of these manufacturing 

firms amounted to $1.3 billion. The pharmaceutical industry 

accounted for $529 million, or 40 percent, of the net plant 

and equipment of 936 manufacturing firms. Other industries 

with substantial manufacturing plant and equipment were 

chemicals other than pharmaceuticals, with 18 percent of the 

total, and food products, with 11 percent. Electrical and 

electronic equipment accounted for 8 percent of the total 

plant and equipment of 936 manufacturing firms. 

Fixed assets of 936 manufacturing firms included, in 

addition to the $1.3 billion of net plant and equipment, $62 

million of land (not shown separately on Table B-1). The 
Table B-1 

Selected Balance Sheet Information by Industry, 1979 

{Dollar amounts in thousands) 

All Manufacturi!!l Industries 

Industries Manufacturing Food & Kindred Textile Mill Apparel Paper Chemicals 

Total Products Products Total :Pharmaceuticals: All Other 

N\.lnber of corporations 546 417 21 9 71 5 78 57 21 

Total assets 13,399,880 10,292,296 820,026 26,076 265,514 17,848 5,666,788 4,849,604 817,183 

cash 1,776,005 1,608,211 283,387 1,146 29,616 142 798,395 773,312 25,082 

Accounts receivable 2,286,321 1,900,405 154 ,158 3,806 103,842 3,505 976,606 677,743 298,862 

Inventories 1,159,504 1,047,991 121,602 3,383 41,575 3,735 428,492 303,983 124,509 

U.S. Government obligations 231,642 225,618 0 0 2,948 0 189,328 171,262 18,065 

State and local obligations 144,385 143,147 9 0 3,384 0 lll,262 82,025 29,237 

Other current assets 646,636 575,588 29,216 636 7,899 2,084 341,769 334,870 6,899 I 

~ Mortgage & real estate loans 1,436,278 98,258 0 0 2,884 0 7,282 7,200 82 U1 

N Other investments 2,973,983 2,847,540 78,929 13,764 38,432 5,437 1,703,564 1,688,740 14,823 I 

Depreciable assets 3,024,691 2,002,836 198,301 5,580 27,109 3,561 1,178,601 682,347 496,254 

Less: Acc\Elulated depreciation 909,559 695,938 58,410 2,299 12,020 826 4ll,654 153,578 258,075 

Net depreciable assets 2,115,132 1,306,898 139,891 3,280 15,089 2,734 766,947 528,768 238,178 

Other assets 603,284 536,883 11,079 57 18,842 209 343,140 281,696 61,444 

Total liabilities and stockholders' F.quity 

Accounts payable 841,236 581,967 61,556 748 46,592 3,226 215,965 ll9,284 96,681 

Notes payable in less than 1 year 248,247 175,205 52,472 2,121 2,056 0 60,681 53,385 7,295 

Other current liabilities 1,551,326 240,345 52,477 457 7,095 216 73,631 68,647 4,984 

Mortgages more than 1 year 543,996 209,188 2,356 250 4,850 0 160,204 154,125 6,078 

Other liabilities 180,900 87,936 10,515 22 1, 716 499 26,584 9,969 16,615 

capital stock 1,552,718 894,125 60,494 1,339 12,692 .1,552 582,506 358,301 224,204 

Retained earnings, total 8,456,591 8,102,213 578,840 21,135 189,510 12,353 4,547,215 4,085,891 461,323 

Appropriated 112,937 69,763 36,986 0 4,538 0 6,592 5,342 1,250 

unawropriated 8,343,654 8,032,450 541,854 21,135 184,972 12,353 4,540,622 4,080,549 460,073 
Table B-1 - continued 

Manufactur!:!!l Industries - continued 

Rubber Leather and Stone, Clay, & Fabricated Machinery, Electrical and Scientific All Other 

Products Leather Glass Products Metal Products Except Electronic Instrunents* Manufacturirg Products Electrical Equipnent 

Nunber of coq:x:>raticns 9 12 6 24 14 99 31 39 

Total assets 31,550 71,039 66,626 232,257 198,043 1, 772,371 407,128 722,030 

Cash 3,278 7,671 28,948 70,268 9,789 292,845 24,562 58,419 

Accounts receivable 4,319 25,205 22,747 31,330 50,916 293,482 77,837 155,196 

Inventory 5,997 13,962 6,887 35,169 39,649 185,158 28,529 134,377 

u.s. Goverrrnent obligations 0 1,750 0 10,535 0 31,590 0 0 

State and local obligaticns 0 10,207 0 248 6,500 11,533 0 0 

Other current assets 306 1,726 399 10,535 18,317 67,370 2,863 92,543 

M:>rtgage & real estate loans 0 0 0 0 0 88,091 0 0 

Other investments 8 8,288 548 27,364 61,113 666,840 187,183 56,065 I 

...... 

\J1 

w 

Depreciable assets 17,903 4,292 13,513 62,404 14,486 197,055 66,946 213,780 I 

Less: Accunulated depreciaticn 2,632 2,751 6,542 16,201 3,651 86,245 12,091 80,733 

Net depreciable assets 15,270 1,541 6,970 46,202 10,835 110,810 54,855 133,047 

Other assets 2,368 686 123 11,137 920 24,647 31,296 92,380 

Total liabilities and stockl'x>lders' Equit.z: 

Accounts payable 3,279 6,499 501 37,434 15,191 92,693 17,676 80,705 

Notes payable in less than 1 year 1,440 201 343 40,116 25 8,421 6,932 391 

Other current liabilities 2,278 1,556 1,226 11, 741 24,327 41,948 8,391 15,095 

M::>rtgages more than 1 year 6,693 0 792 691 5,565 9,194 15,117 4,971 

Other liabilities 1,668 120 21 10,747 2,887 19,986 1,769 11,396 

Capital stock 6,249 1,453 1,632 8,388 4,850 78,051 19,873 115,040 

Retained earnings, total 9,940 61,208 62,107 123,136 145,196 1,522,074 337,366 494,430 

Apprq:>riated 0 1,374 0 14,272 0 59 119 5,821 

Una:i:propriated 9,940 59,834 62,107 108,864 145,196 1,522,015 337,247 488,608 

* Includes fhotografhic c_p)(is and watches 
Table B-1 - continued 

Ncnrranufacturin9 Iooustries 

Nonmanu- Transportation Finance, Services am 

facturing Cbnstruction O::mnunications Wholesale Trade Retail Trade Insurance, Iooustry N'.lt 

am Utilities Real Estate Reported 

Nunber of oorporaticns 129 8 6 22 37 27 28 

Total Assets 3,107,584 16,005 698,562 256,721 197,244 1,858,965 76,077 

cash 167,793 3,708 3,390 93,425 13,852 50,380 2,774 

ACC'OUnts receivable 385,915 5,596 33,640 84,920 10,596 226,805 21,804 

Inventory 111,512 2,028 9,609 44,992 49,712 446 4,193 

U.S. Government obligations 6,024 0 0 0 708 4,914 401 

State and local cbligations 1,238 0 0 0 0 0 1,238 

Other current assets 71,047 2,135 1,421 18,489 7,074 40,561 1,284 

MJrtgage & real estate loans 0 23 0 0 0 1,338,019 0 

Other investments 126,442 20 5 392 11,402 112,785 1,836 I 

...... 

\J1 

Depreciable assets 1,021,854 4,437 792,977 18,536 98, 711 63,120 43,370 ""' I 

less: Accurrulated depreciation 213,621 2,037 148,630 7,332 36,468 8,583 10,445 

Net depreciable assets 808,233 2,400 644,346 11,203 62,242 54,536 32,924 

Other assets 66,400 115 6,147 3,297 16,700 30,514 9,617 

Total liabilities aOO stockholders' Equity 

Accounts payable 259,268 3,899 23,996 20,371 38,371 160,219 12,307 

Notes payable in less than 1 year 73,041 772 2,570 1,162 17,506 48,581 2,448 

Other current liabilities 1,310,981 1,807 23,684 27,963 11,478 1,242,660 3,287 

MJrtgages mJre than 1 year 334,807 1 9,634 6,305 2,948 218,949 6,468 

Other liabilities 92,963 502 3 409 2,885 87,294 1,868 

capital stock 658,593 162 547,588 29,142 33,259 28,142 20,296 

Retained e:lrnings, total 354,378 8,860 2,084 171,367 67,245 73,117 29,400 

AJ:propriated 43,173 54 15 0 0 41,980 1,123 

Una_wropriated 311,204 8,805 2,069 171,367 67,245 31,136 28,277 

Office of the Secretary 

Office of Tax Analysis 
-155-

combined fixed assets represented 13.3 percent of total 

assets held by 936 manufacturing firms. The comparable 

ratio of fixed to total assets for manufacturing 

corporations in the United States was 35.5. percent. !/ 

B. Retained Earnings. At the end of tax year 1979, 

possessions companies reported $8.5 billion of retained 

earnings on their balance sheets, with 96 percent of these 

held by manufacturing companies. Nearly half, or $4.1 

billion, was reported by pharmaceuticals. The electrical 

and electronics industries held $1. 5 billion in retained 

earnings. Retained earnings represented 79 percent of total 

liabilities and stockholders' equity of all 936 manufacturing corporations. The comparable figure for all U.S. 

manufacturing corporations in 1979 was 2~ percent. ~/ 

C. Total Receipts. The total receipts of 936 manufacturing corporations were $7.7 billion in 1979, as shown in 

Table B-2. Ninety-five percent of total receipts was 

attributable to business receipts, and the remainder was 

attributable primarily to interest, including QPSII. 

Interest on Puerto Rican, State, and local government 

securities is excluded from gross income for Federal tax 

purposes and, therefore, is not included in the total 

receipts shown in Table 5-2. The amount of such excluded 

interest income reported by possessions corporations was $16 

million. 

The pharmaceutical industry accounted for 32 percent of 

the business receipts of all 936 manufacturing firms. After 

Pharmaceuticals, the industries with the greatest business 

receipts were electrical and electronic equipment, food 

Products, and chemicals other than pharmaceuticals • 

.!/ Data. for all U.S. corporations are from Federal Trade 

Commission, Quarterly Financial Report, Fourth Quarter, 

1980, 1981. 

l/ Data for all U.S. corporation are from Internal Revenue 

Service, Source Book, Statistics of Income, 1979: 

Corporation Income Tax Returns, 1982. 
Table B-2 

Selected Income Statement Information and Tax Benefits by Industry, 1979 

(D.:>llar amounts in thousands) 

All Manufacturi~ Industries 

Industries Total Food & Kindred Textile Apparel Paper <llemicals 

Products Mill Products Total :Pharmaceuticals: All Otner 

Number of corporations 546 417 21 9 71 5 78 57 21 

Total receipts 9,460,735 7,705,773 763,073 24,688 322,925 21,045 3,181,225 2,458,076 723,148 

Business receipts 8,692,928 7,340,627 738,076 24,338 317,104 20,641 2,978,228 2,260,133 718,094 I Nongovernment interest 442,518 309,633 21,339 241 4,098 348 174,681 170,629 4,051 ...... 

Vl 

Other receipts 325,287 55,512 3,657 108 1,722 55 28,315 27,312 1,002 "' I 

Total deductions 6,624,984 5,123,218 575,759 19,760 270,293 16,712 1,845,647 1,220,676 624,970 

Cost of sales 5,073,872 4,019,634 443,148 17,582 244,746 14,866 1,282,576 723,101 559,475 

Depreciation 182,726 127 ,116 9,566 509 1,751 257 78,976 42,399 36,577 

All other deductions 1,368,384 976,468 123,044 1,669 23,796 1,588 484,094 455,176 28,918 

Estimated net income per return 2,835,742 2,582,554 187,313 4,927 52,631 4,333 1,335,577 1,237,399 98,178 

Estimated net income per books 2,750,311 2,512,609 180,908 4,785 46,363 4,302 1,328,295 1,234,985 93,309 

Reduction in U.S. tax liability 1,040,280 1,040,280 76,329 2,036 20,988 1,783 535,056 494,416 40,639 

Distributions 899,072 827,276 59,090 2,553 12,212 0 420,255 371,400 48,855 
Table B-2 - continued 

Manufacturi~ Industries - continued 

Rul:i:>er Leather and Stone, Clay Fabricated Machinery, Electrical and Scientific All Other 

Products Leather and Glass ~tal Except Electronic Instrunents* Manufacturing Products Products Products Electrical &}uiprent 

Number of oorporations 9 12 6 24 14 99 31 39 

Total receipts 26,034 95,239 80,209 165,034 214,337 1,263,639 349,288 1,202,973 

Business receipts 25,654 93,613 77, 707 159,117 207,966 1,185,162 331,886 1,185,071 

~overnnent interest 356 832 2,214 5,939 4,947 70,231 10,120 14,282 

Other receipts 22 794 287 -21 1,424 8,244 7,281 3,619 I 

....... 

Total deductions 16,640 81,010 61,114 124,420 155, 114 737,515 V1 

210,235 1,011,021 -...J 

I 

Cost of sales 12,411 73,327 54,381 112,204 127,250 634,660 126,764 877,510 

Depreciation 834 271 1,051 3,369 1,266 15,911 2,968 10,452 

All other deductions 3,394 7,411 5,681 8,845 26,597 86,943 80,501 123,058 

Estimated net incane per return 9,393 14,228 19,094 40,614 59,222 526,123 139,053 191,952 

Estimated net incane ~r books 7,304 14,178 17,937 40,272 59,092 524,271 97,890 188,919 

Reduction in U.S. tax liabilit;r: 3,861 5,836 7,747 16,728 24,105 213,009 56,261 76,536 

Distributions 1,036 7,791 3,765 795 6,070 240,069 50,827 23,807 

* Irx:ludes fhotograiil.ic goods and watches. 
Table B-2 - continued 

N:>nmanufacturing Industries 

Non-Ma.nu- Transportation Finance, Services and 

facturing Ccnstruction O::mnunications ~olesale Trade Retail Trade Insurance, Industry Not 

and Utilities Real Estate Re~rted 

Nurrber of CDrparations 129 8 6 22 37 27 28 

Total Receipts 1,754,961 29,894 219,997 818,462 426,273 172,001 84,392 

Business receipts 1,352,301 29,399 12,149 816,279 391,126 23,769 75,636 

Nongovernment interest 132,884 359 874 811 13,056 117,533 249 

Other receipts 269,775 135 206,973 1,371 22,090 30,698 8,506 I 

t-' 

Total Deductions 1,501,765 29,128 147,266 683,008 397,911 168,245 74,177 U1 

OJ 

I 

Cost of sales 1,054,238 26,434 75,195 648,113 247,632 14,343 40,722 

Depreciation 55,610 342 43,189 861 5,957 2,926 2,261 

All other deductions 391,916 2,351 28,881 34,033 144,321 150,976 31,193 

Estimated net incane per return 253,187 765 72,731 135,453 28,353 3,755 10,214 

Estimated net incane per books 237,702 346 72,517 137,030 10,681 6,743 8,470 

Reduction in U.S. tax liabilitJ'.: 0 0 0 0 0 0 0 

Distributions 71,795 3 70,282 221 0 0 1,288 

Office of the Secretary 

Office of Tax Analysis 
-159-

· D. Net Income per Tax Return. Net income per return 

(total receipts minus total deductions on Table B-2) 

amounted to $2.8 billion for all possessions corporations. 

Over 90 percent of the net income was attributable to 

manufacturing firms. The industries with the greatest 

amount of net income were pharmaceuticals, with 48 percent 

of the total income of manufacturing possessions corporat i on s , and e 1 e ctr i ca 1 and e 1 e ctr on i c e q u i pm en t , w h i ch 

accounted for 20 percent of the total net income. 

E. Reduction in U.S. Tax Liability. Table B-2 shows 

that U.S. tax liabilities were reduced by $1,040 million in 

tax year 1979 by the possessions corporation system. The 

pharmaceutical industry obtained tax benefits of $494 

mi 11 ion, and the electrical and electronic equipment 

industry obtained tax benefits of $213 million. 

F. Distributions. The final line in Table B-2 shows 

that 936 corporations reported $899 million of distributions, which was one-third of their net income in tax year 

1979. Forty-five percent of total distributions by manufacturing corporations in these two years was attributable to 

the pharmaceutical industry. 

II. Payroll and Employment in 1979 

Table B-3 provides an industry-by-industry comparison of 

936 tax benefits per employee and as a percent of industry 

compensation. Table B-3 is based on all 936 firms in the 

manufacturing sector for which 1979 employment and payroll 

data could be obtained from the companies' Federal 

unemployment insurance tax returns. The 287 corporations 

included in the table represent two-thirds of the number, 

and 75 percent of the net income, of the manufacturing 

corporations included in Tables B-1 and B-2. 

Table B-3 shows that for all manufacturing industries, 

the Federal tax benefits per Puerto Rican employee averaged 

$15, 690. Tax benefits per employee, or as a percentage of 

total employee compensation, varied substantially from 

industry to industry. In the pharmaceutical industry, the 
Table B-3 

Tax Benefits, F.nployment, and Conpensation of F.nployees by Industry, 1979 

:Qualified : Tax Benefits F.nployees Canpensati.on Tax Benefits Average : Tax Benefits 

Number of :Possession: of F.npl~ees 2/ F.nployee :as a Percent of 

:Corporations:Net Inccme: Arrount :Percent of: :Percent of: Arcount :Percent of per F.nployee Ccnpensation Canpensation 

: ($000} 1/: ($000} Total Nurrber Total ($000} : Total ($} ($} of F.npl~ees 

All Manufacturing Industries 287 1,937,166 891,411 100.0 48,683 100.0 551,469 100 15,690 ~ 11,587 ~ 135.4 ~ 

Feed and kindred products 13 90,542 41,646 4.7 4,443 9.1 55,335 10.0 9,373 12,454 75.3 

Textile mill prcducts 6 1,395 697 * 255 .5 2,173 * 2,733 8,521 32.1 

Af:parel 54 44,798 20,834 2.3 9,493 19.5 76,830 13.9 2,194 8,093 27.1 

Men's and ooy's 8 10,183 4,683 .5 1,914 3.9 16,180 2.9 2,446 8,453 28.9 

W:men's and children's 25 22,396 10,464 1.2 4,171 8.6 32,588 5.9 2,508 7,812 32.1 

Hats, caps, etc. 11 2,574 1,212 * 1,180 2.4 9,412 1. 7 1,027 7,976 12.9 

All other 10 9,647 4,475 .5 2,228 4.6 18,650 3.4 2,008 8,370 24.0 

Paper 3 3,337 1,535 * 79 * 938 * 19,430 11,873 163.6 

Chemicals 55 1,055,439 485,485 54.5 9,955 20.4 145,661 26.4 48,767 14,631 333.3 

Industrial chemicals, 

plastics 7 33,916 15,599 1. 7 510 1.0 6,304 1.1 30,586 12,360 247.4 

Phannaceuticals 41 1,002,553 461,161 51. 7 8,969 18.4 134,130 24.3 51,417 14,954 343.8 

Soaps, cleaners, etc. 3 15,151 6,%9 .8 411 .8 4,442 .8 16,956 10,807 156.9 

All other 4 3,819 1,756 * 65 * 785 * 27,015 12,076 223.7 

Rubber and plastics 4 3,540 1,627 * 287 .6 2,571 .5 5,668 8,958 63.3 

Leather 10 9,724 4,547 .5 1,830 3.8 14,648 2.7 . 2,484 8,004 31.0 

Footwear 6 5,980 2,826 * 1,354 2.8 10,744 1.9 2,087 7,935 26.3 

All other 4 3,744 1,721 * 476 1.0 3,904 .7 3,615 8,201 44.1 

Stone, clay, and glass 6 18,819 8,654 1.0 478 1.0 5,608 LO 18,104 11,732 154.3 

Fabricated metal products 17 29,399 13,519 1.5 1,473 3.0 16,651 3.0 9,177 11,304 81.2 I 

Metal cans and containers 6 17,625 8,105 .9 624 1.3 7,303 1.3 12,988 11, 703 111.0 ...... 

(j'\ 

Cutlery, han::1 tools, 0 

I 

screws, oolts 3 5,655 2,601 * 259 .5 3,054 .6 10,042 11, 791 85.2 

All other 5 2,816 1,295 * 394 .8 3,587 .7 3,286 9,104 36.1 

Machinery, except electrical 7 27,247 12,531 1.4 642 1.3 6,832 1.2 19,518 10,641 183.4 

Office, canp..lting, and 

accounting 3 17,933 8,249 .9 344 .7 3,651 .7 23,979 10,613 225.9 

All other 4 9,314 4,282 .5 298 .6 3,181 .6 14,369 10,674 134.6 

Electrical and electronic 

e:iuiμnent 70 417,367 191,992 21.5 12,435 25.5 138,210 25.1 15,439 11,114 138.9 

Radio, TV, coomun.ication 6 57,351 26,379 3.0 1,343 2.8 13,821 2.5 19,641 10,291 190.9 

Electronic <DlpXlents 16 72,287 33,274 3.7 2,440 5.0 24,699 4.5 13,636 10, 122 134.7 

All other 48 287,729 132,339 14.8 8,652 17.8 99,690 18.1 15,295 11,522 132.8 

Instrunents, thotografhic 

gcods and watches 21 109,618 50,417 5.7 3,130 6.4 35,793 6.5 16,107 11,435 140.9 

Scientific instruments 6 8,814 4,053 .5 425 .9 3,996 .7 9,536 9,402 101.4 

cpt.ical, medical, 

ofhthalmic 15 100,804 46,364 5.2 2,705 5.6 31,797 5.8 17,140 11, 754 145.8 

All other rnanufacturing 4/ 21 125,941 57,927 6.5 4,183 8.6 50,219 9.1 13,848 12,005 115.3 

Office of the Secretary 

Office of Tax Analysis 

* Less than o.5% 

y Equals ret income fran the active conduct of a trade or business in a possession plus net qualified possession source investment incane. 

'!) Canpensaticn of employees was canp..lted by multi plying 1. 225 tilres payroll. The 22.5 percent reflects the employer-paid portion of social security, 

uneI\'l)loyment insurance, and other ra\-payroll costs. 'I.he 22.5 percent is the average for all U.S. manufacturing industries in 1979; see the U.S. 

Department of Cortrnerce, Survey of Current Business, Decercber 1980, Tables 6.5 and 6.6. 

l! ~so.ti.on of. ei:t1pl.oyee.s and n\lnbex 

~in. t'nis ta"o'\.e. 

of. ei:t1pl.o'{ee.s used to ~te t'nese arrounts ~xe ~i.q'nted, 'oj i.nd.ust-cy, 'oj usi.ng t'ne xati.o of. i.nc<::l'l'e i.n Tao1-e 'B--2 and 
-161-

average Federal tax benefits amounted to $51,417 per 

employee, or more than triple the average compensation of 

the comparatively well-paid Puerto Rican pharmaceutical 

employee. In the electrical and electronics industry, the 

average tax benefits amounted to $15, 439 per employee, or 

139 percent of average compensation. The industry where 

average tax benefits per employee were lowest was apparel, 

with $2,194 in tax benefits per employee, or 27 percent of 

employee compensation. 
-162-

Appendix C 

Sources and Limitations of the Data 

Throughout, unless otherwise noted, the data in the text 

and appendix tables are based on corporations that either 

excluded income under section 931 in one or more of the 

years 1973, 1974, 1975 and 1976, or have made an election 

under section 936. Tables for each year are based on 

corporations' accounting periods ending between July 1 of 

the given year and June 30 of the following year. For 

example, tables for tax year 1980 contain data for 

corporations with accounting periods ending on or after July 

1, 1980 and on or before June 30, 1981. 

Data for 1980 and data in the appendix tables for 1979 

include corporations which filed as possessions corporations 

within seven months of the end of the tax year. All other 

figures for years prior to 1980 (e.g., in Tables 5-4 and 

5-6) have been revised to include corporations which filed 

as possessions corporations within 12 months of the end of 

the tax year. 

Income statement and balance sheet data for 1977-1980, 

and some income data for 1976, are from Form 1120, "U.S. 

Corporation Income Tax Return." Additional income data are 

from Form 5735, "Computation of Possessions Corporation Tax 

Credit Allowed under Section 936." 

The primary source of income data for 1973-1975 and some 

data for 1976 was Form 5712, "Election to be Treated as a 

Possessions Corporation under Section 936." If the corporation filing Form 5712 or any other member of its controlled 

group excluded income under section 931 for any taxable year 

beginning in 1973, 1974, or 1975, the net income per books 

of that corporation for each year was reported on the form. 

One problem with this data is that the income for all years 

beginning in 1973-1975 was reported, even though the 

corporation may not have excluded income under section 931 

in all of those years. In particular, some of these companies incurred losses in one or more years between 1973 and 

1975 and therefore presumably filed on a consolidated basis 

with their parent. Inclusion of such companies in the 

tables for these years may cause an understatement of the 

amount of income excluded under section 931 for 1973-1975. 

However, this understatement appears to have been relatively 

small in all three years and does not affect the estimates 

of total tax benefits, which are based on the income of 

profitable firms only. 
-163-

An additional source of income and tax 

1973-1975 was income tax returns (Forms 480. 20) 

the Puerto Rican government. 

data for 

filed with 

The employment and payroll data for all years were taken 

from Form 940, "Employer's Annual Federal Unemployment Tax 

Return." These returns are filed on a calendar year basis. 

For companies with a non-calendar year accounting period, 

the Form 940 data were associated . with income data for the 

accounting period most nearly corresponding to the calendar 

year. For example, the calendar year 1980 Form 940 data 

were associated with taxable years ending between July 1, 

1980 and June 30, 1981. 

The number of employees was computed by dividing total 

taxable wages (line 15(c), Form 940) by $6,000, 1/ the 

maximum amount per employee subject to unemployment tax. 

This procedure gives an estimate of the number of full-time 

equivalent employees during the year, rather than the actual 

number of persons employed at any particular time during the 

year. If the corporation paid its workers less than $6,000 

(the minimum wage in several industries was sufficiently low 

in the 1970s that this could occur), the number of employees 

could be understated. · On the other hand, because the $6, 000 

ceiling is tied to individual employees, the procedure could 

over-estimate employment for a company with relatively high 

wages and part-time employees or a high labor turnover rate. 

However, secondary data from Form 940 and other sources 

suggest that the method used here provides reasonably 

accurate estimates of full-time equivalent employment. 

Some corporations did not report an amount for total 

remuneration or reported the same amount as for wages 

subject to unemployment tax. In the latter case, the firm's 

reporting was assumed to be correct. For the corporations 

that did not report total remuneration, the reported amount 

of taxable wages was used. Total remuneration may therefore 

be slightly understated. 

Total compensation was computed by multiplying total 

remuneration (line 11, Form 940) by a factor representing 

the ratio of total compensation to total remuneration for 

all U.S. manufacturing industries. The value of this factor 

for 1980 and 1979 is noted in the footnotes to Tables 5-3 

and B-3. Total compensation exceeds total remuneration 

because it includes certain fringe benefits and other items, 

such as the employer share of Social Security contributions, 

that are excluded from total remuneration. 

l/ For 1973-1977, the corresponding amount was $4,200. 
Tax Forms from Which Data Included 

in This Report Were Obtained 
Forrn 5712 

(Rev. February 1980) 

Department of the Treasury 

Internal Revenue Service 

Election to be Treated as a 

Possessions Corporation Under Section 936 

(Do NOT Attach to Your Tax Return-File Separately) 

The corporation named below hereby elects under section 936(e) of the Internal 

Revenue Code to be treated as a possessions corporation for income tax purposes. 

Name of corporation Employer identification number 

Number and street Date of incorporation 

Crty or town, State and ZIP code Place of incorporation 

Business code number I Principal business activity Principal product or service 

Number of shares 

Description of each class of stock of each class issued and outstanding 

The following information must be submitted for each shareholder owning 10% or more of the issued and outstanding stock of 

any class: 

......____Name of sh a reholder Identifying number 

Eleq1 day on is made for the taxable year beginning (month, • Year) 

Address 

Date corporation commenced busi· 

ness in a U.S. possession 

Class of stock Number of shares owned 

Annual return will be filed for the taxabla year 

ending (enter the month or "unknown") 

Un de Of my k r Penalties of perjury, I declare that I have been duly authorized by the above named corporation to make this election and that the statements made are to the best 

nowledge and belief, true, correct, and complete. 

~ ....... ·----..... -- ...... --. -- -------- ---- -·--------- -- . --- ----· . --- -. -- --.......... . ---- .. . -- ...... . -- -- --.. -. -- -- . -- .. and title of officer oaie·-------··--------------------

Form 5712 (Rev. 2-80) 
Instructions 

Who Can Elect 

Only domestic corporations can elect to be treated 

as possessions corporations. 

When to File 

Form 5712 must be filed on or before the later of the 

followin~ dates: 

(a) the due date (including extensions) of the first 

return to which the election is to apply, or 

(b) April 8, 1980. 

Where to File 

File this form with the Internal Revenue Service 

Center, Philadelphia, PA 19255. File separately from 

your regular income tax return. 

U.S. Possessions 

For purposes of section 936, U.S. possessions 

include Puerto Rico but not the Virgin Islands. 

Period of Election 

The election applies to the first taxable year for 

which such election has been made and for which the 

domestic corporation qualifies under section 936(a). 

This election may be revoked for any taxable year 

beginning before the expiration of the 9th taxable year 

following the taxable year for which such election first 

applies only with the consent of the Secretary. For any 

taxable year beginning after the expiration of such 9th 

taxable year, this election may be revoked without the 

consent of the Secretary. 

Form 5735 

For every year for which an election under section 

936(e) is in effect, you must complete Form 5735, corn· 

putation of Possessions Corporation Tax Credit Allowed 

Under Section 936, and attach it to your income ta~ 

return. 

Consolidated Returns 

A corporation may not join in filing a consolida~ed return for any year for which an election under section 

936(e) is in effect. 

Business Classification 

Refer to the Codes for Principal Business Activit~ 

and Principal Product or Service in the Instructions f~) 

Form 1120 and enter the (1) business code number, ( r 

principal business activity, and (3) principal product 0 

service. 

Identifying Number . 

The identifying number for individuals is the'~ 

social security number. For all others it is their employe 

identification number. 

Signature 

This form must be signed by the president, vict~ 

president, treasurer, assistant treasurer, chief accoun 

ing officer, or other corporate officer (such as tax officer) 

who is authorized to sign. 
on 

or 

ir 

er 

e 

t· 

r) 

Form 5735 <Rev. January 1979) 

D

1 

•Plrtment of the Treasury nternal Revenue Service 

Computation of Possessions Corporation 

Tax Credit Allowed Under Section 936 

..... Attach to your tax return. 

For calendar year 19 .......... or other taxable year beginning ............................ , 19 .......... , and ending ............................ , 19 .......... . 

Name I Employer identification number 

·;JM·- Gross Income in Applicable Period 

Taxable year (Use a separate line for each taxable year Periods in which trade or ending with or within your Name of U.S. possession business was actively conducted applicable period, starting In which trade or in a U.S. possession 

with the earliest such taxable business was actively (Oates are inclusive) 

year. See instruction B.) conducted - Beeinnlng Ending From- To-

<•> (b) (c:) (d) <•> -

-

-

- Gross income during periods shown in columns (d) and (e) 

-

,, Gross income from the active conduct of a trade All other gross income 

or business within a U.S. possession Gross qualified 

- posssession From From all From source sources other sources From sources From all other From sources investment within sources within within U.S. sources with· within income 

possessions out the U.S. the U.S. U.S. without the possessions the U.S. U.S. 

(f) (S) (h) (I) O> (k) (I) 

-

-

-

-

ii 

~ 

-

l Total gross income in applicable period (add totals of columns (f) through (I)) 

2 Gross tncome in applicable period from sources within U.S. possessions (add totals of columns (f), (i), and (j)) . 

3 Line 2 divided by line 1 (if less than 80%, do not complete Part II) 

4 Gross income from the active conduct of a trade or business within a U.S. possession (total of columns (f), (g), and (h)) . 

~ine 4 divided by line 1 (if less than 50%, do not complete Part II) 

~••- ·-~-- Computation of Section 936 Credit 

6 Qualiifniead gproossssesinscioonmsetirnadceurorernbtuyseianre:ss . i--1·····--I 

(a) From sources without the U.S. from the active conduct of a trade or business within a • 

(b) U.S. From possession sources without . the U.S. from sale or exchange of substantially all of assets used ·---· 

(c) Gross qualified possession source investment income . •-------~ ··--

(d) Less: Amounts received in the U.S. . ~ -

(e) Total (add lines 6(a), 6(b), and 6(c) and subtract line 6(d)) • 

7 Applicable deductions (attach schedule): -· 

(a) Definitely allocable deductions (see instructions) I --~ (b) Ratable part of deductions not definitely allocable =======-=--=--=--=--=-~: R 

(c) Total (add lines 7(a) and 7(b)) . • . • . . . . . . . . . . . . . . . • . . 

8 Qualified taxable income before loss adjustments (line 6(e) less line 7(c)). If loss, do not complete below . 9 

Loss adjustments (attach schedule): •• 

(a) Current year losses from non-qualified sources ••• 

Cb) Recapture of prior year overall foreign losses i-------i • 

(c) Net capital loss or short term capital loss adjustment (see instructions) . -

(d) Total (add lines 9(a), 9(b), and 9(c)) • . 

~O Qualified taxable income (line 8 less line 9(d)) • . • . . . . . . . . . 1 Total taxable income from all sources (enter taxable income from your tax return) 

:: Less: Adjustments to taxable income from all sources (see instructions) . 

14 S~btract line 12 from line 11 . • . . . • . • . . . . . . . . . • 

15 Line 10 divided by line 13 . • . • . . • • • . . . . . • • . . . 

16 Tota.I U.S. income tax against which section 936 credit is allowed (see Instruction E) . 

~ct1on 936 credit (line 14 multiplied by line 15). Enter here and on your tax return . . ..... 
Instructions 

(References are to the Internal Revenue Code) 

A. Corporation Required to File Form 5735.-Form 5735 

must be completed and attached to the income tax return of 

any domestic corporation for which an election to be treated 

as a possessions corporation under section 936(e) is in effect. 

8. Qualifications for Section 936 Credit (Section 936(a)).-

To qualify for the section 936 credit, a corporation must: 

(1) make a valid election under section 936(e) on Form 

5712, Election to be Treated as a Possessions Corporation Under Section 936; 

(2) have derived 80 percent or more of its gross income 

from sources within a U.S. possession during the appli· 

cable period immediately preceding the close of the 

taxable year; and 

(3) have derived 50 percent or more of its gross income 

from the active conduct of a trade or business within 

a U.S. possession during the applicable period imme· 

diately preceding the close of the taxable year. 

Generally, the "applicable period" is the lesser of 36 months 

or the period during which the corporation was engaged in the 

active conduct of a trade or business within a U.S. possession. 

C. Ineligible Corporations.-A corporation is ineligible for 

the section 936 credit in any taxable year in which it is a DISC 

or former DISC, or in which it owns at any time stock in a DISC 

or former DISC. (Section 936(1).) 

D. U.S. Possessions.-For purposes of section 936, U.S. 

possessions include Puerto Rico but not the Virgin Islands. 

(Section 936(d)(l).) 

E. Taxes Against Which Credit is Allowed.-The section 936 

credit is allowed against income tax imposed by Chapter 1 but 

not against any: 

(1) minimum tax for tax preferences imposed by section 56; 

(2) tax on accumulated earnings imposed by section 531; 

(3) personal holding company tax imposed by section 541; 

(4) additional tax imposed for the taxable year under sec· 

tion 1351 (relating to recoveries of foreign expropriation losses); 

(5) increase in tax under section 47 (relating to dispositions 

of investment credit property); 

(6) increase in tax under section 50A(c) (relating to early 

termination by an employer in a WIN program); and 

(7) tax on certain capital gains of electing small business 

corporations imposed by section 1378. 

F. Qualified Possession Source Investment lncome.-Qualified possession source investment income is gross income 

(less applicable deductions) from sources within a U.S. possession in which a trade or business is actively conducted which 

you establish to the satisfaction of the Secretary is attributable 

to investment in such possession (for use therein) of funds 

derived from the active conduct of a trade or business in such 

possession, or from such investment. (Section 936(d)(2).) 

However, income derived from any source outside the U.S. 

from investment of such funds is "qualified possession source 

investment income" if you establish to the satisfaction of the 

Secretary that the income was ear.ned before October l, 1976. 

See temporary income tax regulation 7.936-1 concerning 

certain deposits in Puerto Rico banks and other financial in· 

termediaries which may earn qualified income. 

G. Computation of Qualified Taxable lncome.-

(1) General Source Rules.-The determination of gross in· 

come, applicable deductions, and taxable income within and 

without the U.S., and within a U.S. possession must be made 

in accordance with sections 638 and 861 through 864. 

(2) Income from the Sale or Exchange of Substantially All 

of the Assets of a Possession Corporation.-Taxable income 

from sources outside the U.S. from the sate or exchange of 

substantially all of the assets used by a possessions corpora· 

tion in the active conduct of its trade or business is qualified 

taxable income. 

(3) Carryover Basis Property.-Qualified taxable income 

does not include income from the sale or exchange of any as· 

set if the basis of the asset is determined by reference to its 

basis in the hands of another person. However, if the basis of 

the asset is determined by reference to its basis in the hands of 

another person to whom section 931, 936, or 957(c) applied 

for the entire period the asset was held, then taxable income 

from the sale or exchange of such asset may qualify. (Section 

936(d)(3).) 

(4) Amounts Received in the U.S.--Gross income received 

in the U.S., regardless of source, may not be taken into account 

as income from sources without the U.S. (Section 936(b}.) 

(5) Certain Foreign Taxes.-No deduction (or foreign tax 

credit) is allowed for any tax paid or accrued to a foreign coun· 

try or U.S. possession with respect to qualified taxable income. 

(Section 936(c).) 

(6) Current Year losses.-lf you sustain a loss for the cur· 

rent year in the U.S. or on any type of income for which a sep· 

arate foreign tax credit limitation applies, allocate the toss to 

qualified taxable income in proportion to the ratio of qualified 

taxable income to total taxable income (excluding the toss). 

(7) Recapture of Prior Year Overall Foreign losses.-lf in 

any taxable year beginning after December 31, 1975 you sus· 

tain an overall foreign loss, the loss is recaptured in succeed· 

ing taxable years by treating some portion of your taxable in· 

come from sources without the U.S. as income from sources 

within the U.S. (Section 904(f).) 

H. Adjustments for Capital Gains and Losses.-

line 7(a).-lf the corporation had foreign source capital 

gain net income that is included on line 6(e), enter on line 7(a), 

in addition to the other definitely allocable deductions, the .rej 

duction for the "rate differential portion" of the net capita 

gain included on line 6(e). (See section 904(b)(2).) 

Line 9(c).-lf the corporation has any net capital loss °' 

short term capital loss from qualified sources outside the. u.s.t 

to the extent taken into account in determining capital gain n~, 

income, the loss, decreased by the "rate differential portion 5 of the excess of net capital gain from non-qualified sour~eh 

over net capital gain, is used to reduce income against wh\ 

the credit is allowed. Enter on line 9(c) this reduction and a 

tach computation. 

Line 12.-lf the 

0

taxable income of the corporation includ~5 

income from the sale or exchange of capital assets in line 1 et 

enter the reduction for the "rate differential portion" of n 

capital gain. 

I. Coordination with Foreign Tax Credit.-Qualified ~axa~I: income is not taken into account in computing the foreign a 

credit limitation. (Section 904(b}.) 

J. Where to File.-Attach Form 5735 to your tax return a~ad file it with the Internal Revenue Service Center, Philadelphl ' 

PA 19255. 

-

C
form 1120 

Oe11utment of the Treasury lntern1I Revenue Service 

Check if aA. Consolid1ted return D 

I. Person1I Holding Co. D 

C. Business Code No. (See P•re 8 of Instructions) 

Use 

IRS 

label. 

Otherwise 

please 

print 

or type. 

U.S. Corporation Income Tax Return 

For calendar year 1980 or other tax year beginning 

.. . ...................... ...... ..... .... , 1980. ending ................................................• 19 ....... . 

Name 

Number and street 

City or town, State, and ZIP code 

~®80 D. Employer identific1tion numlMr 

(see Specific Instructions) 

E. Date incorpor1ted 

F. Total 1ssets (see Specific Instructions) 

$ 

1 (a) Gross receipts or sales $ ...................•.• (b) Less returns and allowances $ ................•......• Balance ~ 

2 Cost of goods sold (Schedule A) and/or operations (attach schedule) • • • • • • • • 

1 ( c) ---------------------··· 2 

3 3 Gross profit (subtract line 2 from line l(c)). • • • • • • • • • 

4 Dividends (Schedule C) • • • • • • • • • • • • • • • 

5 Interest on obligations of the United States and U.S. instrumentalities • 

6 Other interest • • • • • • • • • • • • • • • • • • • 

• . --------------------------· ----- 4 

• . -----------------------· ----- • • • 

• • • • • • _6_ -------------------· . ---- 7 Gross rents • • • • • • • • • • • • • • • • • • • • • 

8 Gross royalties • • • • • • • • • • • • • • • • • • • • 

9 (a) Capital gain net income (attach separate Schedule D) • • • • • • . • 

• • • • • 7 ----------------- -----

• • • • 8 --------------------· ·---- • • • 9(a) -----···---------·-----· --··- (b) Net gain or (loss) from Form 4797, tin~ ll(a), Part II (attach Form 4797). • • 9(b) --------------------·-·· ----- 10 Other income (see instructions-attach schedule) • • • • • • • • • • • • • • 10 

_ 11 TOTAL income-Add lines 3 through 10 • • • • • • • • • • • • • • • 11 ~:--~~~~~~~~~~~~~~~~~~---=:..._~----------------------------------------- -----1----------------1---

12 Compensation of officers (Schedule E) • • • • • • • • • • 12 

13 (a) Salaries and wages .............................. _ 13(b) Less WIN and jobs credit(s) ----·---- Balance ~ 13(c) ••••••••••••••••••••••••.••••• 

14 Repairs (see instructions) • • • • • • • • • • • • • • • • • • • • • • 14 ·····-·········--······ 

15 Bad debts (Schedule F if reserve method is used) • • • • • • • • • • • • • • • 15 

16 Rents • • • • • • • • • • • • • • • • • • • • • • • • • • • • 16 ~~~:::::::=::::::::~~:~· ~--:-~ 17 17 Taxes • • • • • • • • • • • • • • • • • • • • • • • • • 

18 Interest • • • • • • • • • • • • • • • • • • • • • • • • 

. -----·----·---------------· ·----

19 Contributions (not over 5% of line 30 adjusted per instructions-attach schedule) • 

20 Amortization (attach schedule) • • • • • • • • • • • • • • • • • 

21 Depreciation from Form 4562 (attach Form 4562) ••...•.••..••••••••••••••••••••••••••••. , less depreciation 

18 

19 

20 

------------------------ ·---- ------------------------· ...... 

claimed in Schedule A and elsewhere on return ........................................................ , Balance ~ ~ ___ _ 

22 Deplet1·on • • • • • • • • • • • • • • 22 ···-····-·------··-·---- • . . . . . . . . . . . . --------------------------· ---- 23 Advertising • • • • • • • • • • • • • • • • • • • • • • • • • • E_ ------------------------- ---· 24 Pension, profit·sharing, etc. plans (see instructions) • 

25 Employee benefit programs (see instructions) • • • 

24 . --------------------------· ---- 25 . --------------------------· --- 26 Other deductions (attach schedule) • • • • 

27 TOTAL deductions-Add lines 12 through 26 • 

26 

27 

28 

29 

Taxable income before net operating loss deduction and special deductions {subtract line 27 from line 11) • • 

less: (a) Net operating loss deduction (see instructions-attach schedule) • • i 29(a) l·----·-------------·---- 28 

(b) Special deductions (Schedule I) • • • • • • • • -· 2_9_(_b_) _______ 1_2_9_.

1 ________ 1 __ ~O Taxable income (subtract line 29 from line 28) • • • • 30 ~~~~~~~~--=:..._~~~~~~~~~~~--'-----~------------------------~----------1 

31 TOTAL TAX (Schedule J) • • • • • • • • • • • • • • • • • • _3_1_ 

32 

r:n::.0 .:::~:.::~~~·::;::::~ 9 ;,: ~!::::: ~:, ·::·:~:~ 44:66 : I:~::::::::::::::::::::~ (d) Tax deposited: form 7004 ...................... Form 7005 (attach) ... ·-················ Total ~ 

(e) Credit from regulated investment companies (attach Form 2439) • • 

(f) Federal tax on special fuels and oils (attach Form 4136 or 4136-T) • 32 

33 TAX DUE (subtract line 32 from line 31). See instruction C3 for depositary method of payment. _3_,3....,.....,..

1

...,._,.,,..,.,..,,..,.,.,.,._,.,__,..,.,.,.,.- 1,.,_ 

(Check .... O if Form 2220 is attached. See instruction D.) ~ $ ................................................ .. ~ ~ 34 OVERPAYMENT (subtract line 31 from line 32) ~ • • • • • • • _3_4_ 1 

_________ 1 __ 

~ Enter amount of line 34 you want : Credited to 1981 estimated tax> Refunded • 35 

Under penalties of pequry, I declare that I have examined this return, including accompanying schedules and statements. and to the best 

of my knowl edge and belief, 1t 1s true, correct, and complete. Declaration of preparer (other than taxpayer) 1s based on all information of Please 

Sign 

~~----T-:~~S~1g~n~a~tu~r~e~o~f_o~H~1~c~c~r---------------------------------------D.;...;.at~e-i-1~~~:_~,t;1e;:;::::_-_-::;~---::::::_-::::::::::::::::::::::::::::_-_-.: Pa'td P_reparer's ~ I Check if I Preparer's social security no. 

which preparer has any knowledge. 

signature self-em· 

Preparer's and date ployed ~ 0 i i 

Use Only Firm's name (or ~ I E.I. No. ~ yours, if self-employed) ------------------------------------------- -Z--IP_c_o_d_e-..._--------"~----------- .....____~------a-n_d_a_d_d_r_es~s;_., __________________________________________________________ ...,: _________ ~-------------------------
Form 1120 (1980) --~rr.tmrw:w Cost of Goods Sold (See Instructions for Schedule A) 

1 Inventory at beginning of year • 

2 Merchandise bought for manufacture or sale • 

3 Salaries and wages • 

4 Other costs (attach schedule) • 

5 Total-Add lines 1 through 4 • 

6 Inventory at end of year • 

7 Cost of goods sold-Subtract line 6 from line 5. Enter here and on line 2, page 1 . . . . . 

Page ~ 

--------------~----· 

8 (a) Check all methods used for valuing closing inventory: (i) O Cost (ii) O Lower of cost or market as described in Regulations section 1.471-4 (see 

instructions) (iii) O Writedown of "subnormal" goods as described in Regulations section l.471-2(c) (see instructions) 

(b) Did you use any other method of inventory valuation not described above? • D Yes O N° 

If "Yes," specify method used and attach explanation ................................................................................................................. . 

(c) Check if this is the first year LIFO inventory method was adopted and used. (If checked, attach Form 970.). . 0 

(d) If the LIFO inventory method was used for this tax year, enter percentage (or amounts) of closing in· 

ventory computed under LIFO. 

(e) Is the corporation engaged in manufacturing activities? • 

If " Yes," are inventories valued under Regulations section 1.471-11 (full absorption accounting method)?. 

(f) Was there any substantial change in determining quantities, cost, or val1.1ations between opening and closing inventory? • 

If "Yes," attach explanation. 

Schedule C Dividends (See instructions for Schedule C) 

1 Domestic corporations subject to 85% deduction 

2 Certain preferred stock of public utilities • 

3 Foreign corporations subject to 85% deduction • 

D Yes 

D Yes 

D Yes 

____________________ ....... 

---------------------·· 

_____________________ ..... 

4 Dividends from wholly-owned foreign subsidiaries subject to 100% deduction (section 245(b)) • 

5 Other dividends from foreign corporations • 

. ------------------ . --------------------

__________________ ,,,. ..... .. 6 lncludibte income from controlled foreign corporations under subpart F (attach Forms 3646) • 

7 Foreign dividend gross-up (section 78) • . -----------------·--·· 8 Qualifying dividends received from affiliated groups and subject to the 100% deduction (section 243(a)(3)) • 

9 Taxable dividends from a DISC or former DISC not included in tine 1 (section 246{d)) • 

-------------------.. 

--------------.. ---- 10 Other dividends 1 

_____ __.._ 

11 Total dividends-Add lines I through 10. Enter here and on line 4, page 1 . ~ 

iiii;:iiiiiiiiiiiiiiiiiiiiiiiiiiiiim-1"::-=::::::::-::7:~~tl'i~::::-:-;-;:-tc:::-;::;-~;:-+;;-::::-;-;:::-;,-i~!;;::-;::;-.,.-;:~------------'------­

.~ ..... :t1~:tt~·~m-t1 .... ~~-- ·~C-o _m~p-e_n_s_a _t i_o_n_o~f~O_ff_i c_e_r_s_(~S_e_e_1_n_s_t r_u_c_t _1 o_n~f o_r_l_i n~e~l-2_)~~~~~~~--~-~--~------

1. Name of officer 2. Social security number d~~o[~:J1~o Perce~:oc ~ ~~~eo;ation 6. Amount of 1. ExfM!nse account 

business 4. Common S. Prefrrred compensation allowances ~~~~~~~~~~~~~~~1-~~~~~~~~~~1-~~~-1-~~~-1-~~~~1:~~~~~~~-1-~~~~----

................. -·------------------... ------- ........... -------- ------------... ·------------ ............. -----..... ---------.. ... .. _________________ ........ .. 

·------------------------·--------··-------···---- ·---------------------------------· ------------· ------------- ------------- ----------------------. ---------·------____ , .... 

----------------------------·---... ---------·------ . ------------------------· --------· ·------------ ------------- ·------------ -------------------.......... ----------------

----------------------

--------··:r;t:-~i-~-~~-P~-~~~ti;·~

~~~~~~~B~ad~D_e_b_t_s_~-:-R_e_s_e_rv_e~M_e_t_h_o_d_(~S~e_e~in_s_tr_u~c~t~1o~n:-:-:;fo Schedule F 

~1-~iti~-~~~=[-~i~·;·ti-~~~--~-~ci--~~-ii~~-i·2:··P~-g~--i·-------------

r-;--:-l1_n_e_l_5~)~~--.,..~~~~~~~~~-------

·- ···---······ i------ ~ 

Amount added to reserve 7 Reserve for bad debts 

1. Viar z. Trade notes and accounts re- ceivable outstandin2 at end of year 3. Sales on account 4

· c;;~:r ~ear's 1 

1975 

__ s_. _R_eco_v_e_rie_s __ _aAr._~_1~-s~_\_~~-=-~~_:d_ ~ 

1976 

1977 

1978 

1979 

-·-----..... ----· ..... ... ..... -------------·---- -------.. ..... --------.. -----..... . ---------------------------- -------------------....... .. ·---------------------- ------------- _ ................... · 

... -------...... -... -.. ----.. ----.. ------------- ... -----.. -------------------- ------.. ---------------------. -... ----.. ----.. ----------- ... -.. ------.. ------------. . ------------- ----.. -----------------· 

=19=8=0==========--=-~:-:--=--:---'--:-~~~~~~~--:--=-~~~~--~-~~~-~~-~~-'-~~~------

==~=========-s_p_e_c_ia_l_D_e_d_u_c_t_io_n_s........c..(S e_e~in_s_tr_u_c_t_10_n_s_f_o_r_S_c_h_e_d_u_le_I)~~~~~~-~~~~~~~~~~-------

1 (a) 85% of Schedule C, line 1 . 

(b) 59.13% of Schedule C, line 2 • 

(c) 85% of Schedule C, tine 3 . 

(d) 100% of Schedule C, tine 4. 

2 Total-Add lines l(a) through l(d). See instructions for limitation. 

3 100% of Schedule C, tine 8 . 

4 Deduction for dividends paid on certain preferred stock of public utilities (see instructic"'!s) • 

5 Total special deductions- Add lines 2 through 4. Enter here and on line 29(b), page l . 

... _________________ .... -.. -

. ______________ ......... --.. ---

.~ -----------------.. ---" __ ........... 

. ·==-====== 

1 

2 

3 

4 

s 

6 

7 

A 

G 
2 

ts 

-·· 

-·· 

Form 1i20 (19901 Page ~ 

PffitmtWI Tax Computation (See instructions for Schedule Jon pages 6 and 7) 

1 Tcr1Ca°bae income (line 30, page 1) . 

2 (a) Are you a member of a controlled group? • D Yes O No 

(b) If "Yes," see instructions and enter your portion of the $25,000 amount in each taxable income bracket: 

(t) $ .............................. (ii) $ .............................. (iii) $ .............................. (iv) $----·-·······-··············-

3 Income t~ (see instructions to figure the tax; enter this tax or alternative tax from Schedule D, whichever 

4 (a) 

is less). 

Foreign 

Check 

tax 

if 

credit 

from Schedule 

(attach Form 

D .... 

1118) 

O . 

. • • • • 

. . . . . . . . . . . -

(b) Investment credit (attach Form 3468) • 

(c) Wodc incentive (WIN) credit (attach Form 4874) • • 

(d) Jobs credit (attach Form 5884) • 

5 Total--Add lines 4(a) through 4(d) • • • 

6 Subtract tine 5 from line 3 • • • • • • • • • • • • • 

7 Personai holding company tax (attach Schedule PH (Form 1120)) • 

8 Tax from recomputing prior-year investment credit (attach Form 4255) • • 

9 Minimum tax on tax preference items (see instructions-attach Form 4626) • 

!O Total tax-Add lines 6 through 9. Enter here and on line 31, page 1 

. . . . . . . . ·1---------

a111mnmtw~• Record of Federal Tax Deposit Forms 503 

(list deposits in order of date made-See instruction C3) 

Date of deposit Amount 

----------------------------------! .. --------------------------- ·---------------------------- ~--D-at_e_o_f _d_epo_s_it __ 1 ____ A_m_o_u_nt ___ 1 

__ o_a_te_of_d_e_p_os_it __ 1 ____ A_m_ou_n_t ___ 1 ____________________________ ·------------------------·---

.._,.. ____________________ . ----------------------------- ·-------·---.. --------------- ----------------------------- ---------------------------- -----------------------------

------------••• • • •••• •• • • ·••••••-••••••••-••----------• ------------.. P•• ·---------' • ••••••••••••-• --------------· • • --------•-••••• --------••• • -------••-•••••• • • • • •••••• •• 

Additional Information (See page 7 of instructions) 

G (l) Did you claim a deduction for expenses connected with: 

(a) Entertainment facility (boat, resort, ranch, etc.)? • 

(b) living accommodations (except employees on business)? • 

(c} Employees attending conventions or meetings outside the 

U.S. or its possessions? • • 

{d) Employees' families at conventions or meetings? • 

If "Yes," were any of these conventions or meetings outside 

the United States or its possessions? • 

(e) Employee or family vacations not reported on Form W-2? • 

Yes No 

(2) Enter total amount claimed on Form 1120 for entertainment, ~ ~ 

entertainment facilities, gifts, travel, and conventions that re- I~ quires substantiation under section 274(d). (See instructions.) ~I 

t-t U> td-·you··3·t-·i11e-·eriC1- -<>r -i11e--tax_-Y_ear_o_wii,--ciireci1Y-·<>r-· ·ii1cii-.-- I~ rectly, 50% or more of the voting stock of a domestic corpo- ~ ~ ration? (For rules of attribution, see section 267(c).) • 

If "Yes," attach a schedule showing: (a) name, address, and 

identifying number; (b) percentage owned; (c) taxable 

income or (loss) (e.g., if a Form 1120: from Form 1120, line 

28, page 1) of such corporation for the tax year ending 

with or within your tax year; (d) highest amount owed by 

you to such corporation during the year; and (e) highest 

amount owed to you by such corporation during the year. 

(2) Did any individual, partnership, corporation, estate or trust at 

the end of the tax year own, directly or indirectly, 50% 

or more of your voting stock? (For rules of attribution, see 

section 267(c).) If "Yes," complete (a) through (e) • 

(a) Attach a schedule showing name, address, and identify- ~ ~ . mg number; (b) Enter percentage owned ............................ :W. ~~ W 

(c) Was the owner of such voting stock a person other than ~ ~ a U.S. person? (See instructions.) • 

~~-"Yes," enter owner's country ..... ----·-----------------------·- ~ 

cu)-E~;;;-;;i;h;;;-~;;,~~~;-~~;d--b;-;~~ -;~-;~-;h-~~;;-,--.;;;; ;~- -1 

(e) :;,~•;i'_:;,;-~-~-~; ;;-~~;d-;~ -;~~-b;- -;~;~ -~~~-;;-;~-,;;;-1 

(~~~ for ~:.::~;-~·;;;---;~~-~(;;·.---.:~;~~;;~--;~~;;;·-~:;~:.--,1 ll<fes Joans .and accounts receivable/payable.) ~ 

I Did you ever declare a stock dividend? • • . . . . J Taxable income or (loss) from Form 1120, line 28, page l, for 

your tax year beginning in: 1977 ................................. _ .................. , 

1978 ............................................ , 1979 ·····································-··· .. 

K If you were a member of a controlled group subject to the provisions of section 1561, check the type of relationship: 

(1) D parent-subsidiary (2) D brother-sister 

(3) D combination of (1) and (2) (See section 1563.) 

L Refer to page 8 of instructions and state the principal: 

Business activity _________ -------------------- ________________ -------·_ -_. 

Product or service ••.. -----------·- _______ .. ·----------·.----··-······--. 

M Did you file all required Forms 1087, 1096, and 1099? . • . • 

N Were you a U.S. shareholder of any controlled foreign corporation? (See sections 951 and 957.) If "Yes," attach Form 3646 for 

each such corporation 

O At any time during the tax year, did you have an interest in or a 

signature or other authority over a bank account, secur!ties account, or other financial account in a foreign country (see instructions)? • • . • • • . • • . • . . · · 

P Were you the grantor of, or transferor to, a foreign trust which 

existed during the. current tax year, whether or not you have any 

Yes No 

II 

beneficial interest in it? • ~ ~ 

If "Yes," you may have to file Forms 3520, 3520-A or 926. ~ ~ Q During this tax year, did you pay dividends (other than stock 11 

dividends and distributions in exchange for stock) in excess of I~ 

your current and accumulated earnings and profits? (See sections 301 and 316.) • - ~ 

~r,;;v~:;· ;;';,;o~:,:~~:i- ;r :::s ~~ ',:s;:~~t:~it'.::;;~; ~:~:~'. '~~· •· 

ule, for each subsidiary. I~ 

R During this tax year was any part of your tax accounting records 

maintained on a computerized system? . 

S (1) Did you elect to claim amortization (under section 191) or 

depreciation (under section 167(0)) for a rehabilitated certified historic structure (see instructions for line 20)? • 

(2) Amortizable basis (see instructions for line 20): 

II 

II 
Form 1120 (1980) 

Schedule L Balance Sheets Beginning of tax year End of tax year 

(A) (8) (C) (D) 

ASSETS 

•• ~--························--~~-----····d . -------------------------- - --------------------------- ------~---~ 1 Cash • • • . . . . . . 

7 Mortgage and real estate loans • • • 

8 Other investments (attach schedule) • 

9 Buildings and other depreciable assets • 

(a) Less accumulated depreciation • 

10 Depletable assets • • • • • • • 

(a) Less accumulated depletion • 

. . 

. --------------------------~ 

-------------------------··· ---------------------------- - ~ 

11 Land (net of any amortization) • • • 

12 Intangible asse~ (amortizable only) • • 

1 Net income per books • • • • • • • • • ··------------------------

2 federal income tax • • • • • • • • • • ---------------·----------

3 Excess of capital losses over capital gains • • • • ························--

4 Income subject to tax not recorded on books this year 

(Itemize)··-········-----·----------··-----·-······-·--

I Expenses recorded on books this year not deducted In 

this return (itemize) 

(•) Depreciation • • • • • $ .•••••••••••••• _._ 

(b) Contributions carryover • • $---··---···········-

7 Income recorded on books this year not included in this return (itemize) 

(a) Tax-exempt interest $ ________________ _ 

8 Deductions in this tax return not charged 

against book income this year (itemize) 

(a) Depreciation • • • $------···-····-

(b) Contributions carryover • $-·--·----·-··-·· 

___________________ ...... 

----------------------------------------------- , ____ ___.,,.. ·-·------------------------------------------------------- 9 Total of lines 7 and 8 • • • • 1 ____ ___ 

6 Total of lines 1 through 5 . • • • • 10 Income (line 28, page 1)-line 6 less 9 • • 

Schedule M-2 _A_n_a....:_lys_is_of_U_n_a..:...:pp:..._r--=op~r_ia...,....te_d _R_et_a_in_ed_Ea_r-=-ni--=ng==..:s_P_e_r ....:....B_oo~k_s -=.(_lin-=-e-=2:......:4_a:....:b-=-ov.:....:e~) ---------

1 Balance at beginning of year • • • • • • • 

2 Net Income per books • • • • • • • • • 

3 Other Increases (itemize)·············-·······'{·--·-·· 

----------------------------------------------------

----·----------------------------------------

5 Distributions: (a) Cash • • • • • • -----·------------······· 

(b) Stock • • • • • • -------------------······ 

(c) Property • • • • • --·-------------···· 

6 Other decreases (itemize>----·----·----· 

------·---------------------------------------- , ____ ___..,,.. _ •-----• 7 Total of lines 5 and 6 • • • • 1 ____ __..-.--

4 ------T~t~i-~'f-ii~;;-i·2:-~;d·;-:----.----.----.----~---. 8 Balance at end of year (line 4 less 7) • • • .......,,....,, 

n 

.

3 
4 

torm 940 ~tlllrtment of the Treasury 

ntern11 Revenue Service 

If incorrect, 

l"l'lake any llrlri... 

llecessary r 

change. 

r 

L 

Employer's Annual Federal 

Unemployment Tax Return 

Name (as distinauished from trade name) Calendar Year 

1980 

Tr1d1 name, if any Employer identification number 

Address and ZIP code 

~®80 

T 

FF 

FD 

FP 

T 

~ Did you pay all required contributions to your State unemployment fund by the due date of Form 940? . . . . O Yes O No 

a If You check the "Yes" box, enter amount of contributions timely paid to your State unemployment fund . . ~ $ ___________________ ._! ______ _ Are you required to pay contributions to only one State? • • • • • • • • • . • • • • • • • • • • • D Yes O No 

If You checked the "Yes" box, (1) Enter the name of the State where you are required to pay contributions. • • ~ --··---------------------------· 

~your State reporting number as shown on State unemployment tax return . . . . . . . . . ~ !YMiil Computation of Taxable Wages and Credit Reduction (To Be Completed by All Taxpayers) 1 lotal payments (including exempt payments) during' the calendar year for services of employees . . 

~ Exempt payments. (Explain each exemption shown, attaching additional sheets if Amount paid 

llecessa ry) ~ ----------------------- _________________________________ ------------------------------------- ___________________ . ____ --· 

a·····----------------------------------------------·----------------------------------------------------·-------- ---------------------------.. -. --- Payments for services in excess of $6,000. Enter only the excess over the first $6,000 paid to individual 

• 

S 10

ernployees 

tal exempt 

exclusive 

payments 

of exempt 

(add 

amounts 

lines 

entered 

2 and 

on 

3) 

line 

• 

2. 

• 

Do 

. 

not 

• 

use 

. . . 

State wage 

• 

limitation 

• . . . 

. . . 

• . • • • • • • • • 

•9.1 

~I 'total taxable wages (subtract line 4 from line 1). (If any portion is exempt from State contributions, see instructions) • . ~ 6 

State wages included on line 5, Part I (d) IL ............................ x .003 ............................... (h) PR .............................. x .003 ............................. . 

(a) CT •. ·-························· x .007 •............................. {e) ME. ............................ x .003 .............................. {i) Rl. .............................. x .006 .............................• 

Cb) Dt ............................. x .006 •............................. {f) NJ. ............................. x .003 •............................. G> vr .............................. x .006 ............................. . 

) ~c) DC .............................. x .006 .............................. (g) PA. ............................. x .006 .............................. {k) VI.. ............................ x .003 •............................• 

~; 6(a) through 6(k). {Enter total on line 2, Part II or line 4, Part Ill, as appropriate) . . . . . . ~ 

~ Tax Due or Refund (Complete if You Checked the .. Yes" boxes in Both Items A and B Above) 

l tUTA 

~Crees 

a lot 4 a 

less 

S 8a1 6 a 

tax. Multiply the wages on line 5, Part I, by .007 and enter here • 

it reduction. Enter amount from line 7, Part I • 

I FUTA tax (add lines 1 and 2) • . : Total FUTA tax deposited from line 5, Part IV. 

nee due (subtract line 4 from line 3-if over $100, see Part IV instructions). Pay to IRS • 

~ ~ Tax Due or Refund (Complete if You Checked the .. No" Box in Either Item A or Item B Above) 

Payment (subtract line 3 from line 4) • 

~ ~oss FUTA tax. Multiply the wages on line 5, Part I, by .034 • • • 

a E axirnum credit. Multiply the wages on line 5, Part I, by .027 • • • • . I • C nter the smaller of the amount on line 11, Part V, or line 2, Part Ill • red·t s C 1 reductions. Enter amount from line 7, Part I • • • • • • 

6 ~/edit allowable (subtract line 4 from line 3) • • • • • • • • • • • • • • • • 

et FUTA t . . ) l ax {subtract lane 5 from lane 1) • • • • • • • • • • • • • • • • . Q ~ss: Total FUTA tax deposited from line 5, Part IV. • • • • • • • • • • • • • 

9 °"~ance due (subtract line 7 from line &-if over $100, see Part IV instructions). Pay to IRS • 

-~ 

-~ 

1-·· 

-

-~ 'iii:•nt (subtract line 6 from line 7). . . . . . . . . . . . . . . . . . . . .... 

Record of Federal Tax Deposits for Unemployment Tax (Form 508) (Do not include contributions paid to State) 

1 ~ b. Liability for quarter c. Date of deposit d. Amount of deposit 

I. ~~ 

~~ 

~~ 

~ lf-y:a

1 

~TA tax deposited (add column d, lines 1 through 4) . . . • . • • ~ . ~I 

IJ 

--

I 

' '"d th:: Of P1r1ury, I declare that I have examined this return, includina 1ccom111nyin1 schedules and statements, and to the best of my knowl1d11 and blh1f, 1t 1s true, correct, and com· ~ no Plrt Of any payment made to a State unemployment fund claimed 11 a credit was or is to be deducted from the payments to employHS. 

~ ... ::~: not have to file returns in the future, write "Final" here (see general Instruction "Who Must File") • .. 

~ 

~ ____________ ...;.;.:~~--------------------------------_;..;,.;...;.;;_;..;.;..;..;..;...;. Slpatura ~ Titl• (Owner, etc.) ~ ______________ __ 
Form 940 (1980) Page 2 

l:/til'M Computation of Tentative Credit (Complete if You Checked the "No" Box in Either Question A or Bon Page I-See Instructions) 1

;

0

·rn 

State Contr1but1ons •art 1f Contr1but1ons pay St1te reporting number(s) State experience rate period Add itional Contributions Taxable p1yroll experi· rate had been able at experience N1me of St1te as shown on employer's credit (col. 6 actu1l ly p11d ence 2.7% (col. rate (col. State contribution returns (IS defined in State 1ct) 4 minus col. 7) to State rate 3X2.70/o) 3xcol. 5) 

1 2 3 From- To- 5 6 7 8 9 

i-o--i--~t~-1~--:--------- ----- ---- -- :-~--i------l ~~j'%,~;f:fi*"df ~W~ 

1-~~~~...:._~~---

11 Total tentative credit (add line 10, columns 8 and 9-see instructions for limitations) • • .... 

1. Household Employers: You do not have to 

file this form unless you paid cash wages of 

$1,000 or more for household work in any calendar quarter in 1979 or 1980. 

2. Household and Other Employers Who File 

Form 940: If your total Federal unemployment 

(FUTA) tax for 1980 is not more than $100, you 

do not have to deposit the tax. If you do not 

have to deposit ~UTA tax and you: 

(a) made all required payments to your State 

unemployment fund, 

(b) are required to make payments to the unemployment fund of only one State, and 

(c) paid wages subject to Federal unemployment tax that are also subject to State unemployment tax, 

complete Parts I and II. Otherwise, complete Parts 

I, Ill, and V. 

3. Employers Who Are Required to Deposit FUTA 

Tax: If you meet tests (a), (b), and (c) above, 

complete Parts I, II, and IV. Otherwise, complete 

Parts I, Ill, IV, and V. 

General Instructions 

Purpose of Form 940.-Use it for the annual reporting of tax under FUTA. This tax is 

paid only by the employer. The gross tax rate 

is 3.4% (.034) on the first $6,000 of wages 

paid to each employee during 1980. 

Who Must File.-ln general, every employer who during 1979 or 1980 (a) paid 

wages of $1,500 or more in any calendar 

quarter or (b) at any time had one or more 

employees for some part of a day in any 20 

different weeks must file. Count all regular, 

temporary, and part-time employees. A partnership should not count its partners. If 

there is a change in ownership or other 

transfer of business during the year, each 

employer who meets tests (a) or {b) above 

must file. But neither should report wages 

paid by the other. Organizations described in 

Code section 50l(c)(3) do not have to file. 

As an agricultural or household employer, 

you must file Form 940 if any of the following apply to you: 

(1) You paid cash wages of $20,000 or 

more to farmworkers during any calendar 

quarter in 1979 or 1980. 

(2) You employed 10 or more farmwork· 

ers during some part of a day (whether or 

not at the same time) for at least one day 

during any 20 different weeks in 1979 or 

1980. Count aliens admitted to the U.S. on a temporary basis to perform farmwork in 

1980 (after 1980, in the current or preceding 

year) to determine if you meet either of the 

above tests. However, wages paid to these 

aliens are not subject to FUTA tax until 

1982. 

(3) You paid cash wages of $1,000 or 

more in any calendar quarter in 1979 or 

1980 for household work in a private home, 

local college club, or a local chapter of a college fraternity or sorority. Note: See Form 

942 for a definition of household work in a 

private home. 

If you receive a form and are not liable 

for Federal unemployment tax for 1980, 

write "Not Liable" across the front and return it to IRS. If you will not have to file 

returns after this, write "Final" on the line 

above the signature line. 

Once you have filed a Form 940, we will 

send you an addressed form near the end 

of the year. If vou do not receive it, ask for 

one from an IRS office in time to file. 

Due Date.-Form 940 for 1980 is due by 

February 2, 1981. However, if you made 

timely deposits in full payment of the tax 

due, your due date is February 10, 1981. 

Where to File.-

If your principal business, office, or agency 

is located in 

New Jersey, New York City and 

counties of Nassau, Rockland, 

Suffolk and Westchester 

New York (all other counties), 

Connecticut. Maine, 

Massachusetts, New Hampshire, 

Rhode Island, Vermont 

Delaware. District of Columbia 

Maryland, Pennsylvania 

Alabama, florida, Georgia, 

M 1ssissippi, South Carolina 

Michigan, Ohio 

Arkansas. Kansas. Louisiana, 

New Mexico, Oklahoma, Texas 

Alaska, Arizona, Colorado, 

Idaho, Minnesota, Montana, 

Nebraska, Nevada, North Dakota, 

Oregon, South Dakota, Utah, 

Washington, Wyoming 

Illinois, Iowa, 

Missouri. Wisconsin 

California. Hawaii 

Indiana, Kentucky, North 

Carolina, Tennessee, 

Virginia, West Virginia 

File with the Internal 

Revenue Service 

Center at 

,,.. 

Holtsville, NY 00501 

Andover, MA 05501 

Philadelphia, PA 19255 

Atlanta, GA 3110 l 

Cincinnati, OH 45999 

Austin, TX 73301 

Ogden, UT 8420 l 

Kansas City, MO 64999 

Fresno, CA 93888 

Memphis, TN 37501 

If you have no legal residence or principal place 

of business in any IRS district, or if your principal 

place of business is in Puerto Rico or the U.S. 

Virgin Islands, file Form 940 with the Internal Rev· 

enue Service Center, Philadelphia, PA 19255. 

Employer's Name, Address, and Identification Number.-Use the addressed Form 

940 mailed to you. If you must use a nonaddressed form, type or print your name, 

trade name, address, and employer identification number on it. 

Penalties and lnterest.-Avoid penalties 

and interest by making tax deposits when 

due and filing a correct return and paying 

the proper amount of tax when due. The law 

provides penalties for late deposits and late 

filing unless you show reasonable cause for 

the delay. If you are late, attach an explanation to the return. 

There are also penalties for willful failure 

to pay tax, keep records, make returns, 

and for filing false or fraudulent returns. 

Taxpayers who willfully claim credit for ded 

posits not made are subject to fines an 

other criminal penalties. 

Credit for Contributions Paid into State 

Funds.-You can claim credit for amounts 

you pay into a certified State (including 

Puerto Rico and the U.S. Virgin Islands) un· 

employment fund by the due date of Forni 

940. 

"Contributions" are payments that Stat~ law requires you to make to an unemplo~ ment fund because you are an employe ~ 

These payments are "contributions" onlYd~· the extent that they are not deducted or 

ductible from the employees' pay. 

You may take credit against the,, ta~ whether or not you paid amounts for e~. ployment." You may not take credit for vo5

t 

untary payments or for penalties or intere 

payments to a State. 

Credit for payments you make after. t~: due date (or extended due date) for f~l~he Form 940 may not be more than 90% o if 

amount that would have been allowa~ete· you had paid the amounts by the due a 

· nee If you have been granted an experie for 

rate lower than 2.7% (.027) by a State en· the whole or part of the year, you are t 15 

titled to an additional credit. This cred 1 aY" 

equal to the difference between actual ifeen ments and the amount you would have 

required to pay at 2.7%. e 

111 or The total credit allowable may not be 

than 2.7% of taxable wages. _,. Special Credit for Successor Employer~·uc· 

If you are claiming special cred.1 t as :oz<e) cessor employer, see Code section 3 t 0r for the conditions that you must mee ' 

contact an IRS office. 

Specific Instructions 1 d part · All filer:; must complete Quest~ons_ A, B. an 1 00e 

Use Part 11 if you pay contributions to ~/ pat 

State unemployment fund, you made all Stfi of the 

ments by the due date of Form 940, and a lo rnent 

FUTA wages are subject to the State's unemP J 

fund taxes. Otherwise, complete Parts 111 and ·

3

r iS 

Complete Part IV if your total tax for the ye 

more than $100. 

d credit Part !.-Computation of Taxable Wages an 

Reduction 1 

e tota 

Line 1-Total payments.-Enter t~ng tile 

payments you made to employees du;~xable· calendar year, even if they are. n?t 5 fee~· Include salaries, wages, comm1ssionnts paid 

bonuses, vacation allowances, amou es an1 

to temporary or part-time employed ~1ott1 

the value of goods, lodging. foodd a2uctions 

ing. Enter the amount before any e t if11" s no How the payments are made 1 wageS· 

portant in determining if they _ar~worK or Thus, you may pay wages for p1ec ~} ge .,. 

(Instructions continued on pa 

~ 
' Annual Federal Employer s t Tax Return 

Unemploymen '''"'"'"' )f ~ u ~=~ 1980 . mb" ra ~ 

~®80 

Employ" ldoolm"h"t ~ r u 

due date o f Form 940? . 0 No 

J__ ,.. ----~--[fv~~----0 No . . 

ment fund by the , loyment fund . . . to your Sta te unemploy . I aid to your State unemp • • . • • • • 

~ re uired contnbut1ons t contributions time y p . • • . • contributions. Did you pay all q " b x enter amount o I one State? • . • • re required to pay . . . . 

h "Yes o • . s to on Y here you a . . ers) II You check t e ay contribu!ton of the State w ent tax return . I .t d by All Taxpay n Are you required to P (1) Enter the name State unemploymt. n (To Be Comp e e . 

"Yes" box, s shown on d't Reduc 10 t employees • . 

~,.. If (2) You checked the e reporting number a Wages and Cre I ear tor services o Amount '"' Enter your Stat tation of Taxable ) during the calendar Y . . al sheets if 

•• -......... Compu t payments h·ng add1t1on """"• · exemp attac 1 

l 

~ (including t ' n shown, __ _ Total payments . ch exemp 

10 

(Explain ea ------·· . . • 1 E:xernpt payments. -------------------- - 'd to individual ... ----------------- ------------------ the first $6,000 pat . necessary) - ---------------- 1 

the excess over limitatmn • • 

-------------- 000 Enter on Y se State wage . ns) 

. ------------------. ·n excess of $6, . n line 2. Do not u . . ns see instruct10 .. x .003 ............ .. 

l Payments for services ' t amounts entered o f om State contnbut10 , (h) PR............ . x .006 -----·-·····--· 

· e of exemp d 3) • . ·s exempt r 

: :::;:Y:::~:~s;aymen~b:;:c~ ::~:~ ~r:: line l\~; :~y ~ .. ~i~n 1 

• : :~~~ : • ~; ~ . : ••• : ·~~: : 

•Total taxable wages (s line 5, Part t (e) ME.. .......................... x .003 ............ -- ............ · (k) Vl... ................ j.:: 

6 State wages included _ ... on x (f) NJ. ............. ----- 006 ··············------. ··t···)·- . . .007 ............ ... .. ...... x . propna e · (a) CT..................... x .006 ................... (g) PA ................ :--· 4 Part Ill, as ap A and B Above) 

(b) DE 

---··· ···- P rt II or line , . Both Items ............ · ...... x 006 ....................... on line 2, a "Yes" boxes m 

~es ) (c) DC .................... ·- ·gi, 6.(k). (Enter tot~lte if You Checked the 6(a) throu Refund (Comp e , . Tax Due or 
Form 940 (1980) Page 4 

M:lttil'M Computation of Tentative Credit (Complete if You Checked the "No" Box in Either Question A or Bon Page I-See Instructions) ___ State Contributions if Contributions pay· State reportini number(s) Name of State as shown on employer's State contribution returns 

Taxable payroll State experience rate period experi· Additional rate had been able 1t experience credit (col. 6 (as defined in State act) ence 2.7% (col. rate (col. 4 rate 3X2.7%) 3xcol. 5) minus col. 7) 

5 6 7 8 

io -i-~t~i~---:--------------------.--~--l-----l~~~§~~~ ---l-----

=1~1~T~o~ta~1~t~e~n~ta~t~iv~e~c=r~e~d~it~<~a~d~d:....:.:.;1in~e:....:1~0~,~c~o~1u~m.:.:.:.:.ns::....:s~an~d::...:~;.._~s~ee;::_;,in~s~t~ru~c~t~io~n~s~t~o~r~1~im,:.;.:.:it~at~i~o~ns~);_;_.__;___;;.._.;__.....:....-=-.....;.·~~:;:__...,:_~~~~~~--'----

as a percentage of profits, and you may pay 

wages hourly, daily, weekly, monthly, or 

yearly. You may pay wages in cash or some 

other way, such as goods, lodging, food, or 

clothing. For items other than cash, use the 

fair market value at the time of payment. 

Line 2-Exempt payments.-"Wages" 

and "employment" as defined for FUTA purpose:; do not include every payment and 

every kind of service an employee may perform. In general, payments excluded from 

wages and payments for services excepted 

from employment are not subject to tax. You 

may deduct these payments from total payments only if you explain them on line 2. 

Enter such items as the following: 

(1) Agricultural labor if you (a) paid cash 

wages of less than $20,000 for such labor 

for each calendar quarter in 1979 and 1980 

AND did not employ 10 or more farmwork· 

ers during any part of a day during any 

20 different weeks in 1979 or 1980, OR (b) 

paid wages to aliens admitted to the United 

States on a temporary basis to perform 

farmwork before 1982. 

(2) Benefit payments for sickness or in· 

jury under a worker's compensation law, 

insurance plan, and certain employer plans. 

(3) Household service if you paid cash 

wages of less than $1,000 in each calendar 

quarter in 1979 and 1980. 

(4) Certain family employment. 

(5) Certain fishing activities. 

(6) Non-cash payments for farm work or 

household services in a private home that 

are included on line 1. Only cash wages to 

these workers are taxable. 

(7) Any other exempt payments or 

services. 

For more detailed information, see Circular E, Employer's Tax Guide (Rev. 11-78). 

Line 3.-Enter the total of the amounts 

you paid each employee in excess of $6,000. 

For example, if you have 10 employees 

whom you paid $8,000 each during the year, 

enter $80,000 on line 1 and $20,000 on line 

3. The $6,000 wage limitation is for FUTA 

purposes only. Do not use the State wage 

limitation for this entry. 

line 5--Total taxable wages.-lf any part 

of these wages is exempt from State unem· 

ployment taxes, you must fill out Parts 111 

and V, even if you checked questions A and 

B "Yes." 

Line 6.-Enter any FUTA wages subject to 

the unemployment compensation laws of 

Connecticut, Delaware, District of Columbia, 

Illinois, Maine. New Jersev. Pennsylvania, 

Puerto Rico, Rhode Island, Vermont, or Virgin Islands. (If in doubt, ask your local IRS 

office.) Multiply the wages by the appropriate rate. This adjustment is required by 

Internal Revenue Code section 3302(c)(2). 

If no wages are subject, enter "none" on 

line 7. 

Part 11.-Tax Due or Refund 

Use this part if you made payments to only one 

State by the due date of Form 940, and all your 

wages shown on line 5 of Part I are subject to the 

State's unemployment fund taxes. The tax rate of 

.007 gives you credit for your payments to your 

State's unemployment fund. 

Part 111.-Tax Due or Refund 

Use this part if you do not qualify for Part 11. 

line 3.-Enter the smaller of (1) line 11, 

Part V-Total tentative credit, or (2) line 2, 

Part 111-2.7% of taxable FUTA wages. This 

is the maximum credit allowable for your 

payments to the State unemployment fund. 

line 4.-Enter the amount from line 7, 

Part I. Subtract this amount from line 3, 

Part Ill. The result on line 5 is your net allowable credit for payments to the State un· 

employment fund. 

Part IV.-Record of Federal Tax Deposits 

Complete this part if your total tax (line 

3, Part II or line 6, Part Ill) is over $100. To 

figure your FUTA tax liability for each of the 

first 3 quarters of a year, multiply by .007 

that part of the first $6,000 of each employee's annual wages you paid during the 

quarter. Enter this amount in column b, 

Liability for quarter. 

The total of column b must equal your 

total tax. Otherwise, you may be assessed a 

failure to deposit penalty computed on your 

average liability. In columns c and d, be sure 

to enter the date and the amount of the 

deposit you made for each quarter. 

If the amount subject to deposit (plus any 

undeposited amount of $100 or less for any 

earlier quarter) is more than $100, deposit it 

by the last day of the first month following 

the close of the quarter. 

Your liability for the 4th quarter is the 

total tax (line 3, Part II or line 6, Part Ill) 

minus amounts deposited for the year. If 

this is over $100, deposit the entire amount 

by January 31. If it is $100 or less, you can 

either make a deposit or pay it with your 

Form 940 by January 31. 

If you deposited the proper amounts, following these rules, the balance due with 

Form 940 will never be more than $100. 

Deposit Federal unemployment tax in an 

authorized financial institution or the Federal Reserve Bank for your area according 

to the instructions on the back of a preinscribed Federal Tax Deposit (FTD) Form 508 

which must accompany each deposit. 

Preinscribed FTD Forms 508 are mailed 

to you around the end of March for your use 

throughout the year. The number of cards 

you receive is based on your history of payments during the previous two years. If you 

do not r~ceive a supply of cards or ne:~ more than the number sent to you, you c 5 order cards by telephoning the toll-free I~. number for your area or by writing the See· 

ice Center where you file Form 940. Your~­ quest should show your name, address, e '/. 

ployer identification number, the kind of%-

(FUTA), the tax period ending date (Dece d 

ber 31), and the number of cards you nee · 

Part V.-Computation of Tentative Credit 

Complete this schedule if: (1) You made pay~t:i~s; to the unemployment fund of more than one the 

(2) You did not make your State payments ~y to 

due date of Form 940; or (3) Any wages sub1ec!ate 

federal unemployment tax were exempted from _Since 

unemployment taxes. If you have a State experie use 

rate lower than 2. 7% for all or part of th~ year, ate, 

columns 1 through 9. If you have no experience ~e of 

use columns 1, 2, 3, and 9 only. If you have a ra nlY· 

2.7% or higher, use columns 1, 2, 3, 4, 5, and 9 ° aYlf you have an experience rate on part of your9

Pthe 

roll, show separately in columns 1, 2, 3, and were 

part that the rate does not apply to. If you ear 

granted an experience rate for only part of th~ Ythe 

or the rate was changed during the year, enter '"rate 

appropriate columns the period each separate1 ibU· 

applied to, your payroll rate, and required con r 

tions for each period. 

state Column 1.-Enter the name of the U 5. or States (including Puerto Rico and the ·aY 

Virgin Islands) that you were required to P 

contributions to. g rfn Column 2.-Enter the State repo 1

01.J 

number that was assigned to you whegt~te· registered as an employer with your 

I that Column 3.-Enter the taxable payrol ent 

you must pay taxes on to the unernploY~pe· fund of the State in column 1. If your et of 

rience rate is zero, enter the amoun011 if 

wages that you would have had to paY 

the rate had not been granted. ·ence Columns 4 and 5.-Your State expen oLJf 

rate is the rate at which the State taxes Y5eS· 

payroll for State unemployment purP~irTle 

This rate may be adjusted from time to state 

based on your "experience" with the and 

fund, that is, based on the number en· 

length of claims for unemployment c_orTlfthe 

sation by your former employees againsnt3ct 

fund. If you do not know your rate, co 

your State employment security agencY· . co. 1 

Column 8.-Subtract the amount '"enter umn 7 from column 6. If zero or less, 

tri• 

Column 9.-Enter the amount of co~. butions actually paid into the State fun 

. e 10. 

Line 11.-Add the total of tin it tor 

columns 8 and 9. The allowable cred di.le 

State contributions you make aft~~ theforf11 

date (or extended due date) for f1l1ng credit 

940 may not be more than 90% of the 11ad 

that would have been allowed if you date· 

paid the State contributions by the due 
Department of the Treasury 

Washington, D.C. 20220 

Official Business 

Penalty for Private Use, $300 

SPECIAL FOURTH 

CLASS MAIL